Thursday 5 June 2014

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.

Tuesday 18 March 2014

What Crowd Funding Sites Won't Tell You








What Crowd Funding Sites Won't Tell You

Today I was surfing various crowd funding sites. I was curious to see how the crowd funding sites promote themselves to investors.  What I was surprised to learn was that basically - they don't.

Can't be true you say?  Go to the homepages of the leading crowd funding sites.  Really read the homepage. Pay careful attention to the attention grabbing slider and the large print headlines.

Here's a summary of the content that dominates the homepages of crowd funding sites:

a) How many hundreds of companies have received funding via the site

b) How many millions of dollars have been raised for companies

c) How many thousands of investors are registered users

d) How many investors invested how much money into each company

e) A warning to investors that there is risk in investing and the website does not make recommendations.

 My guess is that probably nearly 90% of the headline content on crowd funding sites is designed to appeal to companies seeking financing - "list your company with us and you will raise money" is the resoundingly loud message.

During my nearly 20 years as a securities analyst one thing I learned is that the most important information is almost always missing from the conference call, missing from the earnings report, missing from the annual filings.  Companies will almost always present the good news loud and clear. Example - sales in 2Q were up.  Great!  Good news.  The key information missing, however is that some of those 2Q sales were 1Q sales that had been delayed or 3Q sales that materialised early.

Why do the crowd funding sites spend so much time and energy promoting themselves to sellers of equity and not to buyers?  One reason might be that crowd funding sites assume implicitly that the crowd of buyers is really smart.  The crowd understands the self-evident and they come to the table convinced they will find diamonds. Evidently, the crowd is picking these diamonds up as fast as they get listed on the sites. The companies that promote themselves on the sites have great stories, great investment plans. Plus, the sites claim (usually in somewhere in the FAQ section) that are very selective, so only really compelling companies actually get listed. This we will call the "Smart Crowd Theory." Now let's look at an alternative theory.

Perhaps, sites spend so much time and energy promoting themselves to the sellers because ultimately the crowd funding industry is all about selling investments, not buying investments. I've yet to find a crowd funding site that makes a clear compelling case for investments in early stage and startup companies on its homepage.  The closest thing to a case for investing I saw was presentation of a statistic that venture capital investments can generate returns in excess of 25%.  That's a good argument for the asset class.  But what I still miss are the arguments that justify the case for each individual company.  When I invest in a company I want to assess the quality of the management team, I want to assess the market for the company's products. I want to understand the company's business model.  My investment team usually spends three to six months getting to know a company and its business, structuring deal terms, identifying the company's strengths and weakness and figuring out how and if our investment and the work we will do after our investment is made can reduce the weaknesses and capitalise on the strengths. I call all of these things, collectively, the investment process.

Dig a little deeper into the crowd funding sites and some of the sites really do start to talk about investment process.  They talk about how they evaluate each company that applies to be listed on the site.  They talk about how the make sure the company offers deal terms that protect minority investors. They talk about how the vet each company. All of these statements I think generally are true.  Any serious group of professional running a crowd funding site would have the incentives and the desire to select companies that will succeed and to eliminate companies that will fail.

I had an professor in business school who used to say "...here's the rub."  I didn't understand that expression so in my infinite wisdom I asked and he said - "the rub is hole the argument - the part the just doesn't make sense..."  So, in dedication to the good Professor Cliff Smith..."Here's the rub."  The crowd funding sites at are stock brokers, not angel investors.  They stop far short of standing behind the companies they promote.  They dedicate much more space to their disclaimers than they do to their investment process and to explaining to investors the fundamental merits of each company.  Their documentation makes it clear that their compensation is derived from how much is invested.  Usually their compensation structure is something on the order of 5% - 8% of the capital raised.  Sometimes they also provide the investors a nominee holding structure and they take a carried interest in the capital raise.  The carried interest, they say, gives them an incentive to select good companies.  Maybe so, but the skeptic inside me says the carried interest can also be looked at as a lottery ticket, a free ride.

So - what with crowd funding?  Bad? Good? A disaster in the making?  My answer is d - all of the above.

The downside to crowd funding equity platformS is that while all the investors in the crowd are together in reality they are very much alone.  The nominee structure many sites offer is little more than a holding vehicle.  The nominee has no mandate to anything more than transmit information between the company and investors.  The nominee has no obligation or even the resources to take legal action or to ask questions or management or to attend board meetings.  If anything the nominee has the incentive to do as little as possible, lest it expose itself to legal risks. The second downside is that the investors, either collectively or on their own, usually have very little sway or influence on the governance of the company. They are usually in a weak minority position and rarely can negotiate particular terms to protect their interest.

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.

Not all is bad, however.  There will be success stories.  There already have been.  Good companies will get funding that might not have gotten funded in the past. Crowd funding sites will start to differentiate themselves by their success stories. Some will develop a particular skill of bringing good companies to investors, companies who genuinely care about their investors and treat them well.  Perhaps also the crowd investors will band together and appoint one or more of their own to take on a more active role.

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.



Wednesday 26 February 2014

Equity - Crowdfunding - The Good, The Bad and The Ugly



Anyone who knows me well knows that I am not the sort of person that makes foul noises at tea parties.

But investing is a serious matter. An investor takes hard earned money and puts it to work in hopes of obtaining a return on investment. An investor who puts money to work and doesn't expect a return on investment is not investing, at least not in my dictionary.

Where did the term "Angel Investor" come from anyhow?  Are we angel investors really angels or are we simply investors who might happen to be in the right place at the right time and make an investment when  it is sorely needed or wanted?

I manage an Angel Venture Fund which I creatively named Symfonie (that's my company) Angel Ventures.  The fund is great fun to manage.  I get to look at all sorts of interesting projects, I get to meet creative, dynamic people and I get to work with a team of dedicated smart professionals each of whom brings enormous value to the fund.

The investors who put their hard earned money into my fund most certainly did not tell me they didn't expect a return on their investment.  On the contrary, each of them told me in no uncertain times that they want my colleagues and I to do our best, select good companies and make investments that will pay off.   No dollar in my fund is allowed to slack off.  Each dollar must work.  No dollar is allowed to just wander off on its own without agenda or mission.

Recently the Ministry of Finance here in the Czech Republic offered me the honor of presenting some thoughts on crowd funding to an audience at a conference hosted by the Prague High School of Economics (not high school like what we have in America, but high school meaning a school where people earn higher level degrees).

The day of the conference I had a schedule conflict.  I had to be in Warsaw with Bruce Pales of 360 Cities (www.360cities.net) and Radovan Grezo of Click 2 Stream (http://www.click2stream.com)  and the best Symfonie partner in Warsaw, Ewa Chronowska.  Since I couldn't be in Prague and Warsaw at the same time (I'm only human, after all) I asked Pavel Kohout to attend the Prague conference and present his views on crowd funding. Pavel did an excellent job and I thank him for that.

All this leads me back to the crowd funding tea party, where I should be social and polite.  I can't help myself, however. I must be honest.  The entreprenuers in search of money and the crowd funding platforms in search of commissions would like to have you believe otherwise, but in my humble opinion, the investors at the crowd funding party are likely to wake up with a hangover.

Why?  I'll tell you why with my top 10 list of thoughts on crowd funding.

1. Most startup companies fail. To make up for the failures, the success stories must have hugely positive outsized returns to compensate. According to Harvard Business School, upto 75% of venture capital funded companies become loss-making investment.  VC backing comes only after lots of meetings and lots of research on the part the VC firm.  How can the crowd realistically expect to do better?

2. The surviving companies, those that don't fail, may have  to go through several capital raising rounds over several years before finally offering those initial investors an exit.  The returns at that point may be substantial in absolute terms, but when annualised are not likely to have been such great investments after all.

3. There are enormous information assymetries between the founder/manager/entreprenuers and the crowd of investors.  The crowd is simply not in a good position to make very informed judgements.  Either the information the crowd receives is way too little or the information is sugar coated, mainly because the investee company is in fund raising mode. The crowd in practice is likely to know very little about off-balance sheet financing, obligations the company may have to pay bills in arrears, the skills and ability of the management, or the competitive landscape the company faces.

4.  The crowd is not likely to be well represented in the corporate governance structure.  The crowd usually has a weak minority position with no liquidation preferences, no dividend stipulations, no particular ability to monitor and control the company and its activities.  Even if the crowd invests through a nominee holding structure, the nominee is likely to do little and will almost certainly refrain from attempting to act for and on behalf of the crowd or will not even be empowered to act for the investors.

5. The crowd can do little if anything to add value to the company or influence its development.  The crowd's message to the entrepreneur is basically - "here's the money, now go forth and multiply."  The problem is - the company might not simply have the tools and expertise to go forth and multiply.

6. The crowd funding platforms do little more than review the company's business plan and investigate the background of the entrepreneurs.  The crowd funding platforms don't have significant due diligence budgets, nor do they have the incentives to invest in due diligence.  Think about it! If a crowdfunding platform will sell $500,000 of equity and take an 8% commission (about $40,000) after it pays its staff and its marketers and its website programmers how many accountants and lawyers and smart researchers can the platform realistically engage? This is partially why crowd funding platforms have such broad disclaimer language in their terms and conditions.

7. Unless the crowd funding platform has a serious investment in the company, the crowd funding platform is not likely to work to add value to the company.  Rather, the crowd funding platform will have its eyes firmly focused on the next beautiful piece of merchandise to put in the front window of it's internet storefront.

8. Most investors don't have the benefit of day to day, week to week contact with the investee company after the deal is done.  They won't be able to effectively monitor or control or help lead the company to success.

9. The crowd doesn't get the benefit of proper quarterly, semi-annual, even annual transparent accounts and financial reports.  Few startup companies have the skills or staff required for reporting and even if they do, more than likely their lawyers will advise them to say as little as possible, lest they risk opening themselves up to lawsuits.

10. Crowdfunding and computer/internet technology have dramatically lowered the cost of starting a company and obtaining financing.  This means more startup companies are likely experiment and take on business plans without fully understanding or evaluating the risks.

I can go on and list another 10 things, but by now I've probably worn out the welcome mat.

Don't get me wrong.  I'm not totally against crowd funding.  On the contrary, I think crowd funding platforms have an enormous opportunity and can be successful if they invest heavily in selecting the companies for their platform, mentoring the companies, and finding ways to help the companies succeed.

In the next blog I will explain why (in my dramatically biased opinion) investors are far more likely to succeed by working with a good angel investment manager or a smart investor who arranges a syndicate.

Until then.....