Angel Investing – Some thoughts
Peter @conkers3 has asked me to put down a few considerations on Angel Investing. I have been an Angel Investor for about 30 years. This does not mean I am any good at it. But it does mean I am not so bad as to go bust. It is also not my main source of income so my mistakes hurt but they are not the end of the world. They points raised are my opinion only and should be taken only as information, rather than advice.
1 – IMHO Angel Investing is a walk away game. By this I mean if you are not very sure of the situation you should walk away. Statistically speaking over a 10 year period most people with a semi diversified portfolio in publicly traded shares will profit. This is not true of Angel Investing. Most investments in the Angel arena will make you no money. I was told long ago and the numbers still seem to be broadly correct that out of 6 investments, 2 will go bust, 2 will make little or no money for the investor but not have the decency to die and 1 will do OK, probably after you have put more money in. Only 1 in 6 can reasonably be hoped to do genuinely well. But that one pays for all the others. And this is after detailed due diligence and the fact that at the start I was really sure all 6 were great ideas.
2 – Understand what you are signing up for. There are lots of terms that get used in the sector, Seed, Angel, Crowdfunded etc, etc. Great as a general discussion but if you are spending your own hard earned cash be very careful to read the small print. One man’s Angel is another man’s Mug Punter. Very often documents have been drawn up by lawyers who have no experience in the Angel market and no real interest in getting a deal done. Or by lawyers who put in ridiculous clauses �to protect their client�. If the vendor wants overly extensive legal protections I will assume they reckon they will lose me money and walk away.
3 – Much of what is commonly referred to as Angel Investing is in part relationship based. Either the investor has enough time that they can build and maintain a relationship with management, perhaps a Board seat, or the Angel investors act as a group and there is a lead investor that does a lot of the leg work and the other Angel’s are working through and trusting this lead Angel. If there is no real relationship, either direct or indirect it may be sold as Angel Investing but it is probably better labelled as simply higher risk. That is not to say do not do it. But you do need to believe the potential returns validate the high risk.
4 – Headline pricing is often flexible. When you hear about companies putting X or Y into an investment it is often with certain key terms that do not get mentioned. (a) Ratchet clauses. I will value your business at �10 million today. And put in �1 million for 10%. If at any time in the future anyone else invests at a lower price I get more shares for free to keep my �1 million valued at �1 million. (b) Second cash clauses. I will invest today. If you need more money you have to come back to me. And if you need I will squeeze you (they don’t usually put this bit). Though I have seen contracts with money today is X%, but money tomorrow is 2X% (c) Performance clauses. If you do X you get Y, but in off market deals investors often demand that they get Y until the management has done X. So heads they win and tails they do not lose much. ie the Angels get 80% on day 1 of the shares but management get 10% if they hit year 1 revenue target, 10% if they hit year 2 target, etc. So deliver the plan and Angels have 40%, Management 60% but fail to deliver the plan and the Angel gets 80% of what is achieved.
5 – If it is such a good idea why are management and their advisors not putting up the cash? Sometimes everyone is tapped out, or the advisors have already reached their firm’s level of investment. But if a manager is taking a salary and not equity and wants your money why would you give it? Everyone needs a living wage, but equity in from investors for cash out by managers and advisors is not great. Even if the advisors are not putting cash in is are they prepared to take remuneration in locked in equity? If they do not want the shares why would you? Never be fooled by advisors claiming they cannot get involved in a deal for conflicts of interest. If they think it’s a great deal they will find a way to be involved.
6 – Whatever the timetable to get a crystalisation event at least double it. If you cannot wait that long do not start. Most of the companies that have beaten their crystalisation timetable have done it by going bust far earlier than expected. There are of course deals that will run to plan, or in advance of plan, but you must always consider that this is an illiquid investment and exiting it absent the crystalisation will likely scalp you. Last year I looked at an investment that a VC had. The intention had been to wind up a particular fund in 2012 but they could not sell 2 holdings. One was the business I was shown. On paper it was a give away, but then I met the MD. This is a professional VC investing in small and mid cap companies and they are now 4 years behind with their realisation plan and getting pretty desperate.
7 – What is the cashflow plan and does it have enough headroom. People often overestimate what can be done in a year and underestimate what can be done in 5. Cashflow forecasts that rely on a deal being signed in month 10, or the business runs out of cash in month 11 are very, very, high risk. I would suggest you need to understand what is the Plan B for cash in month 11. Even if it is only you getting ready to turn up in month 11 and say “I have the funds to keep this going, but it is going to cost you”.
8 – Do you trust the management and the people selling the deal to you? I am not a great judge of people. I have doubted people I should have trusted, and trusted people I should have doubted. But nobody needs the hassle of wondering whether they are getting into bed with a crook and finding out they were right to wonder. It is knowing it doubted and doing it anyway that really eats me up and costs me money.
9 – Can you appoint/fire management. It is not uncommon for Angel Investors to put themselves in a position where either the FD is their appointee or subject to their veto. Broadly the thinking is that the CEO is critical to the business. So if anything goes wrong he is hard to fire, you need him to deliver the value. But an FD has a range of skills that can often be brought by someone else so sacking him is a real shot across the bows for the CEO, without the damage to the business.
10 – Be aware of your biases. A lot of Angel investing is even more of a story than publicly traded equity. The companies are younger, the managers often less proven, the “idea” less founded in current practise. It is all too easy for your “gut instinct” which is a polite way to say “biases” to kick in and lead you down the wrong route.
11 – Communication. How and when is this company going to keep you informed. If the company commits to a format what happens if it does not stick to it? Is what the company saying it will provide useful to you? More volume, or more often is not inherently better or appropriate. But a set of the basic audited accounts once a year is probably too little. AGM’s only count if you can go to them.
12 – What are the names associated with this company? If the Chairman of a digital marketing company was a Director of Sky or Amazon, that is probably a plus. If the CEO has created and sold 5 businesses for value before it’s a plus. If the CEO is on the board of 15 companies currently in administration you have to wonder. Do your homework. Get the key names and look them up at Companies House. Use Google and Bing to do searches on the name and see what it says. Do not stop at tier 1. Last year I had a look at someone who on first basis looked good. Chairman of a small group of 3 companies. Half an hour later I had the listing of 121 companies he had been on the board of that went bust and enough info on the way some of them went bust to walk away. A very extreme case to be sure, but I am often surprised by what I can quickly find. Going ahead with deals when I have found some worrying information, because the deal was so good or the individual had a “good” explanation is absolutely my most expensive error set as an Angel Investor.
13 – Where is the next round of funding coming from. If the company runs short of cash and the deal is that they have to come back to you, this can enable you to maximise your position. If the company can go elsewhere it is probably someone else who gets maximised. If the company is growing as forecast it may well be that it goes out for another round of funding and this has a higher valuation than you bought in with. But now you find yourself with an illiquid holding possibly with a great new shareholder, possibly with a bunch of sharks.
14 – Do you understand the opportunity and how the business seeks to solve it. And can you value it sensibly. Remember if a lot of your investments will go bust you need a high return on the ones that work. I was recently offered an opportunity to invest in digital recognition technology. I did not understand the market value of the opportunity until I had a contact look at the prospectus. With his knowledge it was (a) an opportunity to invest in a business that could easily be worth 40* my entry point (b) the competition was much more severe than let on (c ) the management team had low credibility. It may be the one that got away but it demonstrates that in most fields there are people who know what they are talking about. If they want to put money in this is a very good sign. But if you do not understand how and why you ought in my opinion to walk away.
All of the above having been said I do enjoy Angel Investing. Most of the time, even when I do not invest, I learn something about business that I did not know before. I have met genuine entrepreneurs and other investors whose opinions I value. I am even still in contact with some entrepreneurs with whom I invested and the business ended up closing. In my opinion it was not their fault. Yes my wallet got hurt but if they brought me another deal to look at I would look.
The article was written by Jonathan Curry who you can follow on @jpsc01.
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