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.