Thursday, September 19, 2013

Early Stage Start Up Due Diligence - The Philosophy Part

Early Stage Start Up Due Diligence - The Philosophy Part

I recently gave a talk to Empire Angels on the subject of early stage investor due diligence, thanks to a kind invitation from Graham Gullans and Christina Bechhold. Graham and Christina are doing a great job establishing a thriving group of New York based young professionals interested in angel investing, hence bringing more diversity and energy to the NYC early stage ecosystem.

I think I surprised them by spending a fair amount of time framing the issue of "what to do" rather than getting straight into a "traditional" check list of steps to things "to do".

I set out to emphasize what, in my view, is the appropriate stance investors should adopt as the undertake due diligence being mindful of the different situations of the players on each side of the table. Those players being:

1)   The buyer of the equity – that would be the angel or VC investor

2) The seller of the equity – technically that would be the company although it amounts pretty much to the entrepreneur/founder(s)

I laid out the different stakes of these two players as follows:

A. What does investing mean for the buyer?

Across large sample sizes angel investing is an activity that generates returns in the +/-20%/year range. Indeed a Kauffman Foundation study pointed to 27%/year returns for angels investing in groups. That equates to returns that are pretty reasonably commensurate with the risk assumed ... on average. The Capital Asset Pricing Model gets it right!

We also know that any individual angel investment is very "risky" due to power law or asymmetric returns involved in early stage investing. ie each individual investment has, other things being equal a high probability of total loss (maybe 40%), a high probability of only modest positive returns on cash invested (maybe another 40%) and that the outcomes that generate that attractive aggregate +/-20% annual return come from the outsized gains on less than 20% of all investments. Indeed there is a power law within the power law. For example approx. the majority of ALL VC returns in 2012 came from one single investment, Facebook!

Of course the financial experts at Empire Angels were well aware than most that this risk can be mitigated by diversification. But, as I pointed out, the degree of diversification required is impractical for all but a very few angels. As David S Rose, CEO of Gust and Chairman Emeritus of The New York Angels, noted in one of posts that make up his prolific Quora record

Several studies and mathematical simulations have shown that it takes investing the same amount of money consistently into at least 20-25 companies before your returns begin to approach the typical return of over 20% for professional, active angel investing. 

So clearly early stage investing is risky in terms of your likely return profile. And mathematically that means that with anything less than well into a double digit number of investments the most likely outcome for an angle investor is the loss of most all of their capital! Ouch.

But this creates a paradox, as I pointed out to Empire. Armed with that knowledge, any rational angel (VCs are somewhat different here because they are investing other people's money for the most part) should only invest money she/he can afford to lose – and lose totally. ie it can "all go to zero" but the angel's lifestyle is unchanged.

Bottom Line: For the rational angel, while their is evident investment risk in this "asset class", there should be zero lifestyle risk ... assuming they only put money to work they can afford to say goodbye to without pain. (i.e. no need to cancel your next vacation, cut down on your restaurant visits or whatever!)

B. What does founding and taking outside investment mean for the seller?

The sellers, the entrepreneurs, are the even more extreme side of these asymmetric returns. The most likely outcome is … they lose "everything" So all the savings they put in to bootstrap the company, maybe the money from the sale of their house, the years of sweat equity and regular earnings forgone. So a big direct financial cost, indeed opportunity cost . (As Noam Wasserman points out in his excellent book, The Founders Dilemmas, rational founders ... will not found! Because the evidence suggests they will be better off getting a salaried job somewhere.)

Bottom Line: A pretty meaningful (and adverse) asymmetry for founders/entrepreneurs in terms of their most likely lifestyle outcome.

The Take Away

So given A+B what, I asked the Empire Angels, is the implication for all us investors as it relates to due diligence?

My point was this: 
"If you take one thought away from tonight I would like it to be this - 
You need to recognize who is taking the real risk here and treat them with commensurate respect."

That does not mean that you leave the entrepreneurs alone and don't impose on their time to conduct due diligence. Indeed the Kauffman study I cited above makes it clear that, for the investor, due diligence improves outcomes:

Investors experienced better returns in the deals where they exercised more due diligence. Sixty-five percent of the exits with below-average time spent on due diligence reported a return that was less than their original investment. Losses occurred in only 45 percent of the deals where investors did above-average due diligence.

Rather, as a practical matter, RESPECT to me in this context means undertaking your investment due diligence with the following three thoughts top of mind:

1   1. Being super sensitive to the entrepreneurs time and not sucking them into your own time wasting analysis paralysis that might be an interesting intellectual exercise for YOU but might kill their ability to execute their business. As I noted to Empire: they have no staff, no admins to hunt stuff down for them; they have incomplete data; heck they probably aren’t drawing a salary.

     2. Getting to YES on NO as quickly as you can

     3. Communication directly and honestly why your answer is NO, if that is where you end up.

So a key issue you face as an early stage investor doing due diligence is a question of balance. There is no right answer to that, but in my view a little (no in this case a large amount of) respect goes a long way.