Readers of last week’s post may have noticed that I left out a fairly large category, most applicable to new angel investors: adverse selection. It’s quite likely that when you start out sourcing your own deals, you aren’t seeing the best opportunities at all. I’m not talking about being left with lemons - even losing access to the top 10-20% of deals (as measured by quality) would be enough to ruin most startup investor returns due to the realities of power law returns.
Let’s dig into the various flavors of adverse selection:
Leftovers
When I started trying to find deals directly rather than through AngelList, I noticed that none of the interest coming inbound (and most of the companies I contacted outbound that responded to me), were startups that later appeared on top AngelList syndicates or TechCrunch articles about funding from well known VCs. And usually I wasn’t getting to chat with them at the very start of their round either (i.e. many other investors had already passed).
This gradually changed over time for the better. I’m not sure anything can be done about it at the very beginning, other than to be conscious of it, apply stringent criteria to making an investment, and embrace a contrarian mindset of looking for diamonds in the rough.
Once I started accessing higher quality deals, and gaining access earlier in the rounds, I still encountered several other types of adverse selection risk:
Speed
There’s a balance point between moving too quickly due to FOMO, and moving so slowly that you miss the best deals. There have been a few times when a startup told me they would take a check immediately, but they hadn’t secured a commitment from a lead investor yet. I told them I wanted to wait for a lead, and when I checked back in with them a few weeks later, the round was closed (either because the lead took the remainder of the round, or because they had other angels in the interim take the remainder without hesitation). Other times, I dragged out the diligence process for too long because I was indecisive, and therefore missed the round.
Check Size
Sometimes I find a high quality deal, and then the founder tells me that they have a minimum check size outside my range (e.g. $50K). A few times, I’ve been able to advertise such unique strategic value to the company that they were willing to lower their minimum for me. But most times, I’ve missed the opportunity. While I think this is a more minor factor overall, I believe that having a bigger bankroll would likely give me slightly better opportunities to pick winners.
Bridge Rounds
This one is very tricky - I’m not against bridge rounds in general and I’ve participated in many. Sometimes, a bridge round might be the only opportunity for an angel investor to get in a great deal, as there may be no way in to the next priced round. However, I would not want to hold a portfolio that consists solely of bridge rounds, for a few reasons:
Agreements for priced rounds typically include more investor protections.
Almost by definition, a company seeking a bridge round did not achieve all of the goals they set from the last round, or else they likely (but not always) would be raising the full priced round that was part of their earlier roadmap. There are many exceptions to this, though:
It could be that they have an opportunity they want to take advantage of quickly (marketing for first mover advantage, hiring, etc.) and a bridge round will be faster to close.
It could be that the company is already cash flow positive and doesn’t have time pressure, and therefore they don’t want to take the dilution of a full priced round until they’ve hit some milestone that will allow them to significantly bump up their valuation.
The company may carry a greater than average risk of running out of money before reaching the next full round because they’re raising a smaller amount.
The valuation cap is less likely to represent the “true” market valuation of the company - some investors may be relying on a discount provision instead, or the smaller size of the round may mean the lead investor’s check is, for them, rather small, and therefore they’re less valuation sensitive.
Valuation Oversensitivity
Naturally I want to find startups with valuations that don’t seem too high relative to their traction and potential. But I try to keep in mind that using heuristics like a specific multiple of ARR to determine valuation represents an average. That means I expect the best companies to be above that average. And conversely, if I were to refuse to invest in any company with a valuation higher than the bottom of the range…then I’m probably getting what I’m paying for. To put it another way, there are no “value investors” making a killing at the seed stage by bargain shopping - everybody is a growth investor.
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