Mourning Angels: What Went Wrong With Your Investment? (Case Study #1)

Some readers of this blog who are interested in getting involved in angel investing recently suggested I do some case-studies as part of this series. I agreed and thought we ought to start by examining some typically negative scenarios that one inevitably confronts as an angel. Hopefully these case studies will stimulate some questions and further discussion from which we all can learn.

Eventually we'll work our way back to the core issue at hand: your own judgment of other people’s capacity. (See my earlier posts on this topic here and here).

(**Disclaimer: These case studies are not modeled after any person or any company in particular- they are designed for illustrative purposes only).

CASE STUDY ONE:

So you hear rave reviews about this guy long before you meet him. The people raving about him are actually some customers of his whom you’ve known for years and respect and who have successful businesses of their own that have benefited greatly from his product. You meet him. He needs some growth capital. He’s an industry veteran, a go-getter, knows the business inside and out, knows how to stretch a dollar and generally checks out at first glance. You and your small band of angels analyze the business and perform your supposed due diligence.  Things look good actually and he’s in talks with a potential acquirer. After a month of analysis and discussion, the investment gets made. 

In the beginning all seems fine. There is some initial growth, some promising leads, but after about 18 months you all realize that nothing is happening. There is no growth and the acquisition talks have broken down long ago. There is also very little communication lately.  You hear that he’s borrowed some money recently and is having trouble paying it back. You fly out to visit him. He’s friendly, but seems evasive, a little down.  He’s gained about 15 pounds since you last saw him. Now what?

QUICK ANALYSIS:

He may have got caught up in other things. He may be having marital problems. He may have made some personal investments in other areas when the going was good but then the market tanked. Remember- as an Angel, you are probably not on the Board and you are a minority shareholder.

             Q: So what are your options?

             A: Welcome to Angel Investing. You have none.

Questions for Discussion:

• So what could you have done differently? Would a convertible note have helped rather than a traditional equity investment?

• Did you really know this person? Did you make reference calls?

• During diligence did you ever meet his family, see his home, see how he lives, what his hobbies are, etc.?

• What does due diligence mean to you?
  

Let's discuss this case study and the questions I've raised.  Looking forward to your thoughts and comments.

Comments

[Gregory Y]

I have started four companies, always had partners, but never took outside investment preferring bank loans, when I could get them. I also made small investments in 2 start-ups before, and unfortunately am familiar with the scenario you had described.

I did meet the family and visited home, but that made the loss even harder to take, as I felt personally "cheated". This is not to suggest that due diligence has to be done, but ultimately it only improves your odds - there is no guarantee. Looking back I could have never guess that character of a person would so completely melt down. It is not detectable in "normal" circumstances, unless you are better judge of character than I am.

And I did have a convertible security, which doesn't yield much in a case of liquidation. The only way I would get involved again is if I am closely and continually involved in operations.

[Dave Lerner]

Gregory- Thanks for your comment and for sharing your own experience. You are right, there are certainly no guarantees. Situations and "meltdowns" of the sort you describe happen all the time. That's why I think it's good to invest with a few other experienced investors around you so as to at least have multiple filters involved in the decision-making.
Dave

[Bill Attinger]

I don't think a convertible note would have mitigated the busienss risk. Capital burned is capital burned. Liquidation at the seed stage is still liquidation. No one does well. My question to the angel in this case study is: how many times did you hear from the entrepreneur between funding and the 18th month? Did the entrepreneur have any simple investor relations mechanism to keep you informed, and better yet, engaged? Did you require at least a simple monthly update to help you see a concerning trend way before the 18th month? Maybe you would have known the acquisition opportunity was not happening, and the cash might be running out due to missed goals or expectations? Maybe you would have learned that unprecedented personal challenges were facing the entrepreneur where you might have stepped in to facilitate management continuity? Just some thoughts...

[Dave Lerner]

Bill- yes indeed. What mechanisms were in place during those 18 months if any? I also think you're right that the convertible note wouldn't have helped one iota. Thanks a lot for the comments and insights, keep them coming!