As Angel Investors Pull Back, Valuations Take a Hit

We have, but hardware doesn't lend itself to small amounts of money. And there are different trajectories depending upon whether you can get 500 thousand, 2 million, or 5 million.

The folks I work with are religious about maintaining a low burn rate. Hardware has a LOT of NRE, and you can get in deep trouble very quickly.

We actually had to be very hard-nosed with customer which we expected to be profitable with about 100K volume (actually kind of the Valley of Death in electronics volume--100K has all the NRE of huge volume without the profitability) because we simply couldn't take the risk with cash we had in reserve. If the customer didn't follow through, the NRE would have killed the company. This is a very different discussion if you have 5 million in the bank.

In addition, while I can't prove it, I suspect that we lost some funding because we're religious about burn rate management. VC's want "Go big or go home" and someone who is managing burn rate well is anathema to this.

(I'm sure you know all of that, by the way, just reflecting on how difficult it would be to convince an investor).

Yes, usually this happens after the terms sheet is signed (and for smaller investments after a letter of intent is signed or a handshake deal is agreed upon). Up to that point it is read as true that everything the founder says will check out.

The due-diligence process is there for two reasons: to fulfill the 'duty to research' for a VC to cover their backs in case a deal goes bad after investment and LPs wonder how the hell they got suckered in like that as well as to simply protect the funds.

For angels the situation is worse here because they don't have the funds or the organization to do this properly.

> What about before?

Typically a VC has a number of analyists that assess the companies that pitch them to see how solid the various commercial claims are. The accent there is usually on the numbers and the commercial side of things, which is reflected in the education of the associates (typically: finance, accounting and/or a bit of legal and commercial).

Angels tend to do this part by themselves.

Angels and VCs do roughly the same thing, only angels do it earlier on (when the risk is higher, companies are cheaper and the deals are much smaller so they can still participate), the biggest difference is dictated by the size of the deals, it limits the amount of money you can spend in order to determine if you spend it wisely.

To make an extreme example: a full legal/commercial/technical/financial dd would cost approximately 100K or so. The bulk of that will be eaten up by the legal portion, the remainder is roughly equally split between the other parts.

If you're looking to plunk down 100K as an angel if you actually did a full DD you'd be out 200K if the deal goes through or 100K if it doesn't, so then there is no point in doing DD at all. Hence my advice to do an abbreviated one scaled down to a portion of the size of the investment, but to definitely look at all these aspects of the company, if possible through the eyes of an outsider.

The other important thing to remember is that doing DD puts a strain on the company you invest in, and if every angel would do a full DD on a company before investing then the company would grind to a halt during their seed round.

Yet another note: for seed investments there usually isn't a whole lot to verify anyway, the company is still tiny, probably has no turnover (so financial dd becomes: look at the model), has very little technology (so tech becomes: look at the proof of concept) and so on. So everything becomes a lot simpler anyway, it wouldn't be possible to do a full process DD on a start-up that has only just become real enough to look for seed funding.

The reason I'm asking is that I keep imagining this picture: suppose there are 20 areas of economy(there are more but bear with me), and each angel knows one area well. Startups come at random from all 20 areas, so for 1 in 20 pitches the investor hears about something he understands deeply, can ask good questions and question assumptions. And so he can make an educated decision. What about the other 19? He can't judge the financials because it's too early. He has to rely on various proxies, such as interest from others (not necessarily any more qualified), the quality of the deck, the looks or pedigree of the founders (PhDs and professors are like really sexy as I found out), and so on. The likely rejection reason then comes out arbitrary, and obfuscated. Few people just say "not my area" before you even start. The startup founders are now wasting their time in 95% of the cases, unless they come with a sexy background and then investors are just piling up.

Wouldn't that be a lot more efficient if investors just referred unknown companies to a buddy who knows the domain area? I don't see it happening. Am I looking in the wrong place?