Crowdfunding Chickens Come Home to Roost

Investing in early stage companies and startups is exciting and can deliver handsome returns.  No debate about that.
But, there is a right way and a wrong way.  The right way is to do what smart, professional angel investors do.  They do good due diligence.  They actively work to add value to the company to help it succeed.  They monitor the activities of the company and they make sure good corporate governance is in place.

The wrong way, in my view, is to invest passively and select the companies from a crowd funding website.
Case in point. Recently the UK's booming crowd funding industry hit a rock.  A number of companies funded on platforms such as Seedrs and CrowdCube, the two leading platforms, went belly up.  Hundreds of investors collectively lost more than GBP 2 mn.

Anyone who knows me can tell you I have never been a fan of equity crowdfunding platforms. My view is that the risks far outweigh the reward and investors will be disappointed in the end.  The platforms, on the other hand, will profit handsomely.

I wrote about this nearly two years ago to the day on my Angel Blog.  Here's a snippet from my post on March 18 2014.

"There will be disasters in the crowd funding space sooner or later. There will be cases of fraud.  There will be lawsuits brought by angry investors who feel they are not treated fairly in a corporate action.  Inevitably there will be cries for tougher regulation."

I won't bore you with the detail here. One article  in the Telegraph I found suggested there have been 70 crowdfunded companies, about 20% of the number funded so far, have gone bust while only 1 has delivered handsome returns of about 3 times investment.

I'll concede the glass maybe half full.  The jury is out on the other 80% of the companies.
Still, the news flow is alarmingly predictable. I did a search on google recently and found a chorus of articles in the popular press talking about potential disasters waiting to happen.  Seems I was not alone in my concerns.

My esteemed colleague  Gonçalo de Vasconcelos,  CEO of Syndicate Room, sent me an e-mail this week.  He pointed to the failure of Rebus as evidence that the industry is prone to problems that go beyond simply the normal business risks of crowdfunding.

Goncalo runs an equity financing platform that takes crowdfunding to a higher level and helps remove some of the risks.  At Syndicate Room, each deal posted has a lead investor who is putting money at risk and who and has a track record of success and who supports the transaction.  Investors in the deal go in on the same terms as the lead investor.

Syndicate Room is not the perfect solution, but in my view it is a far better alternative and will yield far better results than CrowdCube and Seedr's will.  Incidently, I don't have any money invested with Syndicate Room and I have not done any research into Syndicate Room's due diligence process or the due diligence process and integrity of the lead investors on their site.

The conclusion I still can't dismiss is that the keys to successful investing in startup and early stage companies are in the hands of the investors themselves.

Investors should invest in companies where they know the entrepreneurs, they understand the industry and the business and can draw conclusions as to the company's genuine prospects for success.

Investors can increase their chances of success by actually adding value to the company they invest in - introducing the company to clients, opening the doors to financing, structuring company governance, serving on the board of directors.

It is of course impractical for each investor in the crowd to do these things.  However, it is practical for investors to join syndicates, invest in portfolios run by dedicated Angel investors, ask critical questions of companies, do some of their own homework to assess the real propensity for the crowd funded company to succeed.

Call me biased.  I'm an angel investor. I run an angel investment fund. I'm an investment manager.  So naturally I have to stand on this soap box. Or call me practical, wise, full of good old fashioned common sense.  You're the crowd.  Judge for yourselves.

Oscar Brings Seniors & Juniors Closer Together

One of the best things about being an angel investor is that I get to see really interesting projects led by talented, dedicated people who put their heart into their work.

Entrepreneurs must be more than passionate about their ideas, however.  They must be practical.  They must understand when to raise capital and when not to raise capital, when to develop and when to launch, where when and how to advertise, when to grow and when to consolidate the gains. It's very rare indeed to meet one of those exceptional people.

Recently I met Tomas Posker.  Born in the former Czechoslovakia, Tomas is an entrepreneur who established his first business at the age of 16. Starting from scratch, Tomas built his first business Poski.com into to a company with 20 employees and such customers as Henkel, Whirlpool.

Tomas went on to co-found Ki-Wi Digital, a company developing its own digital signage software and designing its displays and interactive kiosks for retailers, advertisers, real estate agencies, municipalities and government.

When you meet Tomas one of the first things you realise is that he is remarkably humble.  He is soft spoken and exudes a quiet, but firm confidence.  He is a person you can immediately feel comfortable being around.

Tomas worked in California, America's technology state.  Like a good and caring grandson, he wanted to keep in touch with his grandmother living in the Czech Republic.  Like many of his peers, he didn't want the internet and computer technology to be a barrier to communication between he and his grandparent.

As Tomas explained to me, grandma frequently needed help understanding with computer and tablet functionalities. Very often Tomas provided help via telephone.  Then one day Tomas looked at his telephone bill and decided there must be a better way.  And thus, project Oscar was hatched.

Put simply, Oscar provides a simple yet permanent interface for seniors that enable them to maintain even continuous contact with their younger family members. 

The system works with all the commonly used communication capabilities: text, video, voice, pictures, reminders. This allows seniors continuous contact with their family members. The younger generation can help to remotely control a senior’s app, thus avoiding a senior’s frustration with technology.

The senior's end is installed on a pc, laptop, mobile phone or tablet and contains a user friendly interface that drives the functionalities.  In most cases a tablet is the preferred device.

The junior's end is installed on a table, pc or mobile phone.  In contrast to the senior end, the junior's end is full or tools that enable the junior to access the senior's device and use a series of tools to provide whatever technical assistance the senior might need.

The Oscar application thus provides the mechanism for trouble-free, internet driven communication between generations.  Functionalities include:

• Communication tools via e-mail, text, voice and video
• Live-view screen sharing to provide help in case the senior gets stuck or needs a problem solved
• Classical internet browsing and embedded access to content such as  weather, news, sports and games
• Reminders so senior and junior can track medications, doctor visits and other scheduled events

Over the past two years Tomas developed and enhanced the application and the user experience.  He built a user base of about 1,500 around the world, mainly by word of mouth.

I asked Tomas why he hasn't done more advertising to move the business faster.  He explained to me that he felt the system improvements in functionality and user experience before he could feel comfortable marketing the service on any scale.  Tomas prefers to have fewer customers who are satisfied than more customers who potentially would be unhappy.

As any right thinking angel investor would do I asked Tomas about his monetisation model.  He told me that he's not so concerned at the moment with pricing.  His first aim is to deliver a good user experience and to learn just what his customers want.  Over time he'll develop value added features that users can pay for, most likley with a monthly subscription.

I asked him about advertising and marketing.  I found his answer remarkable.  He said he wants to experiment gradually to learn which forms of communication are effective.  Tomas believes ultimately the best form of advertising will be word of mouth, personal recommendation and the development of marketing partnerships that can give Oscarsenior visibility to the key audiences - seniors and their adult children.
Tomas pretty much got me hooked on his concept and his product, so naturally, I opened the discussion about early stage investment and here's where the conversation got even more interesting.

Tomas told me that right now he is focused on finishing the iOS version of the product and releasing a new version of Oscarsenior with enhanced features and user experience.  Then, he wants to invest a relatively small amount of money in advertising and marketing to grow the user base and understand their technical needs better.

Tomas believes that while what he as done in thus far is a good start, more needs to be done to develop the business with his own resources before he brings in outside capital.  He thinks the time for outside capital is getting closer, but he is comfortable for now to wait, work and develop.

I think many entrepreneurs can take a lesson from Tomas.  Too often I see startups eager to raise capital before they have really a  developed product with some proven demand.  The result is usually not good.  They struggle to raise capital.  What capital they get they inevitably spend unproductively. The generate sup-par returns for their investors and themselves.

Tomas earns much of my respect for his patience and his focus on product development.  He sees the benefits that this will bring in the long run.  When he raises outside capital he will have a much easier time than most early stage companies, because he'll have proven demand and a marketing strategy grounded with practical experience.

Tomas will presented Oscarsenior at the European Angel & P2P Summit. It's a presentation I think all the investors found refreshing.

Crowdfunding and the Bad Dancer

Dance contests usually follow a predictable pattern. Bad dancers are eliminated early in the competition. Good dancers progress through the rounds. Eventually one of the best pairs wins.

But something funny on the way to the forum happens when the crowd vote is counted. Bad but popular dancers can reach the finals at the expense of much better dancers who, but for the crowd, would have progressed.


Crowd funding websites are the modern day equivalent of this new breed of reality TV shows. Very often the business that gets funded is not the best business, but merely the most popular business.


This, is where the parellel ends, however. The success of the bad but popular dancer is certainly not someting fans of good dancing approve of, but at the end of the day TV is entertainment. Realty TV is in some ways more of an illusion than a reality anyhow. Who wins and who loses really isn't so important.


For the past several weeks Czech TV audiences have been wintessing a battle between style and substance.  At the moment, style seems to be winning, much to the dismay of purist dance fans.
The unfolding drama can be seen on Saturday nights when Czech TV airs the popular series "StarDance."

For those of you who may be unfamiliar with this show, StarDance is based on a British TV series called Dancing with the Stars.   The show pairs a number of well known celebrities with professional ballroom dancers. Each week the dancers compete by performing one or more choreographed routines that follow the prearranged theme for that particular week. The dancers are then scored by a panel of judges.


Audience participation plays a pivotal role. Viewers are given a certain amount of time to place votes for their favourite dancers, either by telephone or (in some countries) online. The show format is highly popular and has been licensed to over 42 territories over the last ten years.

 The protaganist in this drama is a comedian named Lukas Pavlasek.  He is perhaps best known for his appearances in a series of commericals promoting cellular communications provider T-Mobile.  In addition to his regular appearances as a stand-up comedian he's had numerous film and stage credits and he is a prolific writer and song lyricist.















By almost any measurable standard Pavlasek is a poor dancer.  My colleague Jitka Rombova calls him the "anti-talent."  He's not graceful by any stretch of the imagination and he's often out of rythm.  Out of a possible score of 40 points he consistently gets below 20.

Yet what Pavlasek lacks in substance, he makes up for with unbridled character, enthusiasm for dance and his comedic wit.  For this reason up to now he has defied conventional contest logic.  On the strength of his scores he would have been gone several episodes ago.  But week after week he's received enough votes from the crowd to progress to the next round. He's now among the final 4 contestants.

Catering to the popular will of the crowd is profitable.  TV advertising revenues are driven in large part by the number of people watching.  Viewers like Pavlasek, so they vote for him and many viewers look forward to his upcoming performance the following week.  He's what we in the investment world call a "disruptive business model" - one that challenges the status quo and changes the way manner shape and form that products and services are delivered.

The duel between style and substance certainly makes for an interesting program.  All in all, everyone wins.  TV producers get advertising revenues and viewers get an engaging entertainment experience.

But when it comes to investing popular will of the crowd the dynamic of mutual success between supplier and customer breaks down. Crowdfunding websites dangle in front of investors the prospect of investment rewards and the satisfaction that comes from helping an entrpreneur get started.  The companies raising money couple that appeal with presentations that are long on style and often short on substance.

Dancing is a transparent business.  You see the presentation and you can instantly tell if the product or service is good or bad.  Predicting who will win the contest usually isn't so hard, particularly as the field narrows.  Pavlasek is surely the exception rather than the rule.

This is not true with startup and early stage companies.  Presentation is the surfacce.  It is at best only the cover on the book.  You can only judge the real quality by drilling down into the detail.  What drives the success of a crowdfuning campaign is often not the detail of the company, but the packaging and the presentation, combined with the fact that people are naturally more willing to risk a small sum of money for the sport of it than to drill down into the detail and risk a larger sum of money.

The successful crowd funding campaign ends with money in the company's treasury and profits for the website provider.  I've yet to see hard evidence that investors benefit, however. In the investment business when form takes a back seat to substance investors usually wind up losing their money.

The math I see is that at least half of startup and early stage companies fail within five years. An investor who gets an average return of 25% annum will see $100 turn into $244 in five years.  If, however, half the companies fail the other half of the companies much produce each a return of 4X in order for investors to clear the 25% hurdle.

My advice is as follows: Investors should approach crowd funded investments with a healthy dose of scepticism.  Ask questions - lots of them!  Be selective. Select only the companies who you believe really can succeed AND provide the possibility for an exit within five years.

As for our friend Mr. Pavlasek.  I actually think he is improving from week to week, I enjoy his performance and I think the judges have been perhaps a bit too harsh on him in recent weeks.
But my view is that substance and form will win over style.  He'll be well remembered as the guy who almost won StarDance.

My rationale is perhaps naive. The way I figure, the majority of the TV viewers want to see the quality dancer win.  Each week there are fewer good dancers to choose from, so the majority that want to see the good dancer win will finally be able to cheer for the substance and form it desires.

After all, dancing is certainly not the same as crowdfunding.  Is it?

Seeding with Convertible Notes - Watch for Thorns!

I've seen many startup and early stage companies present their idea and ask for funding in the form of convertible notes. This is a particularly common tactic in the US that has not quite found its way to Europe.

Far be it from me to say the emperor has no clothes, but.....guess what! The emperor looks likes scantily clad.

Mind you, that's not to say all convertible notes are bad.  They are not all bad.  All I'm saying here is that I have many more questions than answers.  Call me a frightened old toddy if you like.  But I have several concerns and that's among the reasons why to date Symfonie Angel Ventures has never bought a convertible note.

What's a Convertible Note ?

Those of you who are familiar with the structure can skip this part.  Those you who would like a bit of a primer - read on!

The convertible note is a way of the investor and the entrpreneur saying - "Valuing a startup or an early stage company is a thankless, almost irrelevant task. Rather than haggle over valuation and ownership stake, we'll agree to put that discussion on hold until there is a real business to talk about, which will be when we do a big financing called an A-Round."

So instead of selling equity the company issues a convertible bond.  The terms of the bond are something like the following:  

The bondholder gets a coupon of (for example), 8%.  Maybe this is paid in cash annually, maybe not. Maybe the interest will be paid in cash when the A-Round happens or when the note matures.  Maybe the interest will be paid in the form of shares down the road.  Every convertible note is different, no two are the same and the first question the noteholder should ask is - "when am I supposed to get my interest and how will it be paid."

The convertible note is a bond, so it has a stated maturity - say five years.  By then in theory the A-Round should have happened, supposedly, so its convenient to just assume maturity is not particularly relevant but just some notional fiction to be dealt with down the road.

So the second question the noteholder should ask is - how will this be repaid when maturity comes along?  Am I supposed to assume the business can re-finance the note?  Am I supposed to take it as a given there will be an A-Round and I will never see maturity?  What if the A-Round never happens at all?  What if the company can't repay?  What then?  Are we supposed to have a valuation discussion or am I supposed to assume the business will have failed?

Third element for the convertible note is the definition of an A-Round and what the note converts into.  Well, tough, to say!  Each note is a different animal, each has its own bells and whistles.  Typical I have seen is - "An A-Round is defined as being capital raising of at least $2,000,000.  When that happens the convertible note is converted into shares of the company at the same valuation as the the capital raising.  So for example, $2,000,000 is raised and the company sells shares with a valuation of $10,000,000.   The convertible note is $500,000 so therefore $500,000 converts essentially into a 5% ownership stake.

Often there is a bell on the convertible note called a "Cap."  The "Cap" is designed to ensure the convertible noteholder gets the benefit of the A-Round in the form of a reduced share price - say, for example 50% of the shareprice that is in A-Round.  So when the $10,000,000 valuation  A-Round comes along the convertible noteholder gets shares equivalent to a $5,000,00 valuation, so actually winds up with effectively a 10% stake, using the numbers above.  The bell is supposed to make the investor whistle away with the headline that there is a 50% discount to the A-Round.

The Devil is in the Details

For those of you who read the primer, you can see that I am just beginning to peel the onion on this topic.  For those of you who skipped the primer the bottom line is - this is a terribly thorny garden of roses so before you even consider walking in you'd best think not twice, but five times!

I went to business school at the University of Rochester.  I'm proud of that so I say that as often as I can.  To this day I marvel at the fact that the William E. Simon Graduate Schoold of Business accepted my application and moreover, that eventually, they gave me a merit scholarship. Priscilla Gumina was the admissions officer at the time.  She stayed there for many years after I left, so apparently my admission was not a disaster for Priscilla and certainly not for me!  Thanks again, Priscilla!

I had a professor at the Simone School by the name of Ron Schmidt.  This is where I get to pay tribute to him, which pleases me greatly.  He was undoubtedly among the best professors I had during my graduate and undergraduate training.

Professor Schmidt gave really hard exams!  They required essays for answers.  But in some ways they were easy.  You see, you got 50% credit if you just started your answer by saying "It depends."  The other 50% of the the credit you got by presenting a concise, well thought out answer that explained what it depends on and what the range of outcomes could be.

So - here's the question:  An entrpreneur wants to fund a startup.  An investor wants to invest in a startup. Is a convertible note a good choice for the investment structure?  

The answer is, of course, "It depends."  Now - onto the meat and potatoes.  There are at least five things every entrepreneur and every investor should think about before walking into this supposed garden of eden.  Here they are:

1. The interest rate - is that paid in cash or in kind.  If paid in cash when is it paid?  Annualy?  Monthly?  Quarterly?  At maturity?  Upon conversion into equity?   A cash coupon is nice!  If the company is successful finding other investors or the company starts generating some revenues, or if the company manages to hang around long enough - say really five years, at 8% I stand to get back 40% of my initial capital.  Forgetting the time value of money, there's something to be said about getting back some capital that was placed at serious risk. 

2. The maturity - What happens if the A-Round never happens?  Or what happens if the A-Round happens but not at a threshold valuation to trigger a conversion?  How will the company repay?  Will the company be able to refinance itself?  Or will the company be bankrupt?  What are the noteholder's rights as a creditor?  Is there any security at all is just a lottery ticket?

3. The business prospects - What has to happen for the company to have an A-Round?  What are the milestones and thresholds that need to occur?  What should the company look like in terms of revenue and profits?  Will the company still be loss making when the A-Round comes?  Will the A-Round be one on a long series of capital raisings needed to keep a company afloat while it looks to build moment and traction?  Some companies lose thousands, millions, even hundreds of millions and stay in business a long time and have multibillion dollar IPOS and make fortunes for the early investors.  That's the exception rather than the rule.

Startup City is littered with a pile of companies that received lots of investment only to go down in a ball of flames when there was no more capital to be found or the next great widget came along.

4. The Convertible Valuation - is it reasonable?  Can it be somehow economically and quantitatively justified?  Does the discount to valuation and the time until A-Round comes compensate for the risk?  Does an A-Round represent a real exit opportunity or is just another step to the exit?  When will the exit finally come and what can the return on exit potentially be?

5. Investor Rights - Does the investor owning the convertible have any rights in corporate governance?  What reports will the investor receive?  What say does the investor have in major corporate decisions?  How much more debt can the company take on?  What are the anti-dilution provisions?  Is the company obliged to set aside cash from capital raising, revenues or profits to repay the convertible? Can the entrprener and equity holders get dividends, bonuses and other cash out before repaying the convertible?

The Bottom Line According to Mike

Here's another tribute to Professor Schmidt.  Once he was lecturing about corporate structure and corporatae taxation.  To this day I remember him pounding his fist in the air and stressing the economic reality. I will paraprhase here, the quote might not be exact.

"You don't tax corporations, you tax people.  Someone owns the economic rights in a corporation.  Some derives economic benefits from the corporation.  When you tax the corporation you are taxing people!   Corporate taxation is one of the five greatest idiocies of the twentieth century."

I never asked Professor Schmidt what are the other four idiocies.  Suffice to say, that in my very humble opinion, Convertible Notes for Startups are a good candidate for one of the other four idiocies.  Hopefully they will not come to the shores of Europe anytime soon.  

Stay Tuned!!!

I laid out a fistful of problems.  I have a good friend and colleague named John Vax.   I had the pleasure of working with him for many years and he used to tell me that when he ran the Capital Markets desk at Commerzbank in Prague his staff would come and tell him about problems.  His reply was often (and again, I paraphrase):

"I know there are problems.  That's why I hired you.  I need the solutions, so tell me how you think we should solve the problems."

Having presented the problems with convertibles, the next blog I write will offer solutions.  Real, practical, honest to goodness solutions I will bring!  How's that for service?

Until then - remember - investing money is easy.  Investing takes no talent, takes no guts.  Investing successfully - well, that's a completely different story.

Want more information about my Angel Fund?  Click here!

10 ReasonsWhy We Invested in Venzeo

I often write about criteria angel investors should consider when making an investment.  Recently the Symfonie Angel Fund invested in one of the few companies that fit our criteria - Venzeo.  Time will tell if we were right or wrong with Venzeo and there is much hard work ahead in order for us to make this investment succeed.  I hope my post is helpful to all the other angel investors out there who are considering their next investment. 

1. The product fills a market need.  Any business that uses photos for documentation or evidence can save time and money by using Venzeo.

2. Similar businesses are successful in other markets.  Look at the US.  Fotoin (www.fotoin.com) and pdvconnect.com have emerged and are growing rapidly.

3. It's not all plug 'n play. Venzeo's service is easy to use.  The application downloads easily into many mobile phones.  But once business start to use the service and they realize the benefits, they come back to Venzeo, ask for more devices and ask for customisation to their specific systems and procedures. Customers that integrate a solution into their business are customers that are in for the long haul.

4. Wayra - Venzeo received an investment early on from Wayra, the tech incubator affiliated with Telefonica. Venzeo and Telefonice both come out ahead.  Venzeo developed a relationship with local units of Telefonica to distribute Venzeo service to Telefonica customers.  This partnership has already begun winning customers.

5. Proven demand - Vezneo is winning customers.  The typical customer starts with trial use period.  Once they start to use the service and realise the benefits, they quickly add users to the installation base.  Today's small subscriber becomes tomorrow's key customer.

6. Scaleable  - Adding more users means adding more servers, not building factories or leasing more real estate.  Sales can be outsourced and franchised to re-sellers who are already close to the end customer. When local subidiaries of large international companies share best practices with each other, Venzeo wins additional business.

7. Hard to displace once embedded -  Venzeo's service is not particularly expensive.  Once a customer starts using the service and likes the service, there's no great incentive to switch to another supplier.  If anything, changing suppliers can be painful.  This is why first movers like Dropbox, Facebook and LinkedIn are so successful. Customers like to stay with something that works.

8. Highly fragmented industry - There are only a handful of companies like Venzeo operating and there are hundreds of thousands of companies that can become customers of firms such as Venzeo. Fragmented industries mean there is ample opportunity for new firms like Venzeo to compete and succeed.

9. Not easy to replicate - Developing the application takes  time money and effort.  Venzeo had a small, but dedicated, team of developers working full time for more than a year before it could launch a version of its service.  By learning from customers Venzeo develops value added solutions that enhance it's marketability.

10. The modest investment we make can have a large positive impact on the company.  Venzeo's core solution is developed, tested, proven and operations.   What's needed now is build out of sales and marketing, coupled with value added improvements. The marginal dollar invested today goes quickly to the bottom line, so the company is well positioned to become self sustaining.

Find out more about Venzeo at www.symvest.com/prereg/venzeo. Feel free to contact me directly at  msonenshine@symfoniecapital.com if you have questions or comments.

Consider the Risks

 

Risk Considerations for Angel Investors

Put Risk into Perspective

Angel investing is, plain and simple, risky.  On the other hand, the most successful angel groups  are well rewarded.  They achieve exit multiples in excess of 4X.

Crowd funding platforms make it easy to diversify among several startup and early stage companies via the internet.  The clear and present danger of that strategy is that the winning investments might not compensate for the losing investments.  Secondly, many companies present well, but are inherently more risky or more prone to failure than they appear.

The successful angel investor should do three things.  First, understand the risks associated with each investment.  Second, be selective.  Avoid investments where the risks are just too great.  Third, control and manage the risks.

One of the reasons why groups of angel investors and professionally managed angel investment funds tend to perform well is because they have the experience necessary to evaluate and understand risks and because by taking an active role in the investee company they can help manage and control those risks.

Some Thoughts About Risk

“Go out on a limb. That’s where the fruit is.”  (Jimmy Carter, 39th US President (1977-81). 2002 Nobel Prize for Peace,. b.1924)

“Man cannot discover new oceans unless he has the courage to lose sight of the shore.” (Andre Gide,  French writer, humanist and moralist, 1947 Nobel Prize for Literature, 1869-1951)

“We took risks. We knew we took them. Things have come out against us. We have no cause for complaint.”  (Robert Frost, American poet, 1874-1963)

“Take calculated risks. That is quite different from being rash.”( General George S. Patton, American General in World War I and II, 1885-1945)

“Financial risk taking is the practice, within a well-defined investment, risk management philosophy and business model, of creating economic value by finding profitable opportunities to take financial risks.  Financial risk management is the qualitative and quantitative identification and measurement of risk sources and the formulation of plans to address and manage these risks.” (Tim Grant, MSc in Metallurgy, MA in Financial Engineer, Entrepreneur and Managing Director at O’Connor, responsible for Global Risk, Quantitative Research and Technology)

Company Specific Risks

Most startups fail.  There is a plethora of literature about startups, the risks they face, the reasons they fail and the reasons they succeed.  Many of the reasons are specific to the company.  The product might be excellent but if the management is poorly organised or can’t find enough customers the business is likely to fail.  We categorise company specific risks into three basic groups.

The most commonly cited reasons for failure of new businesses are what we call “core business issues.”  These problems tend to appear early in the life cycle of a company.  Less commonly cited, but also prevalent, are organisational problems.  Finally, the least likely issues appear to be legal or regulatory in nature.  Notably, outright fraud is rarely cited as being the reason for failure.

Core business issues

·                     Lack of demand for the product

·                     Inability to achieve economies of scale/scope

·                     High costs

·                     Lack of capital

Organisational problems

·                     Poor management

·                     Poor corporate governance

·                     Too few staff

·                     Over-reliance on key people

·                     Founder attrition

·                     Disagreements among the shareholders

Legal issues

·                     Trademark and patent disputes

·                     Regulatory problems

·                     Fraudulent corporate governance

Non-Specific Risk

Sometimes companies fail due to factors that are generally outside of the company’s control.  These are external factors.  We categorise these issues into two groups – microeconomic and macroeconomic.

Microeconomic Risks

·                     Low or non-existent demand for the product

·                     Low demand at or near the general cost of production

·                     The product is not attractive relative to the alternatives

·                     Market is crowded with competitors

·                     Better, stronger, more efficient competitors dominate the market

·                     Key production inputs are too expensive or too hard to find

·                     Alternative competing technologies shorten the product life cycle

Macroeconomic Risks

·                     Recession lowers demand for the product

·                     Capital becomes too scarce

·                     Regulator or central authority introduces rules that stifle the market for the product

·                     Input and/or output prices change adversely

·                     Foreign exchange rates change adversely

·                     Technology changes make the product obsolete

·                     Fashion trends, demographics, and consumer preferences shift adversely

·                     The social or political environment changes

·                     War, terrorism, fire, flood, and other types of force majeure

General Risks

The last category we address is the risks inherent to the asset class and to investing generally.

·                     Lack of liquidity – there is not a readily liquid market for shares and debt securities of private companies.

·                     Foreign exchange risk – exchange rates between the investor’s currency and the currency in which the shares or debt securities are denominated may move adversely.

·                     Changes in taxation regimes – during the life of the investment there may be adverse changes in the tax treatment of gains and losses the investor faces.

·                     Changes in the investor’s financial needs and circumstances –What might have been an appropriate investment for an investor at one point in time may become inappropriate at a later point in time.  The investor might not be able to liquidate the investment or make other portfolio adjustments to suit the new financial needs and circumstances.

What’s an Investor to Do?

The risks we’ve listed are not exhaustive and the types of risks embedded in the investment may vary depending on the particular circumstances.  We outline some techniques investors can adopt.

Risk Assessment

Risk assessment means understanding the sources of risk in an investment and determining how and whether those risks might become the sad reality.  Educated investors readily have many of the tools and techniques at their disposal.  We outline some of them here:

Interview the management and founders of the prospective investee company.

Assess the depth, quality and experience of management.

Test the product the company produces.

Research the product.  Find out what drives demand for the product, what solution the products provides its consumers, who are the competitors and what advantages do they have.

Review the company’s business plan.  Understand the critical assumptions and how variances in those assumptions impact the financial model.

Look at the company in light of strategic analytical frameworks.  Michael Porter’s competitive analysis framework is particularly useful.  Another useful tool is a SWOT analysis, which is used to assess the company’s strengths, weaknesses, opportunities and threats and how they impact the company.

Understand the company’s capital requirements.  Determine how much capital the company will need, when the company will need that capital, how the company plans to raise additional finance and what prospects the company has to generate cash from operations.

Look at the company’s sustainability.  If the management work for zero or low salaries, assess how long potentially are they willing to forego salaries and other opportunities.

Review the company’s corporate governance structure.  Find out if the company is audited, if there are checks and controls embedded in the cash management process, if the company has transparent accounting and management information systems, how the company makes day to day decisions and how the company makes longer term strategic decisions.

Review the company’s disaster recovery plans.  Determine how adequate they are and if there are important flaws or gaps.

Review the company’s legal structure.  Make sure the company is incorporated, in good standing, a shareholder register is properly maintained updated and verified transparently.  Review the Articles of Association.  Understand your rights as a shareholder, how important decisions are made and what shareholder protections are present.

Review the legal environment the company operates in.  Find out about key regulations and laws which impact the company, how those regulations and laws might change and how the company can adapt.

Consult with experts.  Review the potential investment with experience, educated angel investors.  Find independent third parties who understand the industry and the product and can offer insight and opinion.  Discuss the investment with your personal financial, legal and tax advisors.

Risk management

Once risks have been assessed the task at hand is to decide how best to deal with them.  The options are as follows:

De-select

Sometimes the best thing to do is walk away.  Each angel investment can result in 100% loss of capital.  Successful angel investors have good returns in part because they find good companies, but also because they are selective.  They ask many questions, they have the benefit of experience and lessons learned and the knowledge and understanding they have gained to their selection process.

Control the risk

Angel investors who take an active role and work closely with their investee companies can mitigate many of the risks stemming from core business issues.  One of the major reasons why angel investors can generate higher than average returns is because they have relevant industry and business experience they can draw on to add value to their investee companies.  Active investors can mitigate risks across the spectrum through their involvement with the investee companies.  Here are some examples:

·                     Generating sales leads

·                     Identifying new customers and new market segments

·                     Working with management to design business plans and strategies

·                     Introducing new investors to the company

·                     Overseeing corporate governance issues such as audits, financial control systems, design and review of operating systems and procedures

·                     Benchmarking to industry competitors

·                     Mentoring managers

·                     Finding additional managerial talent or external consultants

Delegate investment selection to professionals

One of the major reasons why angel groups and angel funds can be successful is that they have highly specific knowledge experience and skills sets that are required in order to make good angel investments.  Their value-added comes from the following activities:

·                     Evaluation of companies, business plan, management teams and business strategies

·                     Creating synergies among their investee companies

·                     Sharing information, research and due diligence with their professional networks

·                     Negotiating deal terms

·                     Monitoring the activities of the investee companies

·                     Identifying problems at the investee companies and discussing solutions with management

·                     Helping investee companies prepare for the eventual exit

·                     Introducing investee companies to new sources of capital

·                     Developing diversified portfolios of investments in startup and early stage companies

Invest in companies where key risks have been addressed

When evaluating companies to investing, map or benchmark the characteristics of the investee companies against a set of key risks.  Set certain criteria for investments you consider acceptable.  Some criteria worth considering might be as follows:

·                     The company is already generating revenues

·                     Company operates in fast growing market

·                     Capital requirements are modest

·                     Financing is ample to take the company to the point where it generates free cash from operations

·                     Management team is strong and is not overly reliant on one or a few particular managers

·                     The skill sets needed to run the company are not highly specific

·                     The company has a strong market position and a unique service that is costly and difficult to replicate

·                     Company has good corporate governance practices and treats investors as valued partners

Select  angel investments in the context of your overall financial needs and circumstances.

Consider your risk tolerance not only in the present, but where it is likely to be in the future.  Invest only what you can afford to lose and take into account the fact that your angel investment might not be liquid when you will have strong need for liquidity.

Review the angel investments in light of FX fluctuations.  Evaluate whether or not you need to hedge all or part of your investment against adverse FX fluctuations.

Take time to exit into consideration.  Select investments that are likely to generate return on capital well before you expect you are likely to need that money.

Diversify your angel portfolio.  Take into account that failure rate within angel portfolios may be high.  Estimate the returns you can expect from investments that are successful and estimate the failure rate you are likely to experience.  Research suggests that failure rate among angel investments is as much as 50%.  On the other hand, successes can result in exits at multiples of 3X to 30X.  Most literature we have reviewed suggests that beyond 15 companies the benefits of further diversification are marginal.  When building a portfolio, take into account how similar are the businesses among the portfolio.  Having mix of companies that operate in a variety of industries, and sell a variety of products is also important to generate benefits from diversification.

Diversify your overall portfolio.  Angel investments by themselves do not constitute a complete and diverse investment program.  Ensure your financial portfolio has a mix of assets that are appropriate for your financial situation.

Parting thoughts

We recently produced a video overview about Symfonie Angel Ventures, which invests in startup and early stage companies. http://www.slideshare.net/msonenshine/symfonie-angel-fund-video-who-we-are-and-what-we-do

 

This discussion paper is intended to provide a general framework for considering risks associated with angel investing. The lists of risks and ways to evaluate and manage risk are not exhaustive.  Investors should not rely solely on this discussion paper when making an investment decision.  Investors should also consult with independent  legal, tax and financial advisors before making any investment decision. . This paper  was produced for publication 12 May 2014.

Investing in startup and early stage companies (making angel investments) is considered suitable only for sophisticated investors with the knowledge, willingness, experience necessary to undertake such an investment and accordingly to bear  the risks associated.  Angel investing on its own should not be considered a complete investment program and investors are strongly advised to consider an angel investments the context of their overall portfolio objectives, liquidity requirements and risk tolerance. There are no assurances or guarantees of any return on investment.

Symfonie makes no guarantee or representation that angel investing will be a successful investment strategy or returns will exhibit low correlation with an investor's traditional securities portfolio.

Questions? Comments? Our e-mail address is info@symfoniecapital.com.