How To Develop An Investment Thesis

Sometimes the excitement of a promising startup can cloud our head… maybe it’s the greed factor, or FOMO which causes us to just invest on a whim. 

But I can’t stress enough the importance of Due Diligence – where you dig deep into the startup’s team, the overall market, its finances, and strategic vision.

One basic way to screen startups rather quickly is by applying the Three P’s of Startup Investing:

Potential – How big can the startup get? Do they have a chance to become a billion-dollar unicorn? Is their market big enough and can they scale?

Probability – Do they have any unnecessary risks? Are there any red flags (ie. cash flow issues, history of failed ventures, replicable product/service)?

Period – How long will it likely take for an exit? Having a rough estimate of your exit timeframe is essential for anyone managing multiple startup investments. After all, the intent of any investment is to get a return on it. 

Looking at a startup under the lens of the Three P’s helps you build an Investment Thesis – the roadmap of a startup from pitch to exit.

After you’ve narrowed down your options, you can then dig deeper into the due diligence process. 

If you’re looking for somewhere to start, I share some of my favorite startups (and basic educational guides) with members of my Angel Investing Insider service.

Now, if you’d like to learn more about my startup due diligence process and how I develop an investment thesis…

The Importance of Due Diligence

In the startup world, there is an ongoing debate around a special subject.

I’m talking about due diligence

There’s one type of angel who has little regard for due diligence. They follow their gut and pattern-matching startups to past successes. These investors spend almost no time formally assessing a company and invest based on their inner compass.

On the other end of the spectrum, some analytical angels insist on weeks of research. They delve deep into a company’s deepest secrets to reduce risk and ensure success. 

Most of us are better off occupying someplace in the middle. There is no hard data to say expansive research yields consistently better results for everyone. 

And not everyone has the instincts of those “shoot from the hip” angels. You will need to find your way that suits your style and abilities.

This little guide will teach you what you need to know as an angel investor about due diligence and show you some tricks to start spotting gems in no time.

What Is Due Diligence?

Put simply, due diligence is gathering info to help you make a good decision. In your case, this means checking out a startup — the team, market, and finances — to make sure you have a high chance of success investing in it.

If you’re going to throw down some money on something, you better do some research first, right? 

There isn’t a minimum or maximum amount required, it’s going to depend on you, on the company, and its stage.

Due diligence is just about putting your focus on a company to see if you should hop on board or look elsewhere. You can look at the startup’s numbers, its background, or its competition before making your bet.

Why Does It Matter for Angel Investors?

Well, first of all, because angel investing is risky!

This wouldn’t be the asset class with the highest average ROI if there wasn’t some risk involved. As an angel, you want to create wealth, not just sustain wealth. You want the risk.

But, an essential part of angel investing is managing risk.

One of the best ways to do this — due diligence.

Due diligence can’t remove all of the risks, but it will certainly allow you to identify deals that have obvious issues. I’m talking about products with no demand, companies with legal issues, and founder conflict. These things will kill your return, and you’ll have to do some sleuthing to pinpoint them.

A great opportunity for angels just starting is getting deals from angel investing teams that have experience spotting good deals.

How Can You Conduct Due Diligence?

There are a few important steps you should always take before investing. For most of you, this is a good starting point. Think of this as your due diligence checklist. 

Here’s what you need to do:

  • Assess the management team
  • Learn about the market
  • Get inside the head of the target customer
  • Ask common sense questions

Much of what you need to look for is the same as what we covered in our article Evaluate Angel Deals Like a Pro. The goal of your checklist is simply to reveal red flags and make sure your startup is set up for success.

Going further, there are some general goals you should keep in mind when conducting your DD.

Identify Risks

Your first impression with a startup may be a presentation, a listing on an angel investing website, or a recommendation from your team. This is where due diligence begins. 

Take in everything you can about the product, team, and goals. If the project seems sound and sparks your interest, start by noting any questions and concerns that pop into your head. Ask, is there something missing? Then distill your ideas down to a few points. 

Take your concerns and ask the founders or put in the research to get answers. our own or ask. Perhaps there is something you need to know about the management team, competition, or financials. You don’t need to go overboard here, just point out the vital issues. Don’t worry about the small stuff, those shouldn’t break a deal. Be efficient and focused. 

Investment Thesis

A great habit to get into is creating an investment thesis. This is like a blueprint of the deal, mapping everything from pitch to exit. This may sound technical, but it’s actually quite simple. 

An investment thesis can be a plan or scenario you put together in your head or on paper. 

For this part, a good way to organize things is into three categories: Potential, Probability, and Period. These “Three P’s” of investing will improve your chances of success.

Potential – How big can the startup get? Does your prospective company have a chance to become a billion-dollar unicorn? Or maybe the scope is more realistic, aiming for a $20M IPO. To weigh risk and reward, you will need to consider the startup’s potential.

Probability – Next, you want to find the startups with the highest probability of success. Make sure the opportunity doesn’t have unnecessary risks. Some warning signs can be corrected, but too many, and you won’t be able to mitigate the risk. Check that the keys to success are all there. Don’t just roll the dice, play the numbers game.

Period – Now, look at how long it will likely take for an exit. This is based on the company roadmap and product/service itself. Having a rough estimate of your exit timeframe is essential for anyone managing multiple startup investments — which you should be doing.

With some startups, you could be waiting close to a decade for the product to get FDA approval. Other companies have a high chance of being purchased by a large competitor within a year or two. You need to draw this distinction.

Final Assessment

Now that you know the risks and have your investment thesis ready, you should make sure you are comfortable making a few assumptions. 

You won’t have any hard facts to predict success, just patterns that look good to you. There will be many things you need to have faith in! 

If you don’t believe that hurdle X can be jumped or target Y can be met, you have doubts and the deal probably isn’t for you.

With this last step, any remaining problems and goals need to be scrutinized. It’s all about keeping yourself honest and double-checking the logic of the deal.

When to Pass On a Startup

Startups need a few things to succeed. If it’s missing more than a couple of these, you should walk away.

Team Necessities

  • A strong CEO – Someone who looks great in a background check. You want experience, passion, and integrity above all.
  • A high-functioning team – Individuals with good track records and skillsets. The team needs to be able to sell, have project management skills, and deep knowledge of the market.
  • Good size –  You usually won’t want to invest in a solo founder or a large group of founders. Go for a startup with two to three strong founders that complement one another.

Deal Necessities

  • Deal economics – You always want a favorable valuation, but that’s not the whole story. Other considerations are the investment stage, size of the round, option pool, and dividends.
  • Rights and protections – As the investor, certain rights and protections may be deal-breakers for you. Things like anti-dilution rights or the right of first refusal and co-sale rights can be the difference between a profit or a loss.

Due diligence is all about looking for potential issues with your startup. If parts of the deal don’t sit well with you, or it lacks a special something that makes you comfortable investing, you’re better off walking away.

Best Due Diligence Shortcut

Due diligence can be a major task. You want to increase your chances of success, but maybe you aren’t yet comfortable vetting companies on your own. Maybe you just want to follow your gut instinct. 

Luckily, there is an option for investors who want to find good deals without hours of due diligence.

Joining a network of angel investors can give you possibly the most important asset of any investor — deal flow.

Angel investing communities syndicate pre-screened investment opportunities. These deals have seen a professional level of due diligence already. If the deal is good enough for the angel network to put its name behind, the chances of success are exponentially greater.

Communities are also a great place to test your skills, learn, and collaborate with investors. While becoming a more formidable angel investor, you can get hand-picked deals you can count on. 

Want to read more about due diligence? Check out our article Evaluate Angel Deals Like A Pro.


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