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.

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.