Many factors go into picking which startups you will select for investment. In this article, I will share the thirteen factors I consider when evaluating angel investment opportunities. At the end, I added a fourteenth bonus consideration, which might be the most important of all.

This article is part of our series on angel investing. You can find all the other articles on this topic here.

Learning to reject companies quickly is one of the most important skills you can develop as an angel investor. You will look at far more companies than you could possibly invest in. That's the only way to find the best candidates. If you don't have ten times more opportunities than money, focus on building your dealflow.

1 – Make a Quick First Cut

Star by eliminating those companies that have significant and obvious issues. Toss companies with absurd valuations, stupid or impractical ideas, or small markets. Get rid of anything that looks like a scam, Ponzi scheme, or snake oil. This often removes more than half of the companies, so you have more time to look at the rest.

2 – Is the Company Angel Investable?

Most companies are not structured to be appropriate angel investments. As an angel, you need the potential for at least 20X returns within the next seven years. That means the company needs to grow fast and be positioned for an IPO or acquisition at a high valuation.

Most companies, even very successful companies, don't look like that, but every company in your portfolio must match that pattern.

3 – Competition

The competitive landscape is a significant factor in the success or failure of a startup.

Is there room in the market for a new entrant? Is the company's solution differentiated and ten times better/faster/cheaper than the alternatives? Will customers switch from their current solution?

4 – Valuation

Is the company's valuation reasonable compared to other startups at the same level of maturity and in similar industries?

Valuations have a massive impact on your returns. If you invest at $4 million rather than $2 million, you halved your returns at exit. If the valuation seems out of line, move on to the next deal.

5 – Problem/Solution Validation

Has the founder done a thorough job of validating the severity of the problem they are solving and the customer's hunger for their proposed solution?

If this is a marketplace, have they validated both the supply and demand sides independently?

Having potential customers express interest is not validation of the problem/solution. You want to see customers actively chomping at the bit. There should be a strong pull from users rather than a push from the founder. Ideally, you want the customers to say, "Shut up and take my money!"

6 – Business Economics

Do the economics of this business make sense? At scale, do the unit economics allow the company to be profitable? Can they sell the service for enough to cover the cost of acquiring the customer and providing the solution?

It is ok if the company loses money on each transaction at the pre-seed stage. You should expect that. Will it work once they get big and have countless customers?

7 – Defensibility

Does the company have a moat or strategic advantage to protect its market? How will they prevent a well-funded fast follower from duplicating their strategy and taking over the space?

This defense could be strong network effects, complex learning, intellectual property protection, etc. But, there needs to be something, or the next company will eat their lunch.

8 – Intellectual Property

Speaking of intellectual property, do they need/have it? Not every company depends on intellectual property protection, but sometimes it is their only defense.

If the company's patents form the core of its value, take a close look. Are the patents just pending, or have they been finalized and issued? Could another company easily engineer around the patent to compete anyway?

Sometimes intellectual property is a strong fortress wall around the business. Other times it is a cardboard box, and the other companies have box cutters.

9 – Need for Additional Funding

Will this company need additional funding before becoming a self-sustaining growth engine? If so, make sure you take the dilution from those future rounds into account when thinking about your potential returns.

Will this round allow them to hit the milestones required to raise that next round at a significantly stepped-up valuation? If that next round is flat, or worse yet, a down round, your dilution worsens. That assumes they can even raise another round if they have not accomplished some important goals first.

10 – What is There?

I see many pitches that talk grandly about their solution, only to discover later that they were describing what they planned to build, not what existed at that time. In many cases, they are raising money with only an early-stage prototype but are trying to hide that reality.

Ask some pointed questions about the current state of the solution. Ensure you understand what capabilities are available now, what will come with this next round, and which are much farther out.

11 – Churn

Keeping customers is far cheaper than acquiring new ones. How is the company doing at holding on to its users? Obviously, this only applies to companies that expect regular repeat business from their customers.

What is their churn rate? What fraction of their user base must they replace each month just to maintain their current size?

It's easy to get people to download an app. I have hundreds of them on my phone, most of which were only used once or twice before I churned off.

If the company doesn't have data showing their users will stick around, you might want to hold off on any investments until they do.

12 – Assumption Validation

Has the founder validated all the assumptions behind their business plan? Any plan is based on many inputs like the cost to acquire users, churn, demand, price sensitivity, technical challenges, competitor reactions, etc.

The founder needs to test and validate all those assumptions to mitigate the risks of backing the startup.

Whenever you find a doubt pop into your mind when listening to the founder, or reading their materials, follow up to see what research or experiments they have done to support their statements. If you find many gaps, or if any are critical, ask them to do more validation before agreeing to invest.

13 – Is this Possible? 

Can this even be done? Many startup business models are fundamentally flawed from their foundations. Sometimes the financial model shows the company will never make money. Other times they assume technological breakthroughs that even far more experienced teams have failed to achieve.

We all want to bet on moonshots, but not on wild dreamers mining for unobtanium.

14 – Team

The team matters more than anything else. These are the people who are going to execute on their exciting plan. Do you think that they can do it?

Do they have the ability to infect other people with their vision? Do they have the technical skills, or a plausible path to finding those people, to pull this off? Do they have the grit and tenacity to go through the difficult times?

The reason the team matters more than anything else is the reality that most startups pivot. If this company is successful, it will probably be doing something entirely different than they described in their pitch deck. All the other information they shared might be irrelevant, but if this is the right team, they can succeed anyway.

Finally:

After a company passes all those tests, it's time to do due diligence. That's when you start digging in deep, looking at all the contracts, all the agreements, the details of the intellectual property, the technical underpinnings of their solution, talking to their customers, and doing your own research. Your success and returns as an angel investor correlate with the time spent on your due diligence.

Until next time, ciao.

Next, you might be interested in this article on getting dealflow as an angel investor.