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The Valley of Death. Why most angel investments lose money.

I have been investing in start-up companies (businesses with little or no trading history) for around 20 years. Unfortunately, despite knowing a great deal about starting and selling businesses, at least half of the ones I pick eventually fail and lose me all the money I invested in them... although some of it might be recoverable as tax relief.

So over the years, I've come to realise that the odds are heavily stacked against me backing a winner - typically defined as a sale of my shares, known as an exit, within 10 years, paying me at least 10 times the money I invested. To get the same result from guaranteed compound interest over 10 years, you would have to be paid a rate of about 25% - so get it right, and it's a big prize. I've managed it a couple of times, so overall have recovered most of what I've lost on the many companies who died, but it's a very high risk game. So why do so many angel investments in particular die, and why is it so hard for us to spot them before we invest?

There are usually three phases in the evolution of a business: Conception; Proof and Growth. The challenge for business angels is to find businesses who need funding for the Proof phase, and who then progress through to the Growth phase.

Conception Phase

This period, which normally lasts a year or two, is almost invariably funded by The Three Fs... Family, Friends and Fools. It's where the idea becomes testable and in all probability thereafter, remains small but manages to pay the founders and perhaps a small workforce, a salary. Despite the ambitions of the founders, these businesses never become great successes and are sometimes therefore known as lifestyle businesses. They are of no interest to external investors like angels and need to be avoided... if you can.

Start-ups of interest to angel investors are unusual businesses ('usual' businesses rarely grow quickly. They are safer, but won't deliver large profits or scalability options). Ideally during the Conception phase, unusual business ideas will be tested and perhaps protected in some way before they start trading. This may involve applying for a patent, making prototypes or dummy websites, and chatting to a lot of people whom the entrepreneurs hope might become customers or routes to customers (like retailers, distributors or wholesalers). At least 90% of unusual start-ups never emerge from this phase, and most don't last the first year. And if they do survive, most remain lifestyle businesses and rarely reward their investors. These are a big problem for the angel investors who pick them. They are unlikely to ever be sold, so their shares effectively become worthless, and any profits tend to be re-absorbed by the business rather than being redistributed as dividends to investors.

There are countless reasons why companies fail in their Conception phase, but the most common is wishful thinking by the founders. It's a lot harder than it looks to create a business that can scale, and it always takes a lot longer than anyone ever predicted or hoped. Virtually every business you see emerge from its Conception phase will have changed its products or services, often radically, to find something that sells and has potential to sell a lot more, rather than something that the founders want to sell. This is known as a pivot - and is one of the features I look out for when I meet businesses seeking angel investment. If they haven't discovered their pivot yet, then I'm unlikely to fund a weak idea that hasn't gained traction. The idea was either good enough to only need FFF funding to reach the Growth phase, and therefore skip the Proof phase, or it needs a pivot (that works) before the money runs out.

Proof Phase

Progressing through the Proof phase usually takes more money than FFFs have available. It's the period in the evolution of a business where the founders believe they've got something they can make and sell at a profit, but they need to actually get into the market to prove this to the really serious funders... the people who will buy into the final phase - Growth. More often than not, a local business angel will be the person, or persons, to finance this intermediary Proof phase. And dangers lurk everywhere!

One of the reasons initial FFF funding might not have been enough to last throughout this phase is because the original hopes and aspirations of the founders were misplaced. They were over optimistic or just wrong. Wrong product, wrong market, wrong timing, wrong price, wrong volume estimates, wrong understanding of competitors, wrong staff, wrong infrastructure, illegal, patent wobbles, it simply didn't work... and many more types of mistake to trip a company up. What then happens falls into two camps. Abandonment or Rethink. 

Business founders are bold people. They wouldn't start something if they didn't have faith in both the idea, and their own ability to make it happen. They are not the sort of people who give up... when maybe they should have. Sometimes, they see another light (or just imagine it), another opportunity that could yield them greater and perhaps faster riches than their original idea. This tends to be when I get introduced to them, usually through my Angel Club. 

Companies pitching to business angels typically seek between £250,000 and £1m. Any less and the business isn't ambitious enough to be worth risking your money. Equally FFFs can usually be found to provide what's needed below £250k - and taking money from them is far easier than getting cash out of wily old retired FTSE 100 board directors - or cynical 'been-there-done-that' entrepreneurs like me. If businesses are seeking more than £1m, they are entering the territory of deeper pockets provided by professional venture capital funds who charge fat fees for doing deals - and who don't like to take risks when the company is still trying to prove it will succeed. Consequently the valuations of these company tend to be far higher than companies being offered to angel investors, but that reflects the far lower risk of investing for a more certain profit if the company grows at the rate it's already proved it can - all it needs to do so, is more money which they will seek in their...

Growth Phase

This is the phase where more than £1m is required to perhaps take one product, and turn it into several products, or one market into many markets, or simply to scale the business in other ways, like more people, more marketing, more machines, or more premises, to make even more money. 

There will still be risks involved in this phase, but usually far fewer because of two factors. Firstly the business will probably already be selling something profitably, or know how to. So proving that customers are prepared to pay for what they are selling is not in question, and the business could survive without any additional funding. And secondly, the potential funders won't just take the founders' word that everything will be rosy if more money is invested. They will do what is known as Due Diligence - effectively their own research around the proposition. And more often than not, they will side-line the original entrepreneur(s) so the company is led by a steadier pair of hands to safely manage their money and obtain a future exit... ideally an Initial Public Offering (IPO) where anyone can buy and sale its shares.

So business angels are left with struggling companies who have tried to skip the 'Valley of Death' (£250k-£1m) funding window while they eke out their original FFF funding, but are now running out of 'runway' (time and money) to make the pivot, to prove they can make a profit using only skeletal resources, while proffering a wildly ambitious plan for significant scaling.

I told you it was hard.

The trick is to spot the difference between two types of businesses pitching for your cash - those who need more time to prove their pivot will work, and those who are still driven by wishful thinking. It's why multi-billion dollar businesses funded by a few lucky angels, are called unicorns... They don't exist, so you'll probably never meet one, and if you do, it's undoubtedly a donkey wearing a horn.


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