Why and how to invest in startups
The following is a fleshed out written version of the points I made in a presentation about startups last night at The Black Onyx private members City networking club.
1) Economic outlook
We are in the process of moving from an economy based on the industrial revolution to one based on the new information revolution and shaped by digital technologies which dramatically change how people organise themselves and do business.
Market leading technologies are now available at the consumer level, such as cloud subscription services and social media networks, which not only level the playing field, but mean that traditional organisations with their legacy overheads and bureaucracies are increasingly uncompetitive. Hierarchical and controlled big companies are in the process of being replaced by more agile networks of free thinking individuals brought together and organised through the internet. As a result, the rise in self-employment and entrepreneurship will continue apace and successful businesses will be marked by such characteristics as the ability to connect individuals and to develop open source as opposed to proprietary systems.
Two years ago Marc Andreessen (founder of Netscape and investor in the likes of Facebook, Twitter, Skype, Groupon and LinkedIn) was interviewed by the Wall Street Journal, where he explained why ‘software is eating the world’. He demonstrated the fact by pointing to the fact that the world’s biggest bookseller is now Amazon, the world’s biggest music retailer is Apple’s iTunes and the fastest growing telecom company is Skype. All are software companies who utilise the internet to sell and serve their products and services and the same principles can be applied to nearly all other businesses.
The growth of Web 2.0 (the ‘2nd version’ of the web where websites act like software as opposed to static pages of content) will lead to more and more web based and software focused platform companies that will dominate their competitors and change the way their markets function. With the emergence of e-commerce software platforms like Shopify and Magento it has never been easier to setup your own online store and start selling products online, although without the overheads of running a physical store and with your products on display to a much wider international audience of potential customers.
Also, for service based businesses, the rise of social media and search engines like Google have made it incredibly cost-effective to acquire customers, while many such businesses are having to change their business models by becoming more like web publishing companies and monetising their knowledge through online content and networks. I think this change is particularly relevant to how legal services are provided.
Another developing trend is that many of the best companies are staying private for a long time in order to avoid the regulatory overload that being a public company entails, while modern companies don’t need the same level of finance provided by an institutional shareholder base in order to scale their business on the web. They also don’t need to fund the armies of employees that used to characterise successful businesses and instead look to grow their ecosystem and community of self-employed contractors that new communication technologies facilitate. Its worth noting that the number of publicly traded companies has dropped by half in the past 12 years.
As a result of these technological changes, the status quo and market incumbents are in trouble everywhere. Long established but unwieldy FTSE companies and banks are proving to be unfit for purpose in a digital age. Whether the government or the corporate elites like it not, and no matter how much they try to bailout the banks and impose top down solutions, we are entering an unprecedented period of creative destruction driven by entrepreneurial and technology focused startups that are able to deliver superior products and services.
2) Different ways to invest
Startups have always mostly been financed by risk capital, i.e. equity investment where the risk is shared with the entrepreneur(s). Although it has always been possible to get a small loan from a bank (to the extent the lender thinks you can repay it), for any significant financing debt has never usually been possible because the startup will commonly not have assets that the bank can register security against and there is no trading record to give the lender comfort.
a) VC firms
Venture capital firms have been the traditional way of providing equity funding. When new business creation was more unusual and much more capital was needed to start and scale a business these firms were able to provide sufficient funding, while because of the larger sums at risk venture capital firms could manage the added cost of legal work, valuations and other administrative expenses that went into the process. Venture capital firms remain relevant for startups raising larger rounds of funding, but it must be remembered that they are formal organisations with high overheads that will need to extract sufficient pounds of flesh even if they rely on the presumption that only a few in their portfolio will deliver a significant return and the elusive ‘home run’.
b) Angel investors
As startups proliferate and the capital that they require to scale and generate revenue reduces, angel investors (commonly successful entrepreneurs who have a knowledge of business and technology) have increased in number and prominence. Angels have always been around but are becoming more common as the capital needed for a startup becomes less and less, startup entrepreneurs proliferate and it becomes easier to put together the legal paperwork required to conclude a deal. Also, in recent years the UK government has offered angel investors significant tax incentives in the form of the Enterprise Investment Scheme (“EIS”) and the Seed Enterprise Investment Scheme (“SEIS”) (more about these two later on).
As a result of the EIS and the SEIS several funds focused on startups (such as Ascension Ventures) have developed that seek out opportunities and invest on behalf of their individual investor clients. Such funds act as a nominee to hold the shares in the investee company, but for legal and tax purposes the individuals are the beneficial owners of their shareholdings. Also there are now many online networks and resources that make it easy to find angel investors and pitch your business opportunity to them. Two examples that spring to mind are the Angel Investment Network and Angel List.
c) Convertible loan notes
Particularly in the US, many startups receive investment via convertible loan notes which are evidence of a loan which is then convertible into equity at a later date, at specific rates or in response to particular events. They allow investors to achieve a healthy yield and obtain the benefits of a call option over shares in the issuer at a fixed price, which is usually exercised when a VC comes in at a certain valuation. Accrued interest is factored into the conversion, up till then the startup doesn’t usually service the debt.
d) Revenue participation notes
Another slightly more unusual form of finance is a revenue participation note. These are described as ‘quasi equity’, in that they combine the note (a typical loan plus coupon) plus a revenue participation structure (percentage of sales for a defined period of time) that gets capital to the enterprise without affecting its ownership, goals or mission. As a result, if the startup is seen as a good prospect the lender/investor believes he/she will be adequately compensated for the risks involved. The only time I have put something together like this before was for a web developer who worked on a project for a friend in his spare time. The web developer investor then received a share of the revenue and interest once the site went live.
In the US rewards based crowdfunding sites like Kickstarter have already proved hugely popular. These sites work by letting the investee company receive donations in return for which they reward their investors with perks, pre-sales and other things of value, thus not falling foul of the US’s securities regulations.
However, in the last couple of years the UK has been leading the world in the development of equity based crowdfunding, principally through Crowdcube and Seedrs which effectively allow startups to do their own mini-IPO and raise money from an army of ‘armchair dragons’ who can invest anything from £10 upwards in return for shares in the company that allow them to benefit from the potential upside of future dividends and capital gains. Such crowdfunding means startups can leverage the knowledge and influence of the ‘crowd’ and makes raising finance much easier through such features as transparent due diligence, standardised procedures and online payments.
With Crowdcube investors commonly receive B shares which only entitle them to income and capital, whereas more significant investors can receive ordinary A shares that also allow them to vote on certain issues. Like Crowdcube, Seedrs also screen startups to try and have a degree of control regarding the quality of startups on their platform, but instead of different classes of shares they have a nominee structure where Seedrs hold the legal title to the shares and monitor and enforce shareholder rights for the investors who receive the benefit of the investment. This gets rid of the administrative hassle of dealing with so many voting shareholders that puts off future investors, but also encourages the companies to be much more respectful of their backers.
3) What to look for in startups
Please note that the following section does not constitute investment advice and is just based on my humble observations of having been involved with startups over the last few years!
People always talk about the importance of the team, but more often than not just one of the founders has the principle vision and is the actual driving force. Therefore look for the dominant personality in the team (think Mark Zuckerberg) and ensure they have adequate control over decision making and are respected enough by the other team members for them to continue to be involved with the company. As a lawyer I often come across businesses where no single shareholder sufficiently controls decision making and this can lead to a lot of ill will, conflict and decision making deadlock which harms the development of the company.
Where one angel investor or a small syndicate of angels invest in a startup quite often there is already some kind of relationship that has been developed with the entrepreneur(s). The parties may have worked together in the past or know each other from the same industry. This means that there is already a certain degree of trust and the investors are more likely to have confidence in the people behind the startup. Ideally, startups should put themselves about and be well networked, so rather than prospecting for funding they are in a position where relevant investors are likely to approach them in the first place.
It helps that entrepreneurs have a track record in, and knowledge of, the industry which they are hoping to disrupt. This background should mean that they can correctly identify where the opportunities and weak spots are, that they will be confident of defeating competitors and that they will be driven by a sufficient level of passion for the marketplace in question.
With the internet everyone is now a publisher and every business is now a media company. Content is becoming more and more important in order to build a business and all startups need a sufficiently well developed and sophisticated content strategy.
I believe that all founders of startups need to be proficient users of social media so that they can apply their influential online personal brands and knowledge of the web in order to grow their startups. Its always been true that your ‘network is your net worth’ and those with large online and offline networks will have access to quality collaborators, a high degree of influence that they can leverage, an understanding of the latest trends, an ability to spread their ideas, access to market leading knowledge and the possibility for receiving and listening to lots of quality feedback from their network. All of these factors will enable entrepreneurs to build a long term sustainable community around their products and services.
With technology being so accessible all investors will now want to see a minimum viable product out there already and gaining traction before they invest. They will prefer to see a startup that has bootstrapped and followed the lean startup methodology in order to get off the ground as this will usually mean that the business will be structured in the best way possible and won’t have wasted money and incurred liabilities as a result of poor decision making facilitated by overspending. No matter how good you think your idea is, investors will want to see the idea already proving it can generate revenue and importantly that the founder team can execute well without burning through cash.
Technology means that a startup can be an international company from their first day of trading. As a result, investors will want startups to be sufficiently ambitious so that they are looking to make use of a global marketplace for their products and services.
As forms of startup finance grow, I believe that serious angel investors will increasingly carry out a form of screening by expecting entrepreneurs to not only have first invested their own savings (and cashflow of the business) and raised funds from family and friends (if possible), but to have already raised small funds from outsiders, for example on rewards based crowdfunding platforms or even through the new UK government Startup Loans Company.
4) Legal structure of deals
I’ve touched above a bit on how the equity crowdfunding sites work, but below I’ll give a bit of detail of how an angel investment is usually put together when such platforms aren’t used to invest through.
In my experience, for a first round angel investment, the investor will usually put in at least £20,000 in return for no more than 25% of the company’s ordinary share capital. Very rarely the investor might be issued with a form of preference shares. The angel will have a place on the board as a non-executive director and look to develop a close mentorship role. He/she will monitor the investment by fairly regularly analysing the management accounts and making suggestions for improvements.
Before engaging any lawyers the angel and the founder(s) will normally agree a term sheet (marked ‘subject to contract’) that will set out the main aspects of the deal. Once lawyers are instructed they will work these points into an investment agreement (also referred to a ‘subscription and shareholders agreement’) and any other relevant documentation that will then be negotiated between the parties. Such investment agreement will include the procedure for issuing the shares and completing the deal, rights granted to the investor to veto certain decisions, information rights, control over how existing shares can be transferred and new shares issued, exit provisions, restrictive covenants, confidentiality obligations and warranties and indemnities to protect the investor. To the extent that any of the warranties (i.e. statements that the investor ask the founder to make at completion) are untrue, the founder will write a disclosure letter qualifying the warranties with all the existing facts that make the warranties inaccurate so that the investor is put on notice of all material information and won’t be able to sue the founder for a breach of warranty.
As well as the investment agreement, the deal may involve changes to the company’s publicly available articles of association, while several ancillary documents will make up the paperwork such as shareholder resolutions, board minutes, a statement of capital form, a director appointment form and a share certificate. A client account operated by a firm of solicitors is normally used to ensure that completion monies are held in escrow and released when all the completion conditions have been met and exchange has occurred.
Having all the paperwork properly put in place is important not only so that the investment is backed by contractual protections, but to also ensure everything is properly discussed and agreed so as to prevent later disagreements and disputes and also to give security to future investors.
5) Due diligence
The investor’s investigations will normally cover separate financial, legal and technical due diligence. Other types of commercial due diligence, such as market analysis, may also take place. The nature and scope of any due diligence will vary and will normally depend on the company’s stage of development.
The investor’s lawyers will be asked to conduct an element of legal due diligence on the target investee company. The extent of this will depend on the trading history of the target and the investor’s appetite for information about the target. In any case, the scope of due diligence will usually cover areas such as the constitution and structure of the board and shareholders, intellectual property, employment contracts, existing financing arrangements, existing licences, research and development and other collaboration agreements, property arrangements and key commercial contracts.
EIS and SEIS schemes
The EIS was initiated back in 1993 by the then Conservative government to encourage entrepreneurship. The minimum investment through the EIS is just £500 in any one company in any one tax year and such investments now qualify for 30% income tax relief. As of April 2012 such income tax relief can be claimed up to £1,000,000 giving a maximum tax reduction in any one year of £300,000 provided you have sufficient income tax liability to cover it. Any gain an investor makes is also free of Capital Gains Tax (“CGT”) if the shares are held for at least three years and the income tax relief was previously claimed. Shares can of course be held for much longer and therefore potentially enable the investor to accrue their CGT exemption over a long period of time which can be a great attraction.
The SEIS works in a similar way to the EIS, but allows investors 50% income tax relief, together with complete exemption from CGT on disposal on investments up to £150,000 (once 70% of such capital raised has been utilised the startup can also then qualify for EIS). There is also a capital gains re-investment relief which entitles investors to an additional CGT exemption worth 28% in the first year (2012/13 only) of the SEIS on the gain of other assets realised in that time period (i.e. SEIS offers a complete exemption from tax on capital gains on the disposal of other assets up to the overall SEIS limit of £100k). Similar to the EIS, investor can also get loss relief (if their investment fails) at the taxpayer’s marginal rate on net cost of investment after income tax relief, subject to the company meeting the general conditions for share loss relief.
The following example gives you an idea how SEIS works in practice:
Jane invests £50,000 under the SEIS in the tax year 2012/13. Jane works out her annual income then calculates how much tax she has to pay taking into account her personal allowance, which results in an income tax liability of £40,000. After three years Jane sells the SEIS shares for £75,000.
By claiming the 50% SEIS Relief on the £50,000 invested, her income tax liability is reduced by £25,000 from £40,000 to £15,000. She therefore holds an investment worth £50,000 at the time of investment which has only cost her £25,000. Any capital gains on this investment after 3 years will be capital gains tax free, saving tax again then. After three years Jane sells the SEIS shares for £75,000. There is no capital gains tax to pay, saving £7,000. Jane’s investment which had a net cost to her of £25,000 has returned her £75,000 after tax – 3 times her net cost.