When I first got started in angel investing, I made a lot of deals based on my gut alone.

Gut instincts are important. Sometimes, they even work.

But angel investing isn’t a craps shoot. The more investments I’ve made, the more I’ve realized that strategy is just as important as intuition.

Some of those early leaps of faith did turn out to be winners – but switching to a more logic-based system has greatly benefited my bottom line.

Now, I only invest in and recommend startups that meet every one of my criteria. I’m not here to throw money away – and neither are you.

I hear pitches from a lot of people. Now that you’ve started, it won’t be long before you know what I’m talking about. There is no shortage of ideas out there – in fact, more than 100 million startups are launched worldwide each year.

That’s about 3 new businesses per second! It can be overwhelming, especially when every founder is maxed out on passion. Here are some of the ways that I narrow down my search.

1) My cardinal rule is probably the simplest: I only invest in startups with a big Total Addressable Market (TAM).

Think about it.

Say you’re looking at a moonshot startup producing Widget ABC. It’s a niche product that only addresses a small market, but it does big things for that market. Maybe it’s the first of its kind and solves a huge problem.

So, a groundbreaking device in, say a, $100 million market.

And because this widget dominates, it takes 100% of that market.

So, $100 million in the bank for this small startup. Not too shabby.

Now consider if the TAM is really big – hundreds of billions of dollars – like the e-commerce market, which is projected to hit $735 billion in just a few years.

Odds are small that a tiny startup will dominate that massive market overnight.

But, say they solve a small problem in that market. Like software that identifies and removes fake product reviews.

In solving that small problem, our startup has now harnessed a tiny 1% of the market.

Well, a small piece of a huge market is still a huge piece.

Because 1% of that massive market means $7,350,000,000 straight into our startup’s bottom line.

2) Another thing I like to see is revenue in the bank.

As I see it, there’s no good reason that companies shouldn’t have some kind of revenue by the time they go seeking investors.

A business that hasn’t made any money yet is basically a shot in the dark. How can you possibly determine the company’s growth rate, valuation, or profitability without a single measurable transaction?

I don’t care if it’s $500 or $50,000 – revenue in the bank tells me that there are customers out there willing to pay for the product. And there is a huge difference between being willing to use a product, and being willing to purchase it.

If a startup hasn’t managed to pull in a single cent, why should I believe that customers will flock to it later?

Here’s the thing about the modern marketplace: it’s pretty crowded. Customers have more options than ever before when it comes to choosing products and services.

These days, it’s not so much about deciding whether you want to spend money – it’s deciding what product to spend it on today. Which means competition for each dollar in the consumer wallet is fierce.

3) That’s why I look for startups that solve a specific problem.

In Silicon Valley, you’ll hear people refer to startups as candy, vitamins, or painkillers.

Candy is just for fun – nobody needs candy, but we all buy it every so often. We get some momentary pleasure out of candy, but it doesn’t make it into the weekly meal plan. Smartphone games are good examples of candy.

Vitamins go one step further. They improve peoples’ lives, but it’s still pretty subtle. Taking your vitamins might make you feel a little better in the long run, but you don’t wake up craving them. Grocery delivery services and instant messengers are a bit like vitamins.

A painkiller, though, is something you suffer without. Uber is a painkiller, because life without it means paying twice as much to ride in a smelly, outdated cab.

Painkillers solve urgent problems… and good ones keep people hooked for life.

When I first started building websites, it drove me crazy that there was no good way to track how visitors interacted with my pages. That was an acute pain for me, and it led me to co-found Crazy Egg.

As it turned out, Crazy Egg was a painkiller for a lot of people, and it’s done very well as a result.

A product that solves a real problem is generally on a path to success. Even better if customers find they can’t live without it. Creating a painkiller is a guarantee of sustained revenue growth.

Speaking of growth, let’s talk about scalability.

4) My ideal investment prospect is a product that can scale without taking on proportionate expenses.

Let me explain.

Say that you run a tutoring company. You’re using a proprietary method that is super successful. Customer referrals are through the roof, and you have the opportunity to expand.

That sounds great… at first. The problem is that, for every new set of customers you take on, you’ll need to hire more tutors. Your profit margin never really grows. Yes, you’re making more money, but not at a faster rate.

Now consider a subscription box service, like BarkBox. For a flat rate, you mail out a monthly box filled with treats and toys to dog owners. This is a highly automated service; most of it takes place in a factory or warehouse.

When you go from 10 to 1,000 subscribers, you won’t need a hundred times the staff to fulfill orders. Sure, some expenses will go up – you’ll be spending more on dog treats and toys – but the factory can handle a higher level of output without needing many upgrades. That’s a business model that scales well.

My last rule is one that I’m a little more lenient about than the others.

Bonus: I like to invest in businesses that I understand. I haven’t always stuck to this rule, but when I do, I tend to get better returns.

That’s because it’s easier for me to spot a good idea in a landscape I recognize. I’m much better equipped to know what will work in the tech world than, say, the food and beverage industry.

As a bonus, I can lend my own experience to the project and help guide founders towards good business decisions. Sure, the founders may not take my advice, but it never hurts to give it.

Remember that this isn’t like investing in the stock market or a mutual fund. You’re not just dumping cash into a machine you have no control over, hoping that more cash comes out at the end. Startup growth is a highly dynamic process that you, as an investor, have some power to influence. Use your standing to steer the ship towards success.

Aside from the big rules, never skimp on due diligence. It’s a good idea to research any regulations, competitors, or industry trends that could help or hurt a startup’s success.

Of course, the entrepreneurial team is key – after all, they’re the ones responsible for executing their vision profitably. Next, we’ll get into the surefire ways to identify founders who have what it takes.

Until next time,

Neil Patel