Big cuts are on the horizon for regional business development

Chancellor George Osborne’s announcement that the Business Department will bear the brunt of £6 billion cuts, could well signal difficult times to come for those businesses seeking regional development aid…

But help could be at hand if business angel numbers expand. As Labour’s ‘big government’ philosophy is unravelled by new kids on the block George Osborne and David Laws, this could affect new business enterprises who rely on development agencies and associated bodies to get them on the first rung of the ladder.

The aim of RDAs is to help create businesses through the fostering of entrepreneurship and growth in their respective regions. However,  according to a report by the Tapayers’ Alliance  success has been limited and, if figures between 1992 and 1996 are anything to go by,  over the course of 14 years the rate of business creation has fallen overall.

This is hardly surprising. Most businesses in the start-up phase will require support which includes money and advice. The former is often in short supply and only given out according to strict criteria and whether the sector is fashionable. Money is one thing, there will be other sources of funding available to the entrepreneur, but with businesses in for example emerging creative industries, access to expert advice  and money may well be in short supply in some areas.

It is understandable then that with this kind of limited success and with £6 billion of spending cuts to find, that the business development department is high on the list of the government’s targets for cuts ─ £836 million worth to be exact.

With cutbacks to a public sector service that was already struggling to deliver, The input of people like business angels will become vital in the years to come as those who are starting up businesses exhaust the goodwill of friends and family and search for support elsewhere. With cutbacks in development funding, and business lending from the UK’s banks still in short supply, business angels will be increasingly called upon to play the role of advisors as well as investors, which many do already.

The growth in the number of organised regional business angel networks in the UK in recent years goes some way towards plugging the gap in advice and funding while help from elsewhere is in short supply. However, with many appealing for more members there is clearly a shortfall in the number of business angels.

Without the valuable support angel investors can provide in terms of expertise those starting up businesses or those looking to take them to the next level may find themselves starved of advice and cash in some cases and forced to explore innovative ways to grow their business. Alternatively they could well be left to feel their way in the dark or, worse still, a promising idea may not be developed into a profitable business.

Enterprise and business is among the key drivers of growth in the UK economy. While government departments have lacked the required agility to support new ideas in rapidly developing sectors in recent years, such drastic cuts in funding could still see those businesses who would have benefited from some kind of government support left high and dry. It is clear that the new UK government’s strategy is to strike some kind of balance which won’t upset all of the people, but a possible imbalance in support for new business will need to be addressed.

Most entrepreneurs will have the instinct to succeed in what they do regardless of changes in government policy, but it would be unrealistic to expect business angels to suddenly ride to the rescue if the axe falls on government help. Firstly, there is an even greater burden of risk to carry, particularly in the current economic climate and there will be less chance of an early profitable exit than in recent years. A big consideration when most angel investors will be looking for a profit inside 3 years.

The number of business angels in the UK is tiny in comparison to the USA where we have just heard that new business creation hit a 14-year peak in 2009 according to The Kauffman Index of Entrepreneurial Activity. This was despite the worst recession in living memory and goes a long way towards revealing US appetite for enterprise.

We may well see a growth in the number of business angels in the UK who are passionate about supporting business creation. We might also see opposition to the decision to put the business development department on the chopping block, but as statistics in the US have proved, even in the worst of times there are more than enough people ready to take a risk.

Valuing a start-up business is no easy task

Seven years ago in August 2003 an unknown company released some software which would allow people to make free voice and video calls over the Internet. A year before the company had received seed capital from a group of private investors to allow the company to develop its idea. That company was Skype.

Skype was later bought by ebay for €2.1 billion and is now an indispensible means of essentially free international communication. Those early investors made a return of around 350 times their initial investment which was no doubt heavenly for those involved at the time.

Most start-ups can only dream of achieving rapid growth of this scale and generating profits of this magnitude for their business angel backers. The reality is that most start-ups will fall at either the first or second hurdle and the angel investors who backed them will be on the receiving end of an 80% failure rate when you look deeper into the stats.

But was it simply luck that allowed those early investors in Skype to hit the jackpot? Or was it as much about the ability to know when the price and the opportunity was the right one at the right time?

The biggest problem for angel investors as they ponder whether or not to invest their cash into a start-up business is assessing its value. Investing at this stage is undoubtedly a gamble as we have explored previously on ibusinessangel.com, but with the odds stacked against a successful outcome and the cash involved, the risk needs to be a calculated one.

So how do you assess the value of a start-up when even established businesses are difficult to value?

This really is the million dollar question and unfortunately impossible to answer for even the most seasoned investor. This is because valuing even an established business is more art than science. As an angel investor you will often be expected to assess the value of essentially nothing other than an ‘idea’. Experience as a business angel or learning from the experience of fellow angel investors is really the only way to gain some idea of how much a start-up business might be worth.

According to the experts there is a simple rule of thumb. If the start-up is just an idea, it is worth maybe £10,000; if it has a credible management team in place it could well be worth £100,000 and if it has sold its product to a real company for real money then it might be worth £500,000. There is of course a question mark against all three, is the ‘idea’ a good one?

For anyone who has watched the BBC’s Dragon’s Den good ideas certainly appear hard to come by. The show has its fair share of deluded entrepreneurs valuing their businesses to highly or often presenting laughable ideas to the panel with a completely straight face. Those individuals make good television but are they representative of the kinds of entrepreneurs out there seeking the backing of angels?

More than 90% of the ideas that find there way into the Den appear to lack the Reggae Reggae Sauce to succeed!

The high failure rate on TV could well be a result of the heavy emphasis on ideas and individuals. Rather than experienced teams of managers the people presenting their ideas often lack the basic fundamental business knowledge to make a credible case for investment. Their businesses are, more often than not, valued to highly and they are often seeking guidance and direction in addition to investment.

With this in mind it is worth considering whether the person with the great idea but with no business sense is worth the risk. Whilst the idea is important and in rare cases can lead to a significant return on investment, as suggested above, a business is worth more when it has a credible management team in place who know the route to market and have a track record of delivering success in their market place. Add this to a product that is already selling and you have a more realistic chance of long-term success.

While the lone wolf entrepreneur with a good idea may offer a bargain, if you prefer to play safe, it may well be worth considering investing a bit more cash in a good proven management team. You can never really know when the price is right , but you can look at the people you are investing in and hope their  expertise will give you a better chance of a heavenly exit three years down the line.

Analysis from the University of New Hampshire Centre for Venture Research at the Whittemore School of Business and Economics, discovered that the total amount of investments last year totalled  $17.6 billion. This represented a fall of 8.3 percent from 2008 investments of $19.2 billion. During the same period, however, the total number of deals increased to 57,225 from 55,480.

Where Business Angels Fear to Tread?

Investors in early stage and start-up businesses are known as angel investors. The tag ‘angel’ coming from their tendency to operate in the margins where venture capitalists, banks and other backers choose not to go.

They also help plug a major funding gap to get such ventures off the ground and they happen to be the kind of investors who are prepared to take a risk, rely on their instincts and invest large sums without too many hard questions asked.

At least this is the accepted view.

But we may well be seeing a new breed of business angel emerge, one that takes a more conservative approach in these risk averse times.

Times, as Bob Dylan once sang, are a-changing as we see a trend emerging both in the UK and the US for a more cautious approach to investing in embryonic stage businesses. With many investors’ fingers burnt by the financial crisis it is hardly surprising that the appetite for risk remains limited – which in turn is making it increasingly harder for start-up businesses to attract funding.

According to the latest NESTA report on business angel activity in the UK, 83 per cent of angel investments were made with co-investors and a significant proportion (28 per cent) were made within just 50 kilometres of home. Working close to home and in the company of fellow investors shows that most business angels need security like anyone else and are careful where they put their money. The figures debunk any myths suggesting otherwise.

This is further borne out by statistics released in the US where an article this month in BusinessWeek suggests angel investors are getting pickier based on their analysis of data supplied by Angelsoft, an internet based company supplying online tools to angel investors.

The study looks at the share of companies seeking angel funds passing through each stage of the ‘deal funnel’ between 2007-2009. Not surprisingly, given the economic climate in the past two years, a glance at the chart reveals a dramatic decline in the number of businesses getting even as far as the screening process between 2007 and 2009. The statistics make worrying reading for anyone hoping for an easy ride when they approach potential investors for their start-up if the pattern is repeated her in the UK. .

More worrying still, just 2.8% of businesses made it as far as the due diligence stage, a fall of more than 50% on 2007/08 figures. This would indicate that angel investors in the US have become, as the article suggests, more ‘picky’.

But is it simply a case of angel investors becoming more picky? The figures reveal that just under half of businesses make it through screening to the due diligence phase, which is a pattern that has been broadly repeated since 2007.

However even though there were around 50% less businesses making it through the deal funnel, when we reach the end of the funnel and to what those business are striving to achieve i.e. investment, the proportion of those businesses making it through the final stages, is shown to be higher in 2009 than in 2007 or 2008, with 2.8% making it to due diligence and 2.1% securing investment.

Herein lies the good news for those businesses who sought funding. The proportion of businesses receiving funding in 2009 compared to 2008 suggests that if a business made it to the due diligence stage, there was a significantly better chance of securing investment.

The small percentage of businesses that made it through screening and the presentation phase also stood a greater chance of making it to the end of the deal funnel. This may suggest that angel investors are indeed becoming more choosy, but it could well be more a case of less money in the angel investor’s pot making it tougher to get past this initial screening process.

We know that more than half of investments fail; therefore it doesn’t take a great leap of the imagination to conclude that angel investors are willing to take fewer risks than they once were. This will be bad news for many start-ups and there will be many innovative businesses that fail to get a vital injection of capital. The number of businesses that have slipped through the net since 2007 is anyone’s guess.

It isn’t all bad news, according to the figures in the US business angels are choosing to invest in a greater proportion of those businesses that make it through screening. But we may be seeing that even business angels have their limits.

Start-ups just aren’t feeling the love from banks right now

It may have been Valentines Day yesterday, but with banks’ reluctance to lend to businesses, they could push more start-ups into the arms of angel investors.

With UK banks still showing a reluctance to lend to businesses, companies could well be forced to look towards alternative sources to fund their ventures. The recession may be over, but with UK GDP figures just crawling over the line into positive territory, how are the banks doing? Those vital foundations of a functioning economy and an equally vital source of lending for start-up enterprises.

Banks may well have received an eye watering £850 billion of taxpayers’ money to keep them afloat but a glance through last week’s House of Commons Committee report, ‘Maintaining financial stability across the United Kingdom’s banking system’ the crisis of confidence that has haunted banks since 2007 appears to have a sting in the tail for businesses in the UK seeking funding.

Despite recent declarations that they are ‘open for business’ banks are still struggling to help those innovative start-up companies the country needs to help UK plc climb out of recession are still being starved of investment. Lending to business, as the report suggests, is ‘falling short of legally-binding commitments entered into by two of the banks that received the most support: the Royal Bank of Scotland (RBS) and Lloyds Banking Group’

The reasons for the banks’ inability to meet their lending commitments are unclear but when it comes to small or medium sized business, lending in a downturn is perceived as even more risky than usual. This creates a paradox where businesses are starved of the vital capital they need to grow which in turn can lead to the failure of those businesses vital to a flourishing economy.

This can only be bad news in the long term for banks looking to bolster their balance sheets. So where can businesses turn to for help? The obvious answer is angel investors.

What has become an age of austerity for the banks could be a golden age for angel investors, those wealthy individuals willing to take a calculated gamble on start-up companies. But it isn’t just start-up capital angel investors will need to provide if banks continue to refuse or give unfavourable terms to businesses hoping to borrow.

According to an article in this week’s Scotsman, angel investors in Scotland are increasingly acting as bankers to fledgling companies, providing £1 million in overdrafts or loans in the past twelve months. Angel investors are also being asked to act as debt providers in the absence of loan and overdraft facilities offered to businesses by banks.

It isn’t just in Scotland that banks are perceived as the villains for taking taxpayers’ money and showing reluctance to lend to businesses. Ask any business owner or entrepreneur in the UK and you are likely to hear that trust in banks is at a low-point.

This could well be good news for business angels, if not for entrepreneurs struggling to launch their businesses. As we have established angel investors are becoming more picky with the businesses they invest in, therefore for all but the most promising businesses, there will be no easy alternative and the door will remain firmly shut when it comes to accessing vital capital.

But what this means for business angels, who unlike banks require an equity stake in the businesses in return for investment, is they can now afford to be even more choosy when faced with more choice. Due to the perception that banks are the villains when it comes to lending, those businesses with the most potential will be more likely to take the angel investment route rather than approach the banks.

And for those entrepreneurs who do make it through the deal funnel, they can gain access to valuable advice and coaching from those who have been there before, rather than just cash from the bank.

There is a caveat. How many of these extra businesses seeking capital from business angels will be viable? According to the banks, one reason they haven’t been able to reach their lending target is the higher proportion of those companies needing credit not having viable business models.

This leads us to two conclusions. Business angels will need to be more wary when it comes to assessing the viability of companies. Banks meanwhile will need to be careful that their reluctance to lend now creates an irreversible trend of the best businesses turning to business angels for their start-up capital now and in the future.

Angelic Agreement? But will it stay heavenly?

More than half of business angel investments fail, but why? How much of this can be put down to the innate vulnerability of start-up businesses?

Surely having an enthusiastic angel investor on board, eager to provide a timely injection of funding to ensure success should mean failure rates i.e. those leaving the business angel out of pocket come exit time should statistically be on the better side of half.

Yet this clearly isn’t the case. In an ideal world entrepreneurs and the angel investors are made for each other, a real match made in heaven as the title to this blog suggests. Put simply most start-ups require money and if it seems like a good idea, most angel investors on the lookout for new opportunities  are eager to supply it – and make a decent return in five years or perhaps less. Perfect, the entrepreneur gets his money, establishes a viable business and the angel investor rides off into the sunset profit in hand ready to fund the next venture.

But life isn’t that simple. Good relationships are crucial to the stability and success of a business. Relationships need not necessarily be cordial at all times, debate and alternative viewpoints are healthy and can be productive , but like all relationships in life, certain elements must be in place to ensure relationships don’t unravel and become destructive.

While some angel investors will be looking more at business structures and the ideas and innovations those businesses are bringing to their market, it would be wrong to ignore the importance of the individuals who run businesses – the management team and the person(s) leading them.

The most successful investors should put fairly large sums into two or three businesses they know something about and whose management is trustworthy, at least this is what the most astute investors like Keynes and more recently Warren Buffet would tell you.

Finding out if the managers of the business you invest in are trustworthy isn’t easy. First you must establish a relationship. We often speak of relationships as having the right chemistry and it is crucial for the angel investor to feel that chemistry when he meets the entrepreneur he’s willing to invest in for the next four, five or maybe more years.

This is no easy task. Not all angel investors are entrepreneurs and many entrepreneurs don’t have the right instincts or ideas to make their business a success even with the help of investment as the statistics show. There can often be gaps in age and experience between business angel and entrepreneur. Take for example an ambitious 18-year-old fresh out of college, full of ideas and exuberance, the business angel who invests in the business may have a wealth of experience to offer, but will he/she be able to pass that knowhow, as well as money, on to ensure a successful future? There may well be gaps in age and understanding as well as experience.

If both angel investor and entrepreneur lack experience of starting up and developing a business, the relationship might turn into a voyage of discovery for both which may then flounder on rough seas. No matter how much money is invested, at least one party should know how to make the best use of it and both investor and entrepreneur must be able to work together and have their interests in alignment to achieve success and a positive return on investment.

Increasingly these days, angel investors are opting to join business angel networks and groups to spread risk rather than be faced with the possibility of choosing the wrong business to invest in. While this approach may have its advantages it will naturally create a distance between them and the entrepreneur. The cash may well pour into the business, but can the entrepreneur be trusted? This is a major question to consider, and also is the entrepreneur self-disciplined to spend the money wisely?

Investing too much money too soon can be toxic for a start-up particularly when an entrepreneur may lack focus or is prone to taking risks with your money.This brings us back to relationships, put simply, the business angel’s role is to invest not only money but also add value. For the relationship to work, therefore, the entrepreneur must be flexible, be willing to be mentored, work as part of a team and frugal with the money at his/her disposal.

Keeping these tips in mind should ensure that at least (market forces permitting) it will be the business that fails rather than the business relationship.

Warren Buffett on a visit to Kansas University Business School

Have you ever asked yourself what would Warren Buffett do if he were a Business Angel?
 
Well, it might be a bit hard to ask Mr Buffett along to attend our investments seminars, so instead we have attempted to summarise the rules Warren Buffett applies to his investments to see if we can apply that to business angel investing?

Yes, we can. With a few adaptations.

From Buffett’s many rules and ideas our take on his work is that it can be summarised very briefly as follows

• lose no money (nor shareholder value)
• buy franchise business (with pricing power)
• align incentives (between management and shareholders)

 

Lose no Money

means
Buy at fair price (neither too much nor too little). Too much and you’ll never make a return, too little and the sellers (who will probably remain in or retain an interest in the business) will resent your presence and are likely to undermine the financial outcome for everyone. What is a fair price? It has to be based on the likely throw-off of cash (net of capital reinvestment required to maintain the business, its assets and its brand) over the next 20 years. It is difficult to assess early stage business values, but that is no reason not to try and Buffett’s method is as good as any and provides a clear starting place.

There are two tricks when assessing future cashflow returns

1. Firstly, most start-up business plans predict steady growth over years one to three and then exponential profit growth. This just means that future costs are unknown, not that the business is likely to experience 80 or 90% profit margins. Nearly all businesses, especially if they wish to maintain growth, will revert to profit margins at or below 30% of revenue. Many mature businesses will have much lower profit margins but are much more stable and reliable. Therefore, use the industry standard profit margin for future returns and never above 30%.
2. Secondly, most businesses forget that they need to re-invest a given amount of cash into the business simply to maintain its value. A good example is brand advertising, which does not have a direct cash generative benefit, but without it the long term ability of the business to grow revenue will be harmed.

Lose no Money

also means
Don’t speculate - but place your money on sure bets at good prices. However, this is not the environment of the business angel investor – who is in early investment sector. The truth is that the early stage investment market is not a sector that Buffett works in. However, the principle can still be applied – albeit that you accept that you are in a speculative environment. iBusiness Angel has written before on how to reduce the chances of losing your money- and it is important to keep these ideas at the front of your mind before making any investment. So Business Angels need to consider reducing the risk of a loss whilst Buffett can focus on ‘Lose no Money’.

Lose no Money

also means
Invest in businesses that you understand. That means that if your knowledge is based on retail businesses, don’t invest in a tech start up, unless it has specific application to the sector that you know about. Buffett famously didn’t invest in Microsoft nor the tech boom. He made his money by sticking to what he knew well so that he could judge a good opportunity clearly and avoid the bad investment options.

Franchise business means
The business must be able to maintain its price position. Hence, it must be creating and delivering a product or service that is unique and protected by intellectual property rights or geography. Without this protection, whatever the business offers is vulnerable to´’cheap immitators’ or ‘me too’ competitors which might not put the firm out of business but will prevent the business maintaining its margin and therefore damaging shareholder value (see point 1 above).

Aligned incentives means
The incentives of the shareholders must be the same as the investors. This is often the case at the beginning of the start up, but if the management start paying themselves large salaries, then their incentive will no longer be to sell the shares but to hang onto the job. The control of future remuneration by shareholders – independent of the management – is critical for any start-up in its middle years. This control needs to be set up right (ie to ensure that shareholders can keep the incentives balanced or have an option to sellout) and it needs to be set up before the business angel invests.

Early Stage investors who can adapt Buffetts rules and principles and apply them to Business Angel Investing stand a far greater chance of success.

This approach does, of course, require a more systematic approach to investing – some might call it ‘professional’ – but the evidence is that this steady handed and cool headed approach is the most successful. And, for the epitome of a cool headed investor, we need look no further than Warren Buffett.

Ps. We’d strongly recommend you keep a copy of Mr Buffett’s thoughts and essays.

There are many books on Buffett, but there is nothing like going directly to the source yourself. The best of the bunch has to be The Essays of Warren Buffett: Lessons for Investors and Managers.

Where are your Dollars Going?

The biggest question for angel investors – and hardest to answer question – is ‘what am I actually investing in’?

However, if we ask the question another way, it does become easier.

If we take the approach that the task of the investor is first and foremost not to lose his money, then the first question that comes to mind will be this:

‘if the business plan as presented fails and the business assets are liquidated, will I get any or all of my money back’?

The answer to this question will tell you whether or not you are investing in anything tangible or whether you are well and truely taking a punt.

Let me give you an example – a business developing a piece of technology to reduce fuel usage – if the business plan goes up in smoke you are left with the patents. It may be that the business size or level of marketing funding wasn’t sufficient to manufacture and deliver the product at a profit – but that doesn’t mean another firm – probably a large auto parts firm – can’t add your patent or product to his range and turn a profit right away.

Hence, what you are really investing in is the patent and the technology. This is the tangible and sellable business asset and what is left once you’ve paid for someone to come and take the spare desks and tatty old notebook computers away.

Another example, if you are investing in a website, what is left if the business fails? The domain name perhaps? You are unlikely to get anything for the web technology for two reasons; firstly, anything clever done today will be copied and available free tomorrow – so there is no lasting value in we technological innovation other than the opportunity to exploit it which falls only to the business that created (and hence can’t be sold on); or, the web development is so clever that no one else can quite understand it (ie they can’t copy it) hence it will be impossible to sell it.

Therefore, web businesses – without a real business behind them – are likely to be worthless in a firesale situation – with one exception – the brand!

Let me give you a final example; I am often asked ‘can you give me a list of buyers willing to buy my product’ to which I can answer ‘yes and no’. This means that I can give you a list of any group you like – it is relatively easy to build such lists – just start a group on facebook or twitter – but, I can not guarantee that they will either read anything I write (or any sales pitch that I pitch) and I have even less confidence that if you do read my marketing copy that they will act on it.

Okay, so how do you increase your email marketing open rates? Easy. you send it from a branded email address where that brand has built a reputation of intelligent and useful ideas and information.

Therefore, the thing of value here is the brand not the list. Oddly, the list of customers is probably the least valuable thing – but buyers of distressed assets don’t always recognise this, so the customer list may still be the asset that generates most cash.

So, getting back to the question – ‘what am I investing in’ the answer will be

a) the creation and development of assets
b) the development of a business model to exploit the value of those assets

If the value of the assets developed will always be greater than your initial investment, then you can see the investment is low risk.

On the other hand if 95% of investment money is going to fund purely a marketing effort (that will either succeed or fail but either way, end quite shortly) then your money is at huge risk.

That is why the way to resolve investment risk is to ask ‘What am I investing in’?

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However, as Nesta warns, the figure could be even higher as their statistical sample was taken from angel investors who have remained active over a number of years.

Therefore, the rate of failure could be as high as 80% , or to put it another way, 80p is lost of every £1 invested.

This rate of failure is too high and the networks and businesses that depend on angel investing are beginning to recognise that it needs to be addressed.

So, how do you, an angel investor, increase your chance of success?

Simple, every investment needs three critical factors to be in place. And if any one of those elements is missing, the investment and underlying business is most likely to fail.

These factors are

1. a great business idea
2. a great management team
3. a great mentor(s)

If any one one of these elements is missing or weak then the business is unlikely to succeed. Instead, the investor would be better off encouraging the start-up entrepreneur or management team to seek to improve their idea, management team or mentors before parting with cash.

As Doug Richard says of his first Dragon’s Den investment; ‘I backed a great jockey (management team) but the horse (the business idea) was dreadful’.

It is easy to get seduced by an energetic entrepreneur who believes in their idea. And you may be correct to assume that this entrepreneur will make a success. However, you have no guarantees that the entrepreneur will succeed with THIS idea.

Hence, whilst conventional wisdom says ‘I’d rather back a great management team than a great business’ investors would be wise to ensure BOTH are in place!

Why? The failure rate of start-up business – that go down with your money – is somewhere between 56% and perhaps 80%. So why risk it?

In fact, the successful angel investor needs to remain cool and clam and slowly (over a period of weeks) decide if this proposal is the right one – that this proposal has the right business idea, the right management team and the right mentors to see it to success.

So, how do you remind yourself to stay cool? Keep this idea in mind

80% or so of business that GET funding fail! That means, only 1 in 5 of funded businesses make it!

So, find 4 businesses that get funding that you would NOT invest in, before you look for the 5th that you do back.

If you can explain why others have invested in the four likely failure, why you have not and how your investment is different, then you have a much high chance of success.

If you can’t explain this distinction, then keep looking but hold onto your cash.