Reducing the Risk of Investing in Start-ups

I've written several times about how risky angel investing in start-ups and early stage businesses can be. Having personally invested in about 20 such businesses over the past 10 years, I have probably had to write off at least half of them within the first couple of years - but that doesn't mean they have disappeared completely. Just that my shares are no longer worth anything. That annoys me not just because they cost me money, but because the assets I helped to create may now be earning money for someone else. It may even be illegal and I am letting them get away with it. Let me explain.

When you buy shares in a company, depending on the class of shares you buy, you are probably entitled to a share of the profits it makes when the board issues what's known as a dividend. Otherwise the profit is retained in the business to be reinvested in growth. In due course, someone may offer to buy your shares for more money than you originally paid. So there are basically two ways of taking reward from the risk you took in placing the bet in the first place. Income or capital gain.

Unfortunately it's rarely as simple as that. Quite often you are asked by the company to bail them out when they hit financial buffers. These days, after being hit many times by pleas from founders, I usually hold tight and prepare to write off the investment. Hitting the buffers means the management failed to deliver on the plans they sold me. Sorry. You had your chance. You failed. Tough (but learn from it and try something else - which will be more likely to win next time). Occasionally the pleas from founders are based on positive requirements (like genuine short-term cashflow hiccups) or maybe unforeseeable events shortening their 'runway' (the delay they are predicting before they go bust if sales don't exceed minimum expectations).

To be fair, the government does help angel investor risk takers with tax relief opportunities which fall under their Enterprise Investment Schemes (EIS). Depending on what you invest in, it may be possible to recover some of that money from previously paid income tax, avoid capital gains tax if you sell your shares, and recover some of your investment if the company goes bust. You still lose money if it ceases trading - but sometimes it doesn't completely...

It's occurred a couple of time to me. Here's what happens:

They start to run out of money. They appeal to everyone they know to bail them out, but usually it's the original shareholders they ask since they'll be the ones who suffer most if it goes bust, and have the most to gain if it doesn't. It probably won't be the first time they've done this. All is far from happy in the business, but generally the founders are still positive about their strategy and will blame external factors for this call for more funding - the bolder of them will even blame the shareholders for not investing enough in the first place... "If we had more money, our product would be better/more sales people/more marketing/... so we would have sold more." etc.

They don't get the money they need and the end is approaching. They're personally facing losing lots of money themselves, and more importantly don't see a future for them and their families. They're desperate people. They start talking to competitors and other opportunist financiers.

Competitors will usually be licking their lips in anticipation of moving quickly onto their turf if the company does go bust. Maybe they'll pick up a few key employees. Maybe they'll buy some equipment from the liquidators and paying next to nothing. Maybe they can worry key clients enough to jump ship before there's panic and pain. But what they might really want is what is known as the goodwill contained in the business. Which generally means their sales or service contracts with clients desperate not to be affected by the collapse of their supplier. It may also mean relationships with suppliers as well as databases of contact details with current and former customers. And it might mean computer code, patents or copyright, otherwise collectively known as Intellectual Property or IP. Whatever it is, it's worth competitors picking up those assets for as little expense as possible. Or possibly for nothing...

It's possible for the board of the company to agree for the following to happen: The company transfers its assets, especially databases and other IP, to another company which is owned by the competitors, or another holding company. This might happen at no cost to the competitor if the assets can genuinely be valued at zero, but the transfer might be subject to other conditions. The original company then ceases trading and informs customers, staff, creditors and shareholders. But shares in the new company are also owned by some of the founders who negotiated the deal with the new owners - otherwise what's in it for them? So customers are also informed "Don't worry. There's nothing you need to do, just expect invoices for the services you ordered to come from another (usually very similar) name."

If the assets were transferred at too little value compared to what expert assessors might claim, this transfer for nothing is probably illegal. It's defrauding creditors and investors in the original company from the future earnings potential of the assets they paid for. But at least investors get some of it back thanks to the government's EIS tax relief (assuming they pay tax). And there may be some (pitiful) funds left in the kitty when the company went down which will be spread amongst the creditors according to their priority status: Government first, then staff, then lenders with secured rights, then ordinary creditors like unpaid suppliers and unsecured lenders. None of it ever reaches shareholders at the bottom of the priority list.

So what can defrauded investors do about it?

They can ask the founders to give them a few shares in the new venture which may one day be worth something, but typically the founders will tell them the funders of the new company won't allow that. They have no reason to be generous to former investors in their competitor - and nothing they are doing is illegal because the assets needed more funding to achieve any value. As for the founders of the original company, assuming they're not taken to court, they don't need to do anything. In fact they may have fallen out with the investors who, in their judgement, didn't put enough money in to stop it going bust.

So investors should file a law suit if they feel cheated.

Lawyers are very expensive. Decent ones can cost several thousand pounds... an hour! And if you win, what might you expect to get? The founders don't have any money to pay you their fine, otherwise they would have put it into their original company to stop it going bust. The new company isn't making money yet, so it will be liquidated - you lose even more money and nobody, except the lawyers, wins anything. The founders and any staff absorbed by the new company will be out of work. And that tax relief you hoped to claim from HMRC... is now disqualified. Lose, lose, lose.

So founders get away with it. And sometimes, with a following wind driven by a lot more experience, they make a lot of money - if not friends. 

Maybe that's the time to hit them with law suits. But it will always be hard to claim that the assets they used to own are the ones that resulted in the new company making money.

Investing in start-ups is always risky... and usually concludes with everyone blaming everyone else when the business doesn't work out the way everyone had hoped. But sometimes, it's especially hard to just take it on the chin.