Being a smart investor

I’ve previously discussed how 1200 people lost $6.8 million by investing into an opportunity that was dubious at best. It was the madness, not wisdom, of crowds.

But sadly investors are still investing in dubious opportunities, and their experiences will continue to give the whole field of private investing a bad name.

Raising Money

In most countries there are strong rules about approaching members of the public with investment opportunities, and for good reason. However founders can approach sophisticated investors for money, as it’s assumed that they have the ability to make an informed considered decision.

In New Zealand these investors are called “eligible investors or eligible persons” under the Securities Act. You can be eligible either by being Experienced or by being Wealthy.

Experienced is defined as “experienced in the industry or business the security relates to or experienced in investing or the business category.” That means the investor is able to assess:

• the offer’s merits;
• the value of the security;
• the risks if the offer is accepted;
• their own information needs; and
• the adequacy of information provided about the offer.

Wealthy means “Net assets of $2million or more or annual gross income of $200k or more for each of last two financial years.”

You can see the issue, right? Wealthy but not Experienced investors have the legal ability to invest and lose a lot of money. And they do.

What type of investor are you?

The beautiful thing about poker is that everybody thinks they can play.
Chris Moneymaker

Just what sort of investor you are depends on the circumstances. For some investments, such as mortgage backed security derivatives,  there turned out to be almost no smart investors. For other investments, such as property and bank debt, the barrier to entry and understanding is much lower – a reason why they are such popular investments in New Zealand.

But let’s focus on the roles investors, individuals or funds, can play when investing in private companies, and in particular in the the earlier phases of growth.

1: Professional Money

There’s no way that spending a few hours a week looking at individual securities is going to equip an investor to compete with the incredibly talented, highly qualified, extremely educated individuals who spend their entire professional careers trying to pick stocks. It’s just not a fair fight. You know who’s going to win before the bell rings.
David Swensen, Yale Investment Office

Funds with teams of investment professionals will always have more time and energy to apply to the field, whether that is picking stocks or investing in early stage companies. Their challenge is fund raising, the time and expertise taken to do deals and the need to exit within a certain timeframe. I’ve written about this elsewhere.

In New Zealand we have far too few entities in this category. It’s a real challenge.

2: Smart Money

Founders ideally want investors who are smart and have access to funds that are very substantial versus the need. These experienced investors understand and can really help with the business.

Smart money investors are generally part of the ecosystem where they have chosen to operate, seeing the very best opportunities very early. They often get involved well before any investment pitch documents are created, and have the time to make well-informed and considered decisions.

The ideal investors in this space are ex-founders who are still active in a community in a very hands-on way. There are just a handful of people that occupy this space in New Zealand, and we need more. These investors can be very selective and tend to make very few deals. The smartest ones are very strict about sticking to the narrow niche or sector that they know. Other smart investors tie themselves to certain lead investors.

Arguably their deal flow, access to funds, low costs and ability to provide 1-1 help delivers superior returns with lower risk of complete loss. However they are generally not full-time investors, and there may be many other things happening in their lives that are more material than making a particular investment.

3: Smart but small money

Next are the experienced but less well off, who may be able to quickly understand the business and investment opportunity, but who cannot make much difference with the funds they have. Every little bit helps, especially in early rounds, which is where these investors must participate.

There are an increasing number of people who can play this role in NZ, but not many who consistently do it well. That’s because it’s a definitional problem, as gaining investing experience needs the ability to commit funds to a number of companies, but that in turn requires wealth.

For founders my advice is to be sure of cultural fit, and to be careful on evaluating skills and experience. Advising early stage companies is very different from being part of the corporate world, and similarly early stage investors need to follow the written and unwritten investor rules. Those include being ready to lose the money, having a very long term perspective and not being a pain for each round.

Investors in this space get only selected access to deals – they simply don’t have the wallets for more. However if they retain their heads, choose wisely and are patient then investors can get very good returns for their small investment.

4: Dumb Money: Investors who don’t know the sector

Finally there are wealthy investors who do not know the sector, but who perhaps know investing or business. They became wealthy somehow, and so are clearly smart at what they do. However while being smart in one area can help, it is generally insufficient for understanding early stage investment and rapidly changing technology.

There are two strategies here. The first is to place the money alongside or with funds or people in category 1 or 2. Choose the people well, make sure they really do understand the sector, and otherwise maintain discipline around investing in what you know.

The second is to go it alone, and that’s when the risk of being “dumb money” is high. That risk is especially high when investing into companies where there is no FMA registered prospectus.

The gap in investor knowledge and the lack of a proper prospectus provides an opening for hype and over-selling of lousy opportunities. It’s a slippery slide from promoting investments that have poor fundamentals to being poorly legally restrained, or even unscrupulous in the quest to land investors under less than favourable terms.

The promotors of an investment may not even understand themselves that what they are promoting is a poor deal. And once investors start to pile on, and a rush to invest occurs, then may can be seen that as validation by other investors. I’ve seen some shockers locally, but the all time classic for me is Pets.com, a famous US story of US$300 million raised and squandered within 2 years.

Are you smart or dumb money?

“Risk comes from not knowing what you’re doing”
Warren Buffet

Obviously nobody wants to be dumb money, but sadly most of us in the investing game, whether in public or private securities, have been in that position. We need both the self-awareness to know when we don’t have enough information and analysis and the discipline to only invest after ding the homework. Anything else is akin to gambling, and with over $2 billion lost in gambling in New Zealand each year I don’t recommend it as an investment strategy. 

It’s very frustrating to see investments made into sectors and companies based on insufficient information and assessment work. The investors may be investing based on a pitch seen with a group, or based on a recommendation from someone who is not a real industry insider, or even from conversations with the founder.

But surely you are different? With human nature being what it is – I doubt it very much. In Tauranga over 1200 investors treated with a clearly un-investable founder who somehow attracted and vaporised  $6.8 million. That’s the risk you take every time you invest, and it’s a particular risk if you are investing without a registered prospectus.

What to look for 

I recommend that investors create a simple checklist of the things that they look for before investing. It’s a good way to ensure that the emotional drive to invest is somewhat contained. Some starter questions are:

Is the end user experience great? Have you tried the products (and those of the competitors)? Have you seen the customer experience yourself, or solid evidence that it is great?  

Do they have a clear route to the paying customers? Have you seen evidence that thy can steadily ramp up sales? Be very careful (better avoid entirely) companies that want to spend the majority of the investment on advertising, especially with the long sales cycles that business to business selling involves. It’s a good way to lose money quickly.  Look for gradual ramp-up of sales team and effective, targeted advertising that is results oriented.

Do they own their competitive niche? Have you really looked hard at the competitive positioning? Are you sure that the company you may invest into has a dominant position in their niche? Play with the competitor’s products, or get on the phone and call or visit them – you may be very surprised.

Is the team full of A players? Are you confident that the management team and board can build a great company with a high performance collaborative culture?

Is the investment good value? Have you verified that the amount being raised and the valuation for the company are consistent with other deals and with the fundamentals? Be very careful about placing large amounts of money with companies with no or very little revenue – they need to grow into investability. 

Seek help

“Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”
Warren Buffet

Whether an offer is public or private, and especially where it is private, the golden rule for investors always applies: invest in what you know. So here are some more questions to ask:

Are you being subject to FOMO?  The fear of missing out is not a reason to invest. Make sure that investment decisions are based on facts and considered sector-informed assessment.

Do you really understand the company? Can you explain to others the products, the route to the customer, the competitive landscape and the approach to growth? Do you have a clear idea of how and why this company will win?

Are real industry insiders investing? Are others investing from the industry involved? Can the deal attract coders and designers as well as more senior figures?

Are the basics making sense? Is the product selling for more than cost price? Is the cost of selling low enough to make money from paying customers? Does the revenue per employee match that of other similar companies? (e.g. this post suggests US$230-310k/employee  is average for software, advertising and media companies.) Are there any triggering warning signs in the language used by founders?

Have you talked to someone in the sector?  Have you tested the investment by sounding out people from inside the early stage industry or the sector? Often the more junior people can provide the greatest insights. They know the duds.

Have you sought investment advice? Are you working with an investment professional who really does understand the sector?  This may mean reaching beyond the bubble that you are in and talking to people who bring very different perspectives. Don’t worry – you won’t miss out on the deal.

Is there security in diversity?

“You have to diversify against the collective ignorance,”
David Swensen, Yale Investment Office

Some may seek diversity through increasing the number of deals they are involved with, but that risks compounding the systematic errors behind selecting lousy investments. It’s better to select diversity through the overall investment strategy. That means investing in different sectors, using different advisors and investing in contrarians. I liked this quote from David Swenson, who leads Yale’s Investment Office and who taught me in Institutional Funds Management at Yale School of Management:  

Small independent firms with excellent people focused on a well-defined market segment provide the highest likelihood of identifying the intelligent contrarian path necessary to achieving excellent investment results.
David Swensen, Yale Investment Office

I worked in one of those firms, courtesy of David, in my summer job while at Yale. New Zealand has come a long way over the last ten years, and we are seeing some players carve out a solid niche. But we do need a lot more of these firms, and investors to back them.

Summary

It’s not hard to avoid behaving as “dumb money” if we have the discipline to invest in only what we know. However we also need to make sure we have a diverse investment strategy, which means stretching beyond what we know. You can choose, for diversification, to apply discipline and work to learning a new sector, becoming an investment professional along the way, as many family offices have done. Alternatively, or more often, as well, you can place funds and trust with a diverse selection of small expert teams.

About Lance Wiggs

@lancewiggs
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