The other two thirds of the time, I spend more time with the entrepreneur to understand the business as best I can and as quickly as possible. After 35+ angel investments, I should be able to determine the value of a startup quickly, yet, it doesn’t actually seem to be getting any easier. Or, at least, I’m not getting any better at it. Of course, the amount of time I spend coming up to speed with the team depends on my interest and varies quite a lot. In the end, the vast majority of people I talk with ultimately get a “no.” That’s just how the numbers work out. I can’t invest in everything.

In almost all cases – there are those who take a “no” like I said their mother is ugly and are complete assholes about the situation – I do my best to be supportive and helpful in my rejection, explain why I’m not interested and almost always try to connect the entrepreneur up with someone who might be better equipped to help or might be interested in investing. But, it’s still a rejection and it’s tough to take. It’s in how the entrepreneur handles this situation, that I learn more about them than during any of my previous discussions.

Once in a great while, someone will hang up on me or clumsily end a face-to-face meeting with some poor excuse. More likely and if email has been the primary form of communication, I might never get a response to my “no,” which is also a non-response to my offer to hook the person up with another potential advisor or investors. Sometimes, the entrepreneur digs in his or her heals and pushes even harder, thinking that they can force me into changing my mind. Often, pleading, in various forms, takes place.

I’m here to tell you folks, this is all bad. If you’re an entrepreneur (or any one doing business), you should treat each relationship you establish as a long-term, important one. You just never know when you’re going to need it. Sometimes you need it and you don’t even know it – like when another investor calls for an opinion or a reference. I don’t hold a grudge, but I’m not shy about sharing my thoughts about things, especially with people I have an established relationship with (there’s some recursion here, I think).

I’m making it sound like very few handle the situation well. Many actual do handle themselves wisely and professionally.  What do I mean by this?

• They politely ask “why?” to fully understand my decision without trying to convince me otherwise
• They thank me for the time I invested and for my consideration of the team and idea
• They usually ask if I mind if they can engage me for advice or guidance in the future or if they can send updates on what is going on with their new baby.

Yes, for the most part, it’s political and maybe even pandering. It’s also smart. Some people handle it so well, I question my decision not to get involved. Handling it well gives me the impression that the entrepreneur might have the right stuff to be a great CEO. I’ll take that over a great idea any day (although both is nice, obviously). Even if I don’t get involved, that’s what I’m going to tell others when asked.

I’m not trying to be the Emily Post of startup venture engagements here. But handling this basic stuff right can get you very far. There will be MANY more “no’s” in your future. They are always harder to handle than “yes’s.” If you can handle them well, you’ll demonstrate what you can do when things are not so good. A much more important skill than what to do when things are going well. And that’ll get around.

I get why certain investors want this term in there – if a co-investor is not going to continue to invest in the company in subsequent rounds, why should they retain the rights and privileges of a holder of preferred stock? The same rights and privileges that investors investing their pro rata portion.

I understand the logic, but as an angel investor, I find little to like about the provision in virtually any form. If I, as an investor, supported the company early on and took on all the risks involved with an early investment, why should I ever lose the rights that came along with assuming that risk? That was the exchange at the time – money for some ownership and rights associated with the form of ownership. In my opinion, no future acts (legal, up-and-up ones, that is) should cause the retraction of rights I already have (superseding those rights is topic for another day).

When I invest in a company, I always reserve some money for the next round. Since I generally invest in startups, I consider what a reasonable jump up in the A round valuation might be and hold enough in reserve to maintain my pro rata share in the company through that round. If the A round is a large – dollar-wise – or there are rounds beyond the A round that I haven’t reserved for, I can easily find myself in the position of not having the funds needed to maintain my share. A pay-to-play provision, in these cases, would cause a draconian (yeah, I’m biased) removal of the rights I had already paid for through investment and risk. It just doesn’t make any sense.

I could whine or cry and say that such terms are unreasonable or unfair, but that would be stupid. In the end, I can only do one thing when I run across a pay-to-play provision in  a term sheet, treat it as a big negative in my investment decision. I strictly stay away from deals that go as far as converting the preferred shares of those who don’t invest their pro rata percentage in future rounds to common. I treat as a negative, but don’t always walk away from deals with such provisions that are less onerous. Like I said, I understand why big, later stage investors want this term in the agreement. From my point of view, though, it punishes those who took the biggest risk when the company needed it most.

I’ve seen this before (although less frequently over time) and it boggles my mind. Yeah, if you have a boatload of little investments the cap table can be a bit complicated, but that’s just math. Generally speaking, smaller investors don’t have any strong voting rights, board seats or other forms of control so punting on them doesn’t improve the speed or operations of the company. It’s treating form well ahead of function.

So why explicitly exclude or inhibit any investor small or large from investing in your next round? Are you afraid that you might scare off a large, future investor who doesn’t want smaller investors involved financially? Think about it. Are there rational people who would take this position? If so, are these people you want to deal with? To me, the fact that existing investors want to invest more money to retain their ownership is a hugely positive signal indicating that the people who know a lot about the company have faith in its progress and opportunities for success. As an entrepreneur, don’t you want to encourage such behavior?

By not explicitly giving investors pro rata rights (keep in mind that this provision simply grants the investor the right, it’s not a requirement – I’ll write a post on “Pay-to-Play” term sheet weirdness soon), you not only create a problem in subsequent rounds of funding, but you also create a problem now, in the current round. If, as a potential investor, I fear that I may not be able to prevent my dilution in future rounds, how anxious a I going to be to get involved. I’m not. Thus, my exit from the deal this week.

As my long-time friend and corporate general counsel, Peter Johnson, always says, “it’s, at worst, giving them the sleeves of your vest.” “Them,” in this case, being the investors you want to have involved in the company now and, hopefully, in the future.

BTW, there are loads of resources on the web discussing term sheets from many points of view. I highly recommend you take a look at Brad Feld’s and Jason Mendelson’s term sheet series as a starting point.

I invest because I have a blast doing it. It’s about 75% of the fun of running the company yourself with only 5% of the stress. I get to meet smart, energetic people with great visions and boundless energy. It keeps my head in the game, and when I can add value (in addition to money) to help a startup weave it’s way through product, market and management mine fields, I avoid feeling like the least productive member of society for yet one more day.

The difference between a second tier investor like me and the first tier guys (other than brains and talent), is that the first tier investors actually work at finding investments. I’m, dangerously (see below), more passive about it, reacting to the investment opportunities that come to me. I get to see my fair share of of potential deals, but by selecting from a smaller set I not only miss loads of opportunities, but my comparative perspective is likely skewed – the best companies I see may be among the worst potential investments out there.

Fortunately, I’ve been moderately successful with this type of investing. A little over one third of my investments have provided reasonable returns over time with a few big successes doing most of the financial heaving lifting for my “fund.” While my 300 foot yacht with accessory submarine and helicopter remains on the wish list for affordability reasons, I haven’t had much trouble putting food on the table.

While I don’t have any absolutes when it comes to investing, I do have some guidelines that I loosely attempt to adhere to, at least when they’re convenient. Some of them are general and are similar to those used by many angel investors. Others are more personal and, for one reason or another, I’ve picked up over time as a result of my investment experiences.

The general guidelines:

• “Drill more holes” – I once heard the CEO of Shell Oil speaking with analysts at a conference. When asked how Shell was going to diversify in the coming year, the CEO responded with the statement, “we’re going to drill more holes.” Investing in many companies is the only way to balance the risks of markets, teams and competition. Maintain a relatively large portfolio.
• Invest in stuff you understand – bright shining objects attract attention (“we have the basis for a cure for cancer”), but the more you know, the less shiny things often look. If you can’t judge the team, market and product relatively thoroughly, it’s probably not a wise investment.
• Keep some powder dry for subsequent rounds – while the best return in a successful investment comes from investing earlier, holding some cash back to see how the company does and to play alongside any institutional money that comes into the company mitigates some risk and ensures you’re playing on the same terms as the rest of the investors.
• Everything looks good during the honeymoon – don’t make assumptions that problems you see will go away or that things, in general will get magically better. They won’t. While making an investment, you’re probably seeing the company in its best light. Things will likely get worse before they get better.

My Personal Guidelines:

• I don’t like convertible debt – the investor takes on an inordinate amount of risk with a convertible note which he/she is generally not compensated for. Think about a note holder who waits 18 months before a conversion is triggered with an equity investment at a higher valuation. For a small percentage (8-10%), the “investor” takes all the risk in funding the company without participating in most of the potential uptick in valuation. Some strange debt instruments are being created now to fill this and other holes, but for all their complexity, the company should just do a seed round.
• Team over idea – Ideas are cool, but quality teams are cooler. A great team can make a mediocre idea soar or morph the idea into a better one over time. Often, mediocre teams struggle to create success even starting with a great idea. I have to believe that the team can knock the ball out of the park. Only then do I consider the idea itself. As a corollary to this, I need to trust the CEO. Surprisingly, I find this to be a real issue from time to time.
• There has to be a grownup involved – for all the energy, drive, brains and talent in most startups, there’s often a dearth of wisdom. Someone needs to be involved to provide it and be a sounding board for the startup team. This person or these people, should be on the company’s Board of Directors (check out Every Company Needs a Board of Directors – Startups Too). They can come from inside or outside of the investor group (inside preferable). If I’m the best qualified person for the job, I’ll step up. Usually, though, it’s someone else involved.
• I hate leading a round – someone has to be in charge of representing the investors in the seed round. Negotiating the fine points of the deal, working with lawyers, getting everything signed, communicating every step of the way, etc. I hate doing it, but once in a while, I draw the short straw. I like investing along side seed or angel funds as a result. They’re pros and do it all the time. It’s not even heavy lifting for them. Most importantly, they’ll do all the herding of the investment cats required. It’s often a real pain in the ass.
• You can’t and don’t even want to try to tie up every loose end – as much as you’d like everything in the investment to be taken care of, completely thought out and totally bulletproof, it ain’t gonna happen. Stuff is going to change along the way anyway.  The investor and founding team need to feel like they will make adjustments together as warranted.
• Friend’s before business – this is a personal rule of mine that have broken more than once. Fortunately, it’s never backfired on me. I take both my friendships and my involvement with companies seriously. As such, the potential for conflict is high if I mix them – things never go the way you plan. There are always going to be situations in which the investor needs to support either the company or the management team. Can you support the company over your friend? Your friend over the company? Why even put yourself in that position?

This is hardly a definitive list of any kind, of course, but hopefully it’s a starting point for anyone wanting to get involved in angel investing and for anyone looking for an angel investment. Keep in mind that none of these guidelines have anything to do with the actually business criteria used in selecting an investment. I’ll leave that for another post.

Don’t get me wrong, in the end, my investments have delivered relatively nicely.  Way more failures than successes (way more), but with enough successes to more than cover losses and provide a reasonable return. Some might even say a good return.  That said, I’m pretty sure that no one who knows what they’re doing in terms of investing is gonna ask me for advice any time soon.

Back to the mistakes part . . . this week, we closed down the company I most recently invested in (names will be withheld to protect the innocent, not that anyone involved is innocent).  Looking back, there were loads of signs that the company was going to fail or, at least struggle, from the beginning.  I ignored them all.  In the end, I can only blame myself.  Not for the company’s failure, of course, but for being involved in the first place.  If you have stumbled on this post via a search or have read this far and actually think you can learn something from me or my experiences, here is a list of obvious red flags that I ignored in making this investment that resulted in my losing a bunch of money relatively quickly.

• I fell in love with the technology – this one is a classic.  I saw the technology (image processing), did a minor amount of due diligence and thought it would change the world.  My passion for photography drove me here.  That, by itself, isn’t a bad thing, but as soon as you feel love, you better find someone who knows what they’re doing to look at it and give you an objective perspective.  I didn’t.  At lest not enough.
• I didn’t have a solid grasp on the market – while this was a software play (broadly, something I actually know a  little about), the target market was cell phones.  Cool, right?  Made sense.  A zillion devices sold every year, cell phones replacing compact cameras, more processing power moving to phones, etc.  Life looked good.  I didn’t understand what a dog-eat-dog world the mobile device ecosystem is.  Handset producers, carriers, sensor manufacturers, it’s a mess out there.  I shoulda found all this out before I wrote the check.
• The valuation was too high – duh!  Well, I suppose that is a red flag, but there’s nothing subtle about it – it’s more like a fact.  In investing, one runs across valuations that are out of whack all the time.  Depending on the situation, you pay the price or not.  The real red flag was something more subtle.  The other investors in the deal (all with more money in it than me), who had already set the price, were all relatively unsophisticated investors.  That’s not to say that they weren’t good business people, but they were newbie investors.  Note to self, avoid deals crowded with investors who have not invested much before, especially when they’re taking the lead on terms.  Stupid, just stupid.
• When I invested and took a board seat, the other two outside investors were from the same company as the two lead engineers, making 90% of the employees coming all from the same place –  let me be clear, each one of these people was excellent and the company never experienced the problem that I initially feared of the group steering the company’s direction.  The issue here is simply a judgment call by the CEO which I disagree with.  If you’re trying to do something new, why load up with something old?  Maybe involving one person from the other company would make sense, but four?  I questioned this when I came on board and chose to let it slide.
• While being “recruited” as an investor and board member, the team made some claims that they couldn’t fully substantiate when questioned about them – now you’re saying, “well you’re an idiot for investing if that was happening,” and you’re right.  See the first bullet.  Shame on me.
• The founder/CTO was unproven – A bright guy with an unremarkable credentials.  Not that every startup CTO should have cured cancer before their new endeavor, but for a guy his age (not a kid any more) he should have had a track record of successes, even if they weren’t entrepreneurial.  This one’s not a slam dunk, but it was another flag that occurred to me and I chose to ignore.
• Company management didn’t see startup activity the same way I do – work hard, juggle lots of plates without dropping any, take pay cuts when required and sacrifice most of the rest of your life while getting the enterprise going.  From the outside, the management team seemed to treat their work in the company like a job, not a commitment.  To be fair, I really didn’t see this, and other problems like it, until after I had made the investment.
• I had previously invested in a company founded by the CEO where I had lost a load of cash – again, itself, not a reason to avoid the opportunity, but it should have created more dissonance in my thoughts than it did.  I didn’t even spend time to consider the causes of the previous failure and how they related to the CEO.  In retrospect, it’s still a little hazy, but taken in concert with all the others, it should have been a bigger deal to me.

Yeah, yeah, I’m an idiot.  It’s not unusual to run across a red flag or two when looking at a new venture, but when the list is long enough to enumerate, well . . . In the end, it was easy for me to dismiss each of the issues individually.  I neglected to look at them as a whole.  My bad.

Obviously, the sum of the issues and their meta-meaning wasn’t quite as clear to me before I made the investment.  My point is, though, that it should have been, especially given the number of investments I’ve made.  I feel like an moron.  I suppose the only good thing about it is that I didn’t let it run its course.  The company will return its remaining capital to its investors once all obligations are paid out.  It’ll be a small percentage of the funds invested (less than 25% of what was invested), but at least it’s not zero.  I just hope I learned something from this experience.  As my good friend Brad Feld likes to say, “I’ll only make that mistake three more times.”  I’ll tell you next time if I even learn that quickly.