iBusinessAngel

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.

Is the Iceberg Melting?

I am not suggesting for a moment that all Green businesses are bad investments, but I am suggesting that whenever a bubble appears or to there is much enthusiasm for an idea, that a number of the businesses ideas sold to unquestioning investors will turn out to serve the middle men far more than the money men.

As the investors, the business angels, we need to be on our guard.

There appear to be two dangers with the current alternative or green energy fad.

Read more…

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.

Read more…

56% of ventures invested in by angel investors will fail, according to recent research by Nesta..

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?

Read more…

Should a Business Angel look to invest in a LLP (Limited Liability Partnership) or a Limited Company?

Often, entrepreneurs will have both LLPs and LTDs for their different businesses.

To answer the question of which is better we need to ask:

Will the business use the profits (in the main) to reinvest? Say, build a franchise business? If so, keep the profits inside the business and re-use them before paying out and paying tax – so use an LTD company.

Or will the business pay out all (or nearly all) profits as ‘earnings’ then choose LLP – as you can offset the cost of cars (which you can’t for an ltd).

So, the answer depends on the business goal. And the tax and legal issue is simply which structure helps you achieve your goal best?

Given that many Business Angels are looking for a sale of the business, and entrepreneurs are not forecasting immediate profits, the entrepreneur will set up a Limited Company, as this allows the reinvestment of any earnings. 

Equally, the standard company law that surrounds the treatment of shareholders and directors is more clearly established for LTDs than shares of Limited Liability Partnerships.  Hence, for larger investments, investors would most likely prefer the cleaner structure of the LTD.

However, not all Business Angels are looking for sales in the short term, and a number of new Business Angels may be willing to accept a mixed portfolio of investments – some of which will seek a sale in the short term, and some of which will seek to pay cash to partners early on.

In the case where the business requires capital assets, it might make sense to have both! Here the ‘operating’ company can lease the assets from the ‘investment’ company. This kind of thinking applies to a manufacturing or tech company – one that buys capital assets – but not a web based or service business.

But decide the business and investment goal first – then the tax and legal structure.

The 9 things every direct business investor or business angel needs:

1. Deal Flow
   There are more and more sources of direct business investment opportunity – you need to find a way to track them and pick out those that deserve more attention. Firstly, you’ll join networks or groups, which is often free, and then you’ll begin to see a flow of deals. Often, the network will consist of some industry specialists and you may find that it pays to get to know those who work in industries that you know or wish to invest in.
2. A Nose for a Deal
   Over time your gut will tell you whether to invest or not. George Soros always says that he sold when his back hurt! However, until you reach that exalted status, you’ll need to track and watch what happens. Key to this is to figure out which companies don’t get funding and become successful anyway! And which companies DO get the money, but fail anyhow!
3. Advice
   Firstly, understand what each persons motivations are. Some advisors are on commission others have a stake in the business etc… This will impact on the degree to which you are wise to trust any advice. Equally, if you can, find a willing mentor who can guide you through your early investments
4. News
   The business angel industry is move from a cottage industry status to become a more established source of finance. As it does, there are better websites and more information and news which you can follow.
5. Standard Contracts
   Legal fees can kill a deal. The levels of business angel investment (from £50k to £1m) mean that legal fees can easily eat up the stake invested if both parties are not careful. Therefore, judicious use of some standard tools or contracts is wise. Then bring your lawyers in to make the final tweaks to those contracts.
6. Checklists
   Checklists are a great way to make sure you don’t forget that all important question! Also, don’t forget that the companies looking to raise finance will be keen to promote the positive aspects of their opportunity. In many ways, your role is to spot the weaknesses and decide if any of those weaknesses are serious enough to kill the idea.
7. Strategy
   There are a number of different investment strategies that business angels use. These strategies will help you build a portfolio of investments rather than help you make a decision about a single investment. Questions you’ll need to answer include how much to invest and how many investments to enter into? One sector or many? Geographically close or distant? etc…
8. Exit
   How can I find out about exit strategies – for example, on straight equity vs debt that converts to equity?
9. Share
   Be willing to share experiences and learn from others. Investors can teach other a huge amount, but only if they are willing to share. Find a group you are comfortable with – who share you ideas and values and start sharing stories and experiences