How Are You Judged By an Angel Investor?

Article originally posted here by Paparelli

The following was said to me by an entrepreneur about an angel investor. This statement says a lot about this entrepreneur’s expectations.

I do believe he is correct.

Angel investors enjoy “the ride.” The experience and the excitement of being part of commercializing a new idea. But over time, “the ride” changes.

In the very early stages, this ride is focused on figuring out who buys the product and why they buy it. The entrepreneur always thinks the answer to these two questions is intuitive. But it doesn’t take long to discover the answer to these questions comes slowly.

This journey of product-market fit, as it is called, should be part of the angel investor playbook. The more competent the angel in this discipline, the more successful the investment. The more competent and patient the entrepreneur in this discipline, the more successful the entrepreneur.

This is the art of the start.

The trick to getting to product-market fit is to do it as cost-efficiently as possible. If the entrepreneur loads up on overhead thinking he already has the answer to these two questions and doesn’t, then he will burn investor money.

And this is where the friction begins between the entrepreneur and the angel. When the money is leaving the building faster than investors expect revenue to grow, tensions rise.

So who is responsible for these rising tensions?

I believe it is the entrepreneur.

It is up to the entrepreneur to set expectations properly for the revenue pace of the business. During the product-market fit stage of the business, this is almost impossible to do. Experienced investors and experienced entrepreneurs know this is the case. And this is why valuations are so low for a seed investor. No one really knows how long it will take to figure this out.

Customers buying the product is the early evidence of the end of product-market fit. (I say this because the product-market fit process never ends. It just enters new stages the deeper the market penetration.)

Now valuations are based on revenue projections.

These early revenue projections are difficult. If they are too low and easily attainable, then the valuation of the next seed round will likewise be lower. If they are high, then the valuation is high and so are the investor expectations.

Most entrepreneurs choose higher revenue projections to justify higher valuations and less personal dilution. When this happens, entrepreneurs need to realize they better get close. The first miss might be as high as 30% off projections. But after this first investor grace period, the gap between the entrepreneur projections and actual revenue must begin to narrow quickly.

Consistently missed projections make for high drama.

This is drama between the entrepreneur and investors. And this makes sense. Based on what the entrepreneur told investors about future performance, a valuation was agreed to for the investment. Then the expectation set was missed. This leads to doubt in the investor’s mind.

Doubt in the entrepreneur.

Doubt in the team.

Doubt in the valuation.

And in the midst of all this doubt created by another missed revenue projection, more money must be raised to keep the company going. Because of increasing revenue, the entrepreneur believes the valuation should also increase. The investor, on the other hand, believes the valuation should stay the same because the revenue projections were missed.

Angel investors are along for the ride in the early stages of a business. But then, as time marches on, it becomes more and more about the money.

An entrepreneur’s competence is eventually measured by how well he meets his revenue projections. The initial revenue projection is the first few buyers. Then the first $250k. Then $500k. Then $1mm.

And you know what, it never ends. The entrepreneur that hits these revenue milestones as projected is a hero. There is great investor confidence in this entrepreneur. He tells investors what he is going to do and does it. Wonderful.

But the challenges don’t end there.

Once the entrepreneur achieves the $1mm annual recurring revenue threshold, he then becomes a real CEO. As the CEO of the investor funded business, he must continue to make revenue, and now profit projections, that he and the team must achieve. Miss them and doubt will set in.

This cycle continues even in public companies, especially in public companies. Miss the revenue and profit projections and the company valuation will take an immediate hit. And the CEO’s leadership begins to be questioned.

Yes, we angel investors are along for the ride. But the ride changes as the company’s valuation increases. The stakes get higher and so do the investor expectations.