By Ricky Richards
// STEP 1
Identifying ideas with enormous upside potential.
The principal that underlies all angel investing is that of upside optionality. Upside optionality can be defined as the property of asymmetric upside with correspondingly limited downside. When looking for ideas to invest in, it is under the assumption that most companies will ultimately fail (90+%) but that the ones that succeed will more than make up for the companies you invest in that fail. Many of the biggest successes in the last decade appeared to be unlikely to succeed when they first started, AirBNB, Robinhood and Uber are some examples that come to mind. All had huge hurdles on their path to becoming successful, making them more likely to fail than succeed. But if you were an early stage investor in any of these companies at the seed stage, by the point of their IPO you may have made upward of 1000X return on your initial investment. This is what makes investing in private companies so appealing, you only have to be right once. That said, there are many kinds of businesses, some of which are profitable but unlikely to return venture level returns. Below is some suggestions to the kinds of identifiers you should look for in companies that have a lot of upside potential
// CONCEPT 1 – DEEP PAINS
Ideas that address a deep pain point that people are prepared to pay for to resolve. If the pain point is frequent enough, it is possible to charge less and more often to resolve the problem, but if the problem is limited to a minority, then the solution will need to command a higher margin to reach that audience and scale.
// CONCEPT 2 – DEMOCRATIZATION
If a product or technology can give everyday people access to desirable options that were previously only accessible to the ultra-wealthy, then it is likely that these advancements will be embraced.
// CONCEPT 3 – SHOVEL SELLERS
When a movement is occurring, look for companies who are providing the underlying infrastructure to allow these changes to take place. The modern-day equivalent of shovel sellers during the gold rush.
// CONCEPT 4 – PARADIGM SHIFTS
Paradigm shifting ideas are unexpected; they question fundamentals and propose new normals. These ideas should have enough novelty to capture the imagination and be compelling enough to drive behavioral change.
// CONCEPT 5 – SECTOR PIONEERS
Some emerging sectors are inevitable and they attract a lot of noise, so picking the right company is difficult. That said, it is only a matter of time before a standout company breaks through. Look for companies who are able to articulate and package complicated ideas in ways that people can readily understand and use.
// STEP 2
Finding the right founder
I don’t prescribe to the belief that there has to be at least two founders, but I do believe a single founder must be technical, because as someone smarter than me once said…
Vision without execution is an illusion.
Founders should preferably be an engineer, product designer or sales individual and they must also have secured the talent to complement their shortfalls. Other factors I look for include…
// FOUNDER QUALIFIERS
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Integrity and honesty
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A reputation among other smart people
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A strong vision
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Long term thinking
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A rabid desire to win
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A background of making
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Taste and a bias toward quality
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Leadership qualities/personableness
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Uniquely qualifiable insider knowledge
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Ability to move and iterate fast
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Evidence of thriving in inverse conditions
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The ability to learn from mistakes/feedback
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Thoughtful and decisive decision-makers
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The ability to sell to investors
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Clear communication skills
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Ability to build a reputable team
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A fulfilment that derives from work
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Rational and calm demeanor
// STEP 3
Sector Trends
Where possible, I look for companies entering into growing sectors. Particularly sub-segments of the economy that are expected to account for a larger portion in the future. The reason for this is that exponential growth is more likely to occur with the momentum of a rapidly growing sector, as opposed to trying to grow in a pre-existing, stagnant or dying space.
If entering a pre-existing sector, I make sure it’s not a sector that is in decline and then I look to invest in innovative startups that are taking one of two approaches.
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They’re challenging a slow incumbent in a multi billion-dollar market.
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They’re monopolizing a niche market to enter other verticals at a later date.
// EXAMPLES OF GROWING SECTORS
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Blockchain Technologies
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BioTech
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Preventative Health
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Consumer Finance
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Education Technology
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Augmented & Virtual Reality
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Food Tech
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Eco Alternatives
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Digitalization of goods
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Access over ownership
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Work Decentralization
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eSports
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Convenience Tech
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Mobile / Home Fitness
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Personal Brands & Solopreneurship
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Secondary Markets
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Artifical Inteligence
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Personal Transportation
// STEP 4
Markets
After assessing the sector then I then look to do a deeper dive into the specific market conditions the company is entering. Is there competition? Is that a good thing, or is it a sign that this is not needed? Is there a big incumbent that owns the majority of the market like Google in search? Or is it a fragmented and multi-faceted industry like direct to consumer fashion?
The distribution of the players in a market and the quality and size of the competitors is vitally important. Are you facing a slow incumbent but one that is embedded? Or are you competing for price in a growing sector but with an undifferentiated product? Finding a market with favourable conditions for growth is a huge advantage as competition is one of the greatest battles founders will face.
// FAVORABLE MARKET CONDITIONS
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No competition but with a validated product need.
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Competition is untechnical incumbents ripe for tech disruption.
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Opportunities that emerge out of organic community growth.
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Proprietary technology or I.P. that provides a first-mover advantage.
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Access to insider infrastructure that is difficult for others to obtain.
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Largest capital stockpile in a winner takes all space.
// STEP 5
Product
Never invest in a company that doesn’t already have a minimum viable product. This is a test to see if founders are capable of executing their vision. If they pass this initial test, then I’m looking to see how effective their product will be, which requires looking at a number of things…
// 1 – REVENUE
Is the product already driving sales? If so, what type of revenue is the product generating and what are their margins? Are these recurring month over month sales or are they one-off purchases? In either case, how did these sales come about? Were they due to marketing or word of mouth?
// 2 – PRODUCT MARKET FIT
Has the company demonstrated that what they are building is being well received and has positive momentum from the community and their potential customers? Are they getting early signs that people like what they are doing via organic signups and word of mouth?
// 3 – BARRIER TO ENTRY
How hard is it for a customer to access and use the product? Do I think people will do this? Is there a high learning curve or is it incredibly simple and easy? A high bar to entry will deter people from using the product unless the pain point is really bad. But if they can onboard quickly and easily, then it’s more likely to be adopted.
// 4 – PRODUCT INFRASTRUCTURE
Is the product built in a way that can be amended and scaled easily? Entrepreneurs don’t want to find themselves in a situation where legacy code is killing their ability to evolve.
// 5 – QUALITY
Does the product radiate quality? First impressions build trust. If a product does not appear intuitive or it’s clear that corners have been cut, then prospective customers are less likely to trust it with their money.
// 6 – BRAND
Brand is vitally important, not just for trust-building on the customer side but also because talented people have many career options. So if an entrepreneur wishes to attract talent, then creating a desirable brand that people recognize and want to work for is one way to stack the deck in their favour.
// 7 – VIRAL LOOPS & GROWTH HACKS
Have the founders worked out a sustainable way of attracting users to the product that doesn’t just involve throwing buckets of money at the problem? If so, how long can these hacks sustain growth and do they feel authentic or is there an underlying spammy feeling to the mechanic?
// 8 – NETWORK EFFECTS
Does the product become increasingly valuable with the addition of each new user that joins, buys or enters the product? Do we see an adoption rate that grows significantly month over month?
// 9 – STICKINESS
Is this is a product that people use often or sparingly? What are the retention rates? Are people returning over and over again or does the product have a leaky bucket problem?
// 10 – MOATS
Is the product able to defend its position? or is there a risk that competitors can replicate the technology?
// 11 – JEWELRY, ASPRIN OR OXYGEN
Is this a vanity product? Does it resolve a mild pain point? Or is it a must-have essential?
// 12 – TIMING
Is now the right time for this product to exist or is it too early? If the latter, is this likely to be an attractive and sizable acquisition target? Or is there simply no market for the product they aim to create.
// 13 – COMMUNICATION
Does the product do a good job of explaining the value proposition, or is it overly convoluted and difficult to grasp?
// 14 – DISTRIBUTION
How does the product reach customers? Is it expensive to ship or is it free? How many hurdles are there in the distribution of the product? Do they have to deal with import and export and multiple tax and sales laws, or even state laws by region?
// 15 – RETURN RATES
What percentage of people who buy into the product then return it? And what does the company do with returned goods? Is it a net negative or net neutral to the companies bottom line?
// 16 – MONOPOLY VS FRAGMENTATION
How many active competitors are there in the space the startup is entering? Can they monopolize the space and build a significant advantage or are they competing with lots of other players? If there are competitors, why are people going to choose this company over others? Is the difference easy to articulate to customers, or is the complexity overwhelming?
// 17 – SUPPLY & DEMAND
Does the company have high demand? If so, how easy is it for them to fulfil their demand needs? Does the company have to hold inventory or can they can scale up and down with the demands of customers?
// 18 – CONSUMER SURPLUS
What is the difference between the price that consumers pay and the price that they are willing to pay? What wiggle room is there in the event that the price of the product increases due to unforeseen rises in production cost.
// 19 – CUMULATIVE ADVANTAGE
Does the startup have an advantage that will compound over time and lead to an increasingly larger advantage? By contrast, are there any competitors who already have a cumulative advantage that makes the introduction of an alternative unlikely to succeed?
// 20 – LOCK-IN
Are there any inherent hooks in the product that make leaving difficult? Equally, are there any hooks in competitor products that make switching to the new product difficult? Is the startup only relying on new purchasers? Or are they able to convert existing customers elsewhere?
// 21 – ECONOMIES OF SCALE
Can the startup benefit from economies of scale to reduce the long-run average costs of the products they produce? If so, how will that affect the bottom line profit that the business is able to create?
// 22 – MARGINAL COST
How does the cost of making a good change as production increases? What are the fixed and flexible costs? Is there a point at which costs are likely to significantly increase due to the number of orders and how much space is needed to fulfil the company’s production needs?
// 23 – PRICE DISCRIMINATION
Does the startup intend to use price discrimination? ie, have different prices to access the same goods depending on how much the consumer is prepared to pay?
// 24 – PRICING POWER / ELACTICITY
How much pricing power does the company have? Can the price of the product be raised, and people will continue to pay? Or will a small increase in price significantly reduce demand?
// 25 – FREQUENCY
How frequent is the product likely to be used? Is this a product that will be used multiple times a week and become a habit for users? Or is it something that is used infrequently but is incredibly useful?
// 26 – INTELLECTUAL PROPERTY
Does the product do something in a novel way that is able to be patented? If so, does the company already have patents or have they filled to protect their IP and are awaiting results? Even if they do get IP, do they have the means to challenge a competitor in the event the technology is stolen?
// 27 – STRATEGIC RELATIONSHIPS
Does the company have any strategic relationships with investors or partners that will help them to reach their desired audience? If no, why not? Is this a company that influencers want to be associated with?
// 28 – BURN RATES & RUNWAY
Is this a costly business to create? If so, has the company kept on top of its overhead costs or are they burning money at an incredible rate? How much runway does the business currently have and how much additional runway is it likely to have if they’re successful in raising? Does the company have any less obvious expenses? Like huge server costs.
// 29 – CAC & LTV
Does the business know what their customer acquisition cost is? And expected lifetime value? If they’ve worked out a way to acquire customers cheaply, can this be sustained? Are their LTV numbers based on real data or future projections, and are these realistic?
// 30 – GO TO MARKET STRATEGY
What has been the businesses attempts to date to market the product? Are they exceptional quality? Or are they lacking polish? Is this approach likely to work? Or are they burning money on ineffective communication? Is the product getting any form of organic marketing either through word of mouth, press or real-world exposure?
// 31 – SOCIAL PROOF
Has the company been successful in elevating its profile such that it can attract notable press, influencers, awards, accreditation or any other indicator of acceptance among the audience it is trying to reach?
// 32 – ROADMAP & USE OF FUNDS
Why does the company need the money? Do they have a huge list of potential customers waiting to buy, and their only limiting factor is money? Or do they believe their upcoming road map will be the unlock to growth? If the latter, do you believe in the roadmap or is this steering the company in the wrong direction?
// 33 – CUSTOMER FEEDBACK
What are customers saying about the product? Does the company have reviews or case studies with pre-existing clients that can indicate people’s thoughts about the product? if there are negative reviews, is this down to someone seeing the product in an early stage or are the comments valid concerns that the company is addressing?
// 34 – EXIT POTENTIAL
What is the eventual exit strategy for this company? Do they have the growth potential to one day IPO? Or are they a natural target for acquisition? What was the best and worst-case outcomes for similar companies who exited?
// 35 – TRACTION
Are people knocking down the door to get access to this company and is the hypothesis from the founder playing out as expected. Are people talking about and sharing the product with others? And are they seeing enough value to switch to the new product if an existing solution exists?
// 36 – LOW COST OF REPRODUCTION
In Summary
Due diligence is the name of the game, so be sure to validate that the company is providing value by interacting with customers. Where possible, get the opinions from those you trust and that you believe have sound judgment. Lean on other investors to help you, and co-invest with them so that they can identify problems with startups that you may not necessarily see yourself.
Warning Signs
Companies die for all kinds of reasons, but here are some of the biggest warning signs.
// 1 – A LACK OF TRACTION
Does the company lack product-market fit? Is the company having to spend large sums of money in order to acquire customers?
// 2 – BURN RATE
Has the company inflated its expenses or valuation too high without making enough money to make the business sustainable or attractive to investors?
// 3 – FOUNDER MISMATCH
Do the founders lack a mutual understanding of their respective roles in the business? Have they not worked together before or are they not that into the product they’re working on?
// 4 – BEING OUT COMPETED
Is a cumulative advantage benefiting a competitor so much so that it’s making the sustainability of the business impossible?
// 5 – PRICING
Is the price required to make the product profitable such that consumer demand will cease to exist?
// 6 – BARRIER TO ENTRY
Is the product too complicated or requires too much of effort on the part of the customer to make it using it worthwhile? Is the advantage for switching, not big enough to warrant making a change?
// 7 – NO REVENUE MODEL
Does the product have no scalable way of making large sums of money?
// 8 – POOR MARKETING
Is the company producing marketing that is underwhelming and doesn’t live up to the aspirations of the company?
// 9 – BAD TIMING
Is the company too early and doesn’t have a customer or any real-world use case where the product or technology can be utilized?
// 10 – LEGISLATION RISK
Is the company running headfirst into a tricky political or legislative situation that will be hard or impossible to comply with or overcome?
// 11 – MANAFACTURING RISKS
Is the company in control of its manufacturing or is there an existential risk to the company if a supplier or third party went out of business?
// 12 – LITIGATION RISKS
Is the company playing with fire by running the risk of being sued due to intellectual property or copyright infringement?