“All great achievements require time.”
– Maya Angelou
So, as an investor, you’re trying to build a Fund to further mitigate the risk on all your investments. You may be thinking that investing all your money to an idea you absolutely believe in would possibly get you where you want, sparing you all the hustle and the bustle. I by no means claim to be “the” expert, but let’s briefly go through a few reasons why a Fund may be the better option among others.
Why would a Fund be better than an independent Angel Investment?
It’s all on risk mitigation. If you were to invest all your money on a single investment, you’d be left with empty pockets, were it to fail. But if you were to split your investment capital among 10 different investments, along with 10 other people, you’d still invest the same amount of money, only you’d lose a tenth of it when a venture failed. That’s reason enough for most investors!
And yes, I know that any smart investor would not invest more than 5% of their liquid assets at any given time. That is, to preserve their status and lifestyle fairly unchanged. By “empty pockets” I mean no more capital will be left out of that 5%.
Building a Fund
And here you are at this great dinner with all the fellow investors, having a good time and casually discussing the details of it all. Some of these people may be trying to build “a circle of trust”. That’s good for business. And they’ll surely have a few questions to go with their beverage. That’s what your trusty pitch deck is for, isn’t it? But what do your fellow investors need to know?
Does the ticket match the runway?
When investors come on board with a fund, they rely on a set of proverbial rules that will be their basis of operations. Say a startup comes in with a request for funding. The investors have to agree on a standard funding ticket, which will make things easier to calculate and control. This will not act as a constraint, as there can always be follow up investments. You should see it more like a way to standardize the distribution of risk and manage occasional dividends more easily.
Just about any startup will go through the early stages of prototyping, technically proofing their concept, validating their assumptions, and then growing. And eventually scaling into this great business that gets to make a spectacular exit. All this, of course, takes time.
Here’s the question:
Based on the ticket they’ll receive from your fund, will they have enough time to reach the point where growth has produced a positive cash flow?
If the answer is “yes”, then that’s the end of the conversation.
But, if the answer is “no”, or “perhaps”, you should consider a strategy that will get them another round of funding.
Now, here’s the catch:
If the second round of investments comes from different investors, then the percentage of ownership in assets and future earnings will be diluted for existing investors. This is something that may be disconcerting to all parties.
If, on the other hand, the second round of investments were to come from the same investors, it would be called — as mentioned above — a follow up investment. It would remove the dissonance resulting from possible dilution. But such an advancement would require a few fail-safes to be in place. For instance, some progress should be visible on the startup’s side. And it should happen within a certain time frame, or at the right timing.
Does the current time-frame allow for stable de-investment period?
As currency decays in value, so does investment capital. And truth be told, if decay doesn’t catch up with you, interest rates probably will. Even if you started an investment with really great interest rates, if you wait too long, they will eventually devalue your profits, or your capital even, to the point you might as well write it off. I may be exaggerating, but you probably get my point. There is actually some flexibility to this effect. More on that below, when we discuss capital loss ratio.
The trick to retaining an acceptable value for money, for each investment, is to keep track of all sorts of advancements that affect economy, to guide your decisions. That’s not entirely easy, since you also need to associate it with a certain level of insight, with an eye toward the future. Soft of predict what’s coming.
If this does not happen, you might be better off getting index value for your capital and stay home having cocktails (so to speak). Index value is measured by “Weighted Average Market Capitalization”. Although it’s an average, it gets its data from economically relevant sources. Which makes it inherently relevant to the value of your Venture or Fund capital.
Currency decay and interest rates are, among others, stabilization factors that best serve our investment by not changing. The real question is, did we make an investment at the right time that will allow us for a de-investment period without any unpleasant surprises?
So, again, timing. Most investments are allowed to yield the results they do, due to a certain trend in a certain market. Incidentally, for those of us in the SaaS sector, there seems to be an emergent trend towards Fintech, Insurtech and Spacetech products, more or less. Guided or naturally occurring as an eventuality, a trend is one of the most important factors affecting group investments.
A trend is not forever. There is a certain time window that allows for maximum performance. Otherwise, competition takes over. Investments can still be made, but they won’t be as extensive. In a case of B2C relationship, a less than ideal investment in capital, could be devastating for a startup. But how does competition deprive a startup from its success, at the investment level?
Say a very important fund or VC (international or not) kicks off a round of investments throughout a certain market segment. It is certain that in the next few months to a year, all competing funds, VCs, etc will have found similar opportunities to dive into. That is, given that this side of the market is not forecast being in any immediate “danger” of being saturated. It’s now a matter of time before all real problems are validated by the key players and all viable solutions are developed and ready for “consumption”. If you can’t make a difference by then, you probably won’t get to have a shot at the spectacular exit you were wishing for.
Do legacy investments allow for a clear track record?
Back to building our Fund, our investors are here because they’re already interested in coming on board. One of the first things they’re looking for is our track record. A healthy track record is an excellent indicator of risk mitigation. That goes to say, the better the track record, the higher the probability of success for the Fund. Risk mitigation in all its splendor. Sublime! But wait, there’s more!
How about write offs? — The dreaded slide #13
A failed venture, or a write off, is like a black hole for investment capital. Oftentimes, it’s a venture that you have invested enough in, to completely turn around your track record. You have to handle such cases very carefully. Investors that are interested in your fund will want to know why it failed and how it has helped you avoid the same outcome in the future. Knowledge is power. On the other hand, having paid a great amount of money for a few bits of knowledge you could perchance have acquired more easily, is a fact that can and probably will impact your track record like nothing else.
So, was it a write off, or was it a pivot? Why did it happen? Was it a lost time window? Lack of method? Lack of commitment? Or is it lack of proper guidance? Give it some extra thought and what you’ll find out may save your future ventures from certain failure.
What’s a healthy capital loss ratio?
Capital loss is the loss incurred when a capital asset, such as an investment, decreases in value. This loss is not realized until the asset is sold for a price that is lower than the original purchase price (or funding price for sole investors). It is essentially the difference between the purchase price and the price at which the asset is sold, where the sale price is lower than the purchase price. Its ratio is the price an asset was sold, divided by the purchase price.
That said, let’s consider early stage investments. Even though a maximum combined capital loss ratio of 20% would be ideal in theory, it could be an indicator that you avoid risk at all costs. A combined capital loss ratio of 40%, anywhere upwards of 2 years into the investment would still support profitability, while indicating that you take your risks whenever needed. More importantly it shows that you’re not a quitter.
How EBITDA affects your track record in the short and the long term
Ah! Earnings before interest, tax, depreciation and amortization. It affects your track record in a couple of different ways.
Besides interest rates being the ever changing beast that it is, indirectly devaluing your investment, taxes are different for less earnings than they are for lots of them. Meaning, taxes are not applied linearly. The more the earnings, the more the taxes in comparison. You have to make sure that if your earnings increase to that point, you have the growth rate and retention rate to keep your earnings from taking a fall.
Then there’s depreciation. If you’ve started an investment in a stable environment, it’s impossible to see the effect of depreciation during the first period. But if you haven’t made it through in a couple of years, depreciation is almost certainly going to make its presence obvious. It occasionally goes hand in hand with interest rates, amplifying or speeding up the effect. You need to be conscious of the local economy at all levels.
Amortization is a bit different. It ensures you don’t let the entire investment capital go in an uncontrolled manner. But there is a side effect. In case of capital impairment, you’re holding a good portion of the capital that has not been spent but has just decreased in value. And it’s actually sort of on the opposite side of taxation. The less capital you have in your hands due to amortization, the less is the loss due to devaluation.
How a time window for trending investments in your sector affects funding options
That, at least, should be obvious. The right timing is the difference between you getting all the glory or your competitors beating you to it. If the thought leaders and influencers in your industry have made it so there is a wave of investments happening as a means to rethink or simply revisit the way problems get solved, you need to be able to get on that train, just as it pulls up at the station. If you don’t make it, your opportunity cost is probably much greater than you thought. That goes to say, you may have lost the opportunity altogether.
A time window usually ends almost as abruptly as it started. A few months may be all you have as a fighting chance. Try to be ready for cases like this. Be ready to pivot, design, develop, release and learn at the blink of an eye. And while a lean approach, such as this one, is not mandatory for a Fund to execute their business model, it is one that will help you prepare for speed and agility.
Originality Vs safe bets
As an entrepreneur, one may be thinking: “We’ll solve this existing problem in a different and much more efficient way. People will thank us for it. We don’t need to find an original problem!”. And they may be right! Or not.
As it is, you need to make sure you can find investors that specialize in your target market, who also happen to think the same way you do. If you can find none, you may have done your teams a serious disservice. It’s easy to veer off course by following a mindset that should make sense. It may actually not. Validate the assumptions under which it would work, before you set up your business model on it.
While some investors would agree that an original idea wouldn’t mitigate their risk as much as a safe bet would, you will surely find others that would have you believe the exact opposite. Let me elaborate. An original idea and a solid team with just the right skill set is oftentimes what leads to a unicorn. A billion dollar company, sort of speak. The reason why this is more likely to happen with an original idea than with a safe bet is that an original idea can be realized without precedence. This is an advantage, inasmuch as it will take competition a great deal of time to come up with a viable alternative. You can use this advantage to create your solution in a way that is really, really hard to reproduce. Thus, giving your business model the market power it needs to grow and scale. In a way, that’s fuel for your track record.
Having said that, a safe bet is exactly that; A safe bet. Given a somewhat good combination of team and skills, it will probably get you there faster and with minimum surprises. But…, it may get you only so far in ROI. Having to split the pie with competitors can seriously limit everyone’s income. Compared to the previous case, your market power would now be much less, to start with. Finding specific markets with low competition is one way to go about it. Be sure to explain that to everyone that wants to join your Fund.
Being in a Fund, getting a tenfold ROI is not as important as simply getting a ROI. You just need everyone on the same page.
Getting in existing markets has more of a barrier to entry. Go-to-market strategy becomes a little bit harder to devise. However, in defending “safe bets”, training consumers to understand your product or service and having them understand its value and why and how its better that what your competitors have, is actually a breeze. Safe bets are actually found to scale up more easily.
Equities and dilution — The slide to rule them all
There are a couple of different settings to place yourself into. Incidentally, you can find yourself in both, at the same time.
In co-investment with co-founders
As we know, in most cases, an entrepreneur may invest his or her own money to get started. Friends, family and “fools” (as the old adage goes) may come next, as a certain cash flow is needed to maintain the pace. Eventually, though, they will have to reach out to investors, possibly Angel investors, to try and raise a small-ish round that will keep them going for a year or so. That’s most of us, isn’t it?
Depending on the status of the startup and the type of investment that is agreed upon, we may ask for a considerable amount of the company, in equity. Sometimes, Angel investors will believe in the idea so much, that they may want to come on board as co-founders. In that case, owning a considerable portion of a company is alright, as long as they keep in mind that their equity will be diluted later on. A non co-founder investor owning more than 20–30% of the company would get future investors muddled up, having second thoughts about getting on board.
In co-investment with investors
We also know that most investors don’t really want to actively participate in the endeavor. So they mostly try to mitigate their risk using other means. Such as a three month acceleration program. They may call in a few entrepreneurs or investors that have the experience, to train your team in handling all the business level tasks at hand. This would give them the advantage of handling anything that comes up, with knowledge; by example, out of the box thinking and some general wisdom they may have collected over the years and want to share or pass on. This knowledge should keep them on track long enough, until the company gets to become “a person of its own”.
So, yes. This kind of investment is different. And we will most likely ask for less equity than before. This actually makes it easier for the team to raise another round at a later stage. The reason is, your say is less powerful than theirs. And every investor’s equity gets less diluted — that’s a Fund for you. So, it’s easier for future investors to decide on coming on board.
Usually, we only need to worry about proration when we’re about to get ourselves a spectacular exit. But then again, things may not go exactly as planned. So, proration may happen during an acquisition, as well.
The “acquiring” party usually offers a combination of cash and equity, and shareholders on your board can elect to take either. The remaining stock is prorated in case the available cash or shares are not sufficient to satisfy the offers that shareholders tender. In that case, the company grants a proportion of both cash and shares for each offer tendered so that everyone still gets their fair share of the deal.
Tough case, but being in a Fund, you can cut your losses and go on without considerable setbacks. Losses are distributed throughout the Fund, as would any dividends. So, the Fund worked like a shield and no one got hit with the full blow.
What did we learn?
Well, we did go through some of the important things in every investor’s mind when considering to join a Fund.
What’s the stake? Are we after the same thing? Are the teams getting the right coaching? Is there enough skin in the game? Has the team invested their own money first? Is there a strong skill set? Is this the right timing? Is there enough time? When is the economy projected to shift? When will interest rates start their ascend? Is the track record better than the norm? Are EBITDA indicators clear enough? Are equities worthwhile? What is the maximum dilution that can happen? Are my prorata rights protected?
That’s a lot to think about and it takes time. Then again, investors are used to considering all of these factors prior to a decision. All you need to do is make sure everything is clearly defined and answered in your presentation for the Fund you’re about to start. I mean, you couldn’t go wrong with that! Could you? Alright… you decide. Thanks for tuning in!