Put another way, most venture capital firms will expect to “blow up” 60 per cent of their capital on failed ideas, with 20 per cent of their capital returned dollar for dollar and the remaining 20 per cent hopefully finding fruitful concepts to pay for all the losses and – with luck – produce multiple returns.
Sydney Angels, for example, has about 80 members who can invest $50,000 or more a year and meet once a month to be exposed to ideas in a forum like Shark Tank, the reality TV series based on the Dragon’s Den concept, in which founders pitch their ideas to willing investors.
Deals on crowdfunding platforms are only open to established funds or registered sophisticated investors, although there is draft legislation before Parliament to make crowdfunding platforms available to a broader range of investors.
Maarbani says he’s aware of established investment firms working on crowdfunding platforms to meet demand for more investors looking to back early-stage ideas.
Experienced investors also suggest newbies start spending some time to “get their heads in the game” attending events and “pitch days” that are open to the public and held by organisations including Start Up Australia, Fishburners, Innovation Bay and Incubate.
Venture capital firms tend to invest in as few as one in 100 ideas that are pitched to them, so the more exposure investors have to entrepreneurs, the better chance they’ll have to find an idea with the potential to be successful.
TYPES OF COMPANIES TO LOOK FOR
Companies with expenditure and income of less than $1 million and $200,000 in the previous income year respectively which meet the government’s tax incentive criteria will likely be capital-light and require minimal capital to get off the ground.
Companies in this category are likely to include software as a service or marketplace concepts, says Daniel Petre a co-founder and partner of venture firm AirTree Ventures. Among the successful start-ups in the AirTree portfolio which began from early-stage angel funding are Edrolo, creator of online interactive educational resources, and GlamCorner, a designer dress rental business.
Ben Chong, founder and partner of venture firms Right Click Capital and Sydney Seed Fund, says the first question a potential investor in an early-stage company should ask is, how large is the potential opportunity?
“I want the company to have the ability to be worth a few hundred million dollars, so it has to be in a market that’s already a billion-dollar market, which means it has potential global application,” he adds.
Start-ups in Chong’s investment portfolio that fit this bill include GoFar, an analytics and hardware developer for tracking driving habits for better fuel efficiency, and hipages, an online home-improvement marketplace.
Invest in an area you know, says Tony Glenning from venture capital firm Starfish Ventures.
“The less you know about something, the better it can sound, whereas if you know about the area, more pitfalls become apparent,” he adds.
Rules for evaluating early-stage companies aren’t the same as assessing more mature companies such those listed on the stock exchange because the start-up opportunities will be pre profit and in some cases may not even have earnings.
“We look for teams, certainly more than one person. I want to see a range of skills within a team including technical, business and domain expertise,” says Chong.
He adds some “validation” before investing in a start up is an important way to get some proof the founders can do what they say they can do.
“We want to see a prototype, a minimum viable product, a test customer to make the business attractive,” he adds.
Mark Carnegie, a well-known early-stage investor, says start-up companies in the angel funding stage should have much more than a “power point slide presentation extolling the potential market for an app”.
“We want to see businesses with a client base at the ready and founders with considerable domain expertise,” he adds.
An important part of angel investing is backing the founder so it’s important how founders are treated within the business and if they are incentivised to stay, says Clare Hallam, director at start-up adviser Pollenizer.
Pollenizer has a venture capital fund that’s five years old but also consults to large corporates on innovation and mentors entrepreneurs through incubate and start up phases.
New investors should look for companies with legal agreements to retain the founder and a vesting plan for shares over time, Hallam says.
WHAT YOU GET FOR YOUR MONEY
Early-stage investors can expect ordinary shares but not preference shares, which are introduced during later-stage investing rounds, according to AirTree’s Petre. Preference shareholders have liquidation rights over ordinary shareholders.
Early investors should expect to buy into a deal on the same terms as the founder and should also expect follow-on rights to stump up more capital in later rounds, he says. Usually an early-stage funding round will last between six to 12 months and will be used to “burn through” to get to the next performance level.
An angel investment round is likely to raise up to $300,000 in total and an individual should look to put in no more than 30 per cent, Petre says.
Investors in start-ups of this size don’t want to find themselves as the only investor next to the founder, he adds. “If I own 50 per cent then I’d have to ask, ‘Why me? Am I the dumb money coming in because all the smart money has run away in this scenario?'”
Starfish’s Glenning advises investors to put some capital aside to invest in future rounds.
“Companies tend to spend more and take longer than they expect, so we recommend spending half and keeping the other half to avoid getting diluted or wiped out in follow-on rounds,” he says.
All of the experts in early-stage investing stress the importance of investors putting less in a number of companies to achieve a “portfolio effect” rather than investing in one or two companies with the hopes of getting lucky.
Some believe an increase in capital funding to start ups because of the government’s tax incentives will lead to a better quality of investment, as fewer entrepreneurs exodus to foreign markets, But others think the changes could result in more risk for green investors.
“What we will see is financial industry pond-scum peddling get-rich-quick scams, which usually happens with these types of tax incentive schemes,” Carnegie says.
“Hot” start-ups already have investors lining up to invest, Chong points out.
“Capital is liquid, it will move to where the best deals are. This will allow companies on the fringes to get access to more capital,” he says.
He adds: “You’ll never win if you invest on the basis of a tax incentive alone. You have to make sure it stacks up as an investment above anything else.”
The government’s innovation statement included a 20 per cent non-refundable tax offset on investments in start-ups, limited to $200,000 per investor per year.
Somebody would have to invest $1 million in order to get the maximum amount of $200,000.
There is also a 10-year exemption on capital gains tax for investments held for three or more years.
The measure is slated to begin on 1 July 2016.
An eligible start-up will be defined as company with expenditure of less than $1 million and income of less than $200,000 in the previous year.
The company will have to have been incorporated in the past three years and cannot be listed on any stock exchange.
The sorts of business activities that will be eligible will be determined in consultation with industry.
The government wants to create an army of angel investors who invest in help cash-starved start-ups and therefore help create jobs.
But business investors and super funds will also be able to access the tax break. The offset is non-refundable and so it can’t be used to reduce tax below zero.
The early-stage investor initiative is based on the UK’s successful Seed Enterprise Investment Scheme, which resulted in $500 million of early stage investment for about 2900 companies in its first two years.
The government’s material says: “In a 2013 report, PriceWaterhouseCoopers estimated that start-ups have the potential to contribute $109 billion to the Australian economy and create 540,000 jobs by 2033. The report also found that funding for start-ups is in short supply. Around 4500 start-ups miss out on equity finance each year and access to additional finance is reported as one of the main barriers to innovation for start-ups.
In addition, there will be a 10 per cent non-refundable tax offset for capital invested in new Early Stage Venture Capital Limited Partnerships (ESVCLP). Fund managers who pool investors’ capital can apply for status as an ESVCLP, which means they receive flow-through tax treatment—that is, it is not a taxing point. Examples of these funds include Blackbird Ventures, BlueChilli Venture Fund and Carnegie Innovation Fund.
The government gives this scenario as to how the angel tax break measure will work:
Jessica is the founder of a start-up business called PaySmart Pty Ltd that is developing a software application to automate bill payments. She is looking to raise $200,000 in equity finance to continue developing the software.
Alex is an experienced early stage (angel) investor and believes that PaySmart has excellent growth potential. He invests $200,000 and claims a 20 per cent non-refundable tax offset, reducing his income tax payable by $40,000.
In addition to contributing capital, Alex uses his business skills to help PaySmart grow. He sells his shares for $400,000 four years later. As Alex has held the investment in PaySmart for the minimum three-year period and less than 10 years, the full capital gain of $200,000 is exempt from capital gains tax.