Archaeologists have just discovered a small fleet of 18 m boats just off the coast from Rome, Italy.

The boats date from 5th top 7th century BC and were full of cargo – wine, olive oil, garum (a favourite Italian fish sauce).  The trade – probably between Spain and the nascent Roman empire, is an indication of business risk and investment 2,500 years ago.

In addition, the number of boats found, suggests that a fleet sailed in convey and that in turn, this suggests that the trade route was a regular one, with well known ports and middle men ready to buy and sell the goods at both ends of the trip.

So, were these the ancient business angels?

Perhaps not.

The trading activity, although ancient, was mainly an entrepreneurial activity, ie. individual merchants risking their own life, limb and cash to sail their own boats and purchase their own goods (often sleeping on them at night). There might have been a family or series of friends who supported the venture, but this could not really be called business angel investing as it remained an informal structure.

Instead, the first business angels began to appear once a trading company was formed. This trading institute was set up apart from the national government to purchase and provision boats for long voyages. Nearly always, it would obtain a royal charter – an exclusive right or monopoly – to trade certain products.

A trip to the spice islands, around cape of Africa, might take 18 months, including a number of trading legs along the way, and deliver a profit of 500%.

The sailors – many of whom did not return, along with lost boats – took a share in the profits or were allowed to trade their own goods on the ship, in return for their risk and effort. They were rarely, please note, paid salaries.

The returns, in some cases, were fabulous, which encouraged further investment and better institutions.

These informal coalitions gave birth to the major corporations – the Dutch East Indies Company and the English East Indies Company in 1604 and 1602 respectively.

The major difference between these two institution was the role of capital. In the case of the English, the capital was initially lent to fund a single voyage after which everything was sold (including boats and sailors released) and profits taken.

The Dutch, on the other hand, had a remarkable commitment to leave their money in the company to allow profits to be reinvested in future voyages and conquests with investors receiving a steady dividend.

The Dutch company therefore, took on features that we would recognise in a global publicly listed company today. Where as the English company, in its first instance, was a narrowly defined business angel investment – with a time horizon of between 18 and 24 months.

Both trading companies went on to become major corporations in their own way and sporned many competitors, however, they are both early examples of individuals financing a company in a formalised fashion, and so, is the best example of where business angel or VC funding began.

And, given the recent report from Nesta about 7 years to realise a return on investment for successful angel investments, funding a highly risky 18 month voyage doesn’t seem so risky after all (that is, so long as you didn’t have to crew a boat).

It is also worth noting that each company obtained its charter or monopoly prior to the voyage begining and no doubt planning the voyage would have been a one to two year activity.

In today’s world, the monopoly or patent or intellectual property (IP) is just as important. But how many entrepreneurs know that business angels want to see the IP before they commitment to invest?

Various firms have been developing psychometric tests to identify the personality traits of a successful entrepreneur and it turns out, that there is no agreement on whether any of these work.  So what can research tell us?

In fact, funding of research into entrepreneurial issues in the academic world is beginning to dry up – as Durham University have closed their department for entrepreneurial research, partly in response to the failed hope of being able to teach entrepreneurial skills to carefully selected students.

So, if business angels can’t find a common personality trait, what should an investor look for when interviewing cash hungry entrepreneurs?

Well, there appear to be two ideas that can be supported in the accademic research.

Firstly, becoming a highly successful entrepreneur is a process. It takes time and you can make a pretty good judgement – after interviewing – where someone is on their business path. A colleague of mine suggested that a really experienced entrepreneur is someone who has built a business and lost it, built a second and exited with a healthy gain and now is on their third business.

Okay, you can discuss alternative formula – but you get the idea.

Secondly, how the entrepreneur is able to respond to what is going on around him or her is a critical factor that determines if they are likely to succeed. Or perhaps, to put it another way, how do they deal with uncertainty and difficult situations?

This reminds me of the famous story of the criminal who said ‘I had no choice, I became a criminal because my father was a drunk’ and his brother said ‘I had no choice either, I had to succeed’ . The successful brother became CEO of a global business.

So, in summary, you can forget personality and therefore personality testing. Look instead for where the entrepreneur is on the path and then asking searching questions about how they dealt with uncertainty.

So, the good news is that there is evidence of there being a way to systematically identify likely successful entrepreneurs – and also the quality of the team – and your fellow investors – that surround the entrepreneur.

Good luck.

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.

The first is the classic investment risk taught by Benjamin Graham and discussed in his book The Intelligent Investor. Graham, the mentor of Warren Buffett, took apart the reasons for investing in the 1950s boom industry – the airlines.

His analysis has been proven to be right as Buffett now claims that in 50 years, airline investors taken as a whole still have not had a return on their money.

However, Graham did spot that a large number of companies supplying the new industry did make a lot of money for investors. Airports, retailers and caterers have done well.

Graham’s conclusion was that it is far better to supply a growth business sector than to be a part of a great swam of investment as inevitably too much money will be invested too easily squeezing the profit margins of good ideas.

The second risk is that climate change will turn out to be a Malthusian idea that solves itself as population growth, mutually assured destruction and other apocalytic senarios usually do.

This is illustrated by the increasingly sceptical scientific community which is beginning to raise its head against the slavish commitment to all forms of greenery.

I and my fellow investors are not scientists, but it is worth noting their scientific concerns as it could up-end a few business models and a lot of start up ideas.

Firstly, there is a generally held view by the (admittedly few) academics that I know that if a scientist wishes to receive funding for research he is well advised to research ‘the affects of climate change’ and that research into ‘climate change – the myth’ isn’t currently being funded. By making the assumption that climate change is real, researching get money, if not then not.

Therefore, the scientific literature being published is already biased by the incentives of the research grant process and therefore, can needs to be viewed as biased in favour of climate change. The latest report from the IEA (International Energy Agency which made the front page of the Financial Times) might be a good example as it take it as proven that global temperatures are rising).

Next, dissent is beginning to break out in normally green magazines such as the UK’s Big Issue (sold on the streets by UK homeless) as well as larger circulation magazines such as The Economist.

In fact, a recent letter to the Economist by Horst-Joachim Luedecke, retired professor of physics, Heidelberg set out three reasons to be scepitcal of green alarmists.

1. There has been no discernible increase in storms, hurricanes, floods or droughts according to the Intergovernmental Panel on Climate change.
2. Rises in sea levels of 1-2mm per year have been occurring for many centuries and therefore this is not evidence that sea levels are rising as a result of any climate change factors.
3. Mean global temperatures have actually declined since 2001 and the research scientist, Professor Mojib Latif of University of Kiel, predicts further declines over the coming decades.

Let’s not enter the green / not green arguments here.

Let’s simply take this as a warning and a reminder that green start-up business are at greater risk of hype and hyperbole, rather like dot coms in 1999, and therefore each idea needs to be scrutanised much more closely.

Or indeed, that if you are not an expert on this sector, simply do not allow yourself to be drawn into it on the promise of easy winnings.

If you want to read some more science based sceptiscm on climate change then head over to http://cfact.eu/

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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By the way – have you subscribed to iBusinessAngel? If you do – you’ll get updates when ever an interesting article is added to the site…

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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.

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