20 Oct 5 questions for building a seed investment portfolio
By Matthew Cushen…
Investing in start-up businesses has exploded over the last 4 years. The introduction of Seed Enterprise Investment Scheme (SEIS) relief has attracted more investors, which in turn attracts businesses looking for equity funding. The underlying number of start-ups has blossomed, as has the visibility of deals through crowdfunding platforms and organised angel investment syndication.
My business partner and I have been seed investing for over 12 years – well before it became mainstream. We’ve had some success and collected some battle scars. My IRR, unaudited, is 52% per annum over that time. We found ourselves codifying our investment philosophy into 5 questions – and then starting an SEIS fund on the back of it.
Question 1: how do we access many potential investments then efficiently distil the best choices?
Of course, the more frogs you kiss the better the chance of unearthing a prince. As we became more experienced, we started to appreciate that it takes 60 to 75 business plans to end up with an investment that really excites us (even if they have supposedly been pre-vetted by an agent). Many will be scanned quickly and binned, whilst with others it’s important to remain positive minded when diving into a more detailed exploration.
From this question we created a seed competition – The Start-Up Series – that is promoted by startups.co.uk, unsurprisingly a ‘go to’ website for entrepreneurs to gain advice. Open for entries for 14 days each month, the Start-Up Series creates an average of 100 entries per month. There are plenty of frogs but generally we take around 15 businesses into a more considered evaluation, culminating in spending half a day with each of 3 or 4 businesses. This gets us under the skin of the team, proposition, strategy, priorities and plans.
Question 2: how can the selection criteria increase the proportion of successful businesses and reduce failures?
When investment decisions are not based on objective criteria, it becomes easy to fall in the trap of finding false positive data to validate your emotional decisions. Because we often invested as a pair of mates, we developed a simple scoring system to reconcile our judgements. It’s based on five broad criteria (market; team; big idea; marketing & communications; business model & finance). Each criteria is supported by a detailed set of questions and assigned a weighting. As we’ve developed this we’ve gained more confidence in our decisions.
When we set up the competition series we adapted the criteria a little and developed an online platform. This makes it easy for a wider group of judges to score independently and blind to each other. We then gather the collective scores for further conversation, so we focus our time on where there is divergent opinion.
Question 3: how can we ensure valuations reflect risk appropriately?
Whilst SEIS tax reliefs are attractive for investors, some seem to have forgotten that they are there to compensate for the high risk of investing in very early stage start-ups. Over time, valuations have increased – in effect shifting the benefit of the reliefs to entrepreneurs rather than as source for risk mitigation to angel investors. Crowdfunding platforms are culpable here as valuations are set for largely unsophisticated investors, with many of the valuations quoted, and sometimes achieved, out of kilter with an objective perspective on potential exit returns and the risks. The media also skews investors and entrepreneurs sense of what is sensible. Naturally they focus attention on the outliers – often US based, tech businesses with global potential and aspirations of becoming the elusive unicorns. Whilst some of the tech valuations are realistic and have delivered remarkable returns, there is plenty of bubble behaviour and too many solutions desperately searching for problems to solve – a recipe for cash burn with no returns.
We have an SEIS fund that investors can join that invests in the winners of our monthly Start-Up Series competitions. One of the advantages of spending a half day digging into a business is that it is then possible to have a properly informed and sensible conversation about the valuation at which our fund will invest. We share benchmarks, stress test the valuation logic and help entrepreneurs look ahead to future rounds. We are looking for fair valuations for both parties (occasionally we have even suggested a higher valuation to an entrepreneur). Sometimes we disagree on valuation and part company before this half day.
Question 4: how can we construct a portfolio across companies and sectors?
Inherently, seed investing has three outcomes – fail completely; mature into a sustainable business but with no exit; or grow and exit at a significant multiple. It’s essential to create a portfolio to increase the chances of liquid returns. The maths will work if several investments are made in one narrow sector. But the portfolio will be more effective if spread across sectors. The tension here is between sticking to one or more sectors where the investor has expertise or going broader but with less expertise.
The scope for our seed competition series is for both consumer and business products and service. We tend to go for businesses that are changing behaviours and building brands as that is where my business partner and I are most confident of spotting potential and then helping the businesses. But the scope is deliberately wide, so that an angel investor builds a portfolio across different sectors.
Question 5: how are the start-ups being helped to reduce risk, accelerate growth and achieve maximum value?
One of the advantages of angel investment syndicates is that generally one of the investors will have some expertise in the category and will step up to representing other investors as Investor Director. This is completely missing with crowdfunding. This can be a heavy commitment for the Investor Director and their expertise can be a bit hit and miss, but the best Investor Directors are an incredibly valuable to the businesses and investors they serve.
Just like the private equity model, any investment made by the Start-Up Series Fund come with an Investor Director for at least two years. This is not just representing investors as a formal director, it is also to support the entrepreneur with experience, expertise, an extensive network and sometimes emotional support. This is not putting the business into a pre-prescribed mentoring process, but flexing the help to the times when they need it most.
These 5 questions have emerged over 12 years of seed investing. Defining them led to the design of our Start-Up Series competitions to unearth high performing investments for the Start-Up Series Fund. Naturally we’d be delighted for investors to join the fund, but we’d also be delighted if the same questions prompt other ways to achieve a high return on investment in an inherently risky investment class.