The investment process
There’s a common misconception amongst angel investors that the investment process is some quick and efficient undertaking. We’ve managed to close an investment deal in two weeks but that was a complete outlier. Most investments take longer than you’d like, at least that’s if you do it right. On average its a 4 to 8 week process but it could take months particularly when syndicated. In this blog we explore the various steps of the investment process which will hopefully iron out some creases in your journey.
1. Choosing a startup
Our previous blog explored the factors that you should consider when finding a suitable startup. Obviously, the first step is to find a match. Investment options can be found through a range of channels including a referral through an entrepreneurial network, networking events, angel investor websites or engaging at various innovation hubs. See our blog on Jo’burg’s list of hubs for more on this.
2. Light Due Diligence
Once you have chosen the startup that ticks all your boxes, it is time to ensure that the appearance of the startup meets reality. A more thorough due diligence will follow. This part of the process involves digging a bit deeper to confirm the business is a fit for you. During this phase you’ll work through a detailed pitch deck or business plan and meet with the founding team to get to know the people you’ll be backing. Here’s a blog on the questions you could ask at this point.
Some investors tend to switch 3 (negotiation) and 4 (due diligence) around. The reason for doing the negotiation first is that this is often where deals break down. As a result we always advocate for getting on the same page first and then fact checking through a due diligence. The process generally begins with the issuance of a term sheet followed by various discussions between the investor and entrepreneur. The term sheet is a non-binding agreement that lays out the basic terms and conditions under which the investment will be made.
Negotiation is often described as the interactive process of creating value. To do this, Chris Voss in his book Never Split the Difference, promotes the use of tactical empathy. This involves developing empathy for the person you’re negotiating with by asking calibrated, open-ended questions - these are “what” and “how” questions. It's then a case of getting them to understand your perspective.
For the deal junkies negotiation is the best part of every investment. Your negotiation experience depends on your objective, perception, communication, persuasion and personality. Negotiating investment deals can be uncomplicated or complex, easy or difficult, enjoyable or painful.
Let’s start with what you need to aim for - you should never go into negotiations blindly. Economics and game theory contrasts two types of engagements: zero sum situations versus positive sum situations. In zero sum situations, one person can only gain resources or win, if somebody else gives up his/her resources or loses. It is the ultimate battle for the biggest piece of pie and one can only advance their position if somebody else loses out. This is distinguished from positive sum situations where the size of the entire pie is increased so that everybody can get a bigger piece. With positive sum engagements, both sides end discussions with a net gain. Both the investor and the entrepreneur need to gain simultaneously and should ultimately gain more by co-operating.
Why are negotiations such a big deal? Well, the investment opportunity being discussed is not a once-off interaction where both parties walk away afterwards; it is rather a long-term partnership that should bring value to the table for both parties. This long-lasting partnership needs honesty and integrity from both parties to be sustained. Both parties must be completely straightforward, open and honest in their interactions from the start to set a good foundation for a functional partnership.
4. Performing Due Diligence (DD)
DD involves fact checking the information shared and identifying the risks with a potential investment. There are three primary areas of assessment:
Business - An assessment of the company, its financials, the team and how they fit in to the landscape;
Legal - A review of the business’ contractual of obligations; and
Tech (where applicable) - An inspection of the infrastructure used to bring the solution to life.
So you are probably asking yourself: Why does due diligence even matter? Is it not just a technical requirement that should be left for the lawyers to handle? Well, a study done by Willamete University in Oregon showed that angel investors who spent over 20 hours performing due diligence prior to making an investment choice, had twice the likelihood of success, when compared to those who spent fewer or no hours on due diligence. Due diligence, therefore, does not only increase the success rate, but will enhance the quality of the information available to the decision maker (investor) ensuring a well-informed decision.
Syndication is becoming more popular in our market, it makes deals more accessible and allows investors to spread their capital further, resulting in greater diversification. It is the act of clubbing together to invest in an opportunity. For more on the benefits and challenges of syndication please read our blog on the topic.
There are several ways of structuring a syndicate, one is to create a special purpose vehicle (SPV) where all syndicate members are shareholders of the SPV. At Jozi Angels we use a syndicate agreement which governs the relationship between syndicate members. It offers all the benefits of syndication without the running costs and layers of admin of an SPV.
Execution is the proverbial handshake where the deal terms are processed. This stage can be rather complex as it involves completing all the documentation, it's where the deal details are presented for the first time. While the high level terms are agreed during the negotiation process, the investment agreement is where the DD remedies are put forward and where the legalese is dialed up. Along with the syndicate agreement, one of the following legal agreements are executed on:
Note purchase agreement in the case of investing via a convertible note;
Subscription agreement in the case of purchasing shares through the issuance of new shares; and
Share purchase agreement in the case of purchasing shares from an existing shareholder.
6. Post-investment activities
The journey of the angel investor does not just come to a halt after the execution stage. You bring three things to the table, capital being the starting point of discussions, but it's often the knowledge and the networks that add the most value. Angel investing is not a passive asset class, getting involved will help you de-risk your investment and improve the chances of success. The same is true for a small investor tagging along or the lead investor who shoulders most of the workload.
Your involvement in the startup can range from daily check-in calls to receiving periodic investor updates. The appropriate combination of support is dependent on where the business is at and the requirements at the time. Angel investors play a variety of roles, including: advisor, mediator, director, mentor and match maker.
It is however very important to establish a balance between supporting versus micromanaging and becoming ‘too involved’ with the day-to-day running of the business. Remember: you’ve invested money behind an entrepreneur and his/her particular vision, skills and team, and therefore need to have some faith in the process. Don’t be that helicopter investor where your involvement becomes intrusive, rather than helpful.
There are two primary differences between this process at that of a venture capital (VC) transaction. Firstly, a VC transaction involves an investment committee, usually after the DD process. Secondly, a VC DD process involves a number of different employees and consultants. As an angel you’re expected to do most of the work yourself and it's therefore important that you educate yourself on the various steps involved.