Private Investors and Technology Companies why it's so hard?

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Whenever you as a private investor invest in technology companies at the initial revenue stage, why DO you have to take the long-term view and high risk on this type of investments?
It's a common understanding that tech companies may bring prosperity to investors. However, maybe the risk doesn’t have to be so high, and maybe both sides can share the prosperity with less risk of the investment?

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Private Investors and Technology Companies why it's so hard?

  1. 1. Alternative Technology Investment;           Blog, Jan 2014 Private Investors and Technology Companies why it's so hard? Whenever   you   as   a   private   investor   invest   in   technology   companies   at   the   initial   revenue  stage,  why  DO  you  have  to  take  the  long-­‐term  view  and  high  risk  on  this  type  of   investments?   It's   a   common   understanding   that   tech   companies   may   bring   prosperity   to   investors.   However,  maybe  the  risk  doesn’t  have  to  be  so  high,  and  maybe  both   sides   can   share   the  prosperity  with  less  risk  of  the  investment?   One   thing   is   for   sure;   building   the   right   investment   structure   could   open   tech   investment   opportunities   to   more   types   of   investors,   by   reducing   the   risk   and   shortening  the  investment  period.               Technology   companies   in   initial   revenue   stage   (Series   A)   need   to   get   funding   from   private  investors.  Their  chances  to  get  funding  through  other  venues  are  very  low.  The   incubators,   accelerators   and   crowd-­‐funding   sourcing   focus   on   seed   money   and   the   initial   stage   entrepreneurs.   The   private   fund,   small-­‐mid   size   VCs   and   Family   Offices   prefer  to  invest  in  growing  tech  companies.   Although  there  are  a  few  private  funds  that  are  looking  to  invest  in  initial  revenue  stage   companies,   they   try   to   scout   after   tech   companies   with   millions   of   dollars   in   revenue   rather  than  invest  in  those  with  few  hundreds  of  thousands  of  dollars.       So,  we  are  left  with  only  one  main  venue  for  those  companies,  angel  groups  that  include   the  private  investors.  Those  groups  have  been  built  in  the  venture  market  as  a  solution   to  these  stages  of  companies.  Some  of  those  groups  make  the  investment  directly  as  a   group,  however,  sometimes  these  groups  don’t  have  the  time  and/or  the  manpower  to   manage   the   funds   after   the   investment   is   made,   which   is   so   important   in   these   companies’   stage.     Some   of   these   groups   serve   only   as   a   'deal   flow   avenue'   for   their   private/angel  investors,  as  they  can  invest  only  a  few  hundreds  of  thousands  of  dollars   as   an   individual,   while   the   company   needs   millions   of   dollars   in   this   stage   to   move   forward  to  the  next  level  as  a  technology  company.         Typically,   the   companies   in   this   stage   have   a   proven   innovation   (even   a   granted   IP),   a   team  working  full  time  (and  more  than  that),  and  the  first  customers  who  purchased  the   products  and  paid  for  it!    
  2. 2. Alternative Technology Investment;           And  as  I  mentioned  above,  years  ago  the  market  created  the  solution  as  the  angel  group   for  these  kind  of  companies.  And,  at  this  stage,  the  angel  investors  may  be  able  to  get   the  best  deal  with  a  small  amount  of  capital.   So,   how   come   it’s   so   hard   and   takes   so   long   a   time   for   these   companies   to   get   funding?  Where  is  the  gap  between  the  companies  and  the  investors?       In  today’s  market,  the  company’s  CEO  needs  to  chase  after  those  private  investors  and   angles,  one  by  one.  Each  one  of  them  might  invest  $100K  or  less,  and  maybe  after  some   time,   they   will   gather   enough   to   close   most   of   the   round.   Both   parties   know   that   $100K   or  $200K  for  a  company  that  needs  $2M  will  not  be  much  help,  but  it’s  a  start.   The  worst  part  of  this  hard  procedure  is  that  the  CEO  and  the  management  team  put  a   lot   of   management   time   into   pitching,   raising   the   funds,   and   negotiating   with   dozens   of   investors   or   more   to   raise   the   funds,   instead   of   investing   their   precious   time   to   bring   more  business  to  the  company  and  to  increase  the  companies’  sales  and  value.           I   assume   that   we   can   expect   a   wide   gap   on   one   of   the   big   negotiated   issues:   VALUATION   The  founders  evaluate  the  company  in  a  way  that  give  the  investors  less  position,  than   what  he  would  like  to  have  at  this  stage.   We  can  understand  the  company’s  side;  they  wouldn't  like  to  release  too  many  shares,   they   know   that   there   will   be   additional   investment   rounds   and   are   afraid   to   lose   the   control   of   their   dream.   From   the   other   side   we   can   understand   the   private   investors;   they  don’t  feel  good  about  receiving  (only)  5%  for  hundreds  of  thousands  of  dollars  in   investment.   This   valuation   issue   creates   a   few   other   points   which   may   prevent   the   company   from   getting   funding:   (1)   Due   to   the   small   portion   in   the   company’s   shares,   the   investor   wouldn’t  get  a  stable  and  long  run  position  in  the  company  (2)  they  may  need  to  wait  5-­‐ 7   years   and   might   see   the   return   (3)   on   top   of   that,   they   know   how   the   venture   market   works,   eventually   the   big   fund   gets   most   of   the   return   (and   first)   and   leave   a   small   portion  to  the  investors  in  the  early  rounds,  especially  due  to  the  fact  that  first  investors   after  5-­‐7  years  will  likely  not  be  involved  in  the  company  to  protect  their  interest  during   an  exit  event.       Small-­‐Mid  size  investors  would  prefer  to  get  a  return  of  4X  or  5X  within  a  few  years  than   having  to  wait  7  years  or  more  until  the  big  exit  event.    
  3. 3. Alternative Technology Investment;           In   general,   the   small-­‐mid   size   funds   and   VCs   have   been   structured   for   this   investment   type.  Typically  their  strategy  is  to  invest  in  10  tech  companies  and  to  succeed  with  two   or  even  one,  which  will  maybe  bring  the  anticipated  IRR  (30X  and  more)  and  will  cover   all  the  other  unsuccessful  investments,  but  they  can  afford  to  take  this  kind  of  risk.   The  private  investor  can’t  play  the  same.  They  can’t  wait  for  7  years  and  hope  that  one   of  their  investments  will  come  to  fruition,  and  for  sure  they  can’t  trust  that  they  will  be   in  position  in  the  long  run  to  protect  their  interest.       Over   the   last   several   years   all   kinds   of   investment   structures   have   been   developed   to   solve   those   issues   which   might   close   the   gap,   from   convertible   notes,   to   equity   with   warrants  and  some  other  creative  structures.  But,  still  the  gap  hasn’t  been  solved.       Having   said   all   of   that,   we   understand   that   it’s   not   only   VALUATION,   therefore   we   could  assume  that  the  gap  could  be  in  the  deal  structure.   It   doesn’t   seem   so   attractive   at   this   stage   while   the   risk   is   so   high   for   the   angel   investors?       So  maybe  create  a  structure,  which  the  private  investors  consider  as  a  relatively  short-­‐ term  investment  with  the  opportunity  for  an  upside  in  the  long  run  can  become  the   game  changer  for  funding  initial  revenue  stage  companies.  This  works  in  other  markets   like  Real  Estate  so  why  not  in  technology  companies?       Typically,   a   technology   company’s   financial   forecast   will   present   a   ‘Hockey   Stick’   revenue   strategy,   which   is   ok   due   to   their   being   in   an   early   stage   and   a   technology   company.   We  can  use  this  forecast  to  decrease  the  risk  on  the  investment  while  not  affecting  the   company‘s  valuation  that  is  so  important  to  the  founders  at  this  stage.       One  of  the  main  elements  in  the  new  structure  should  be  a  fast  return  to  the  investor(s).   The  company  may  even  prefer  to  allocate  less  shares  by  giving  a  small  percentage  from   the  revenue  as  the  return  for  the  investor.   The   investor(s)   can   realize   a   portion   of   their   investment   during   the   first   years   and   by   doing  that,  reduce  the  risk  on  the  investment;  the  company  will  allocate  less  equity  with   the  ability  to  reduce  the  debt  during  the  first  years.    
  4. 4. Alternative Technology Investment;           However,  the  deal  structure  shouldn’t  be  only  convertible  note  with  the  return  from  the   revenue   or   equity,   or   just   warrants;   it   should   be   a   combination   of   all   three   elements   for   companies  this  stage  of  development.       With   combining   all   three   elements,   we   may   be   able   to   increase   the   value   and   the   attractiveness  of  the  deal;  (1)  The  investor  can  see  return  a  portion  of  his  money  in  the   short  term,  which  may  solve  the  investor’s  fears  of  losing  their  position  after  few  years   once   the   new   big   fund   will   come   into   to   the   investment;   (2)   Have   the   opportunity   to   realize   profit   in   the   long   term   with   an   upside   without   dramatically   reducing   the   company’s  current  valuation;  (3)  Due  to  the  attractive  deal  structure  it  might  reduce  the   time  management  is  needed  to  raise  the  funds.       In  any  case,  you  have  to  take  into  consideration  that  this  kind  of  structure  has  to  build   based   on   the   company’s   forecast,   professional   due   diligence   and   analysis,   while   the   trade-­‐off   between   all   the   elements   should   be   based   on   the  parties  investment   expectation  which  is  so  important  to  the  success  of  the  investment.         But,  that’s  not  all;  eventually  it  comes  down  to  funds  management.  Companies  at  this   stage   need   a   lot   of   attention   and   hand   holding   to   get   to   the   next   level,   and   do   the   private  investors  have  the  time,  ability  or  manpower  for  that?   I  know  we  have  to  take  these  big  issues  in  consider,  and  then,  we  might  have  the  right   structure   for   becoming   THE   game   changer,   and   closing   the   gap,   but   this   will   be   in   the   next  blog…   See you in the next blog. Happy New Year! Kfir Hazaz. Fruition TechFund LLC   Fruition  TechFund  LLC  is  a  U.S.  (Chicago)  based  management  company  that  scouts  and   invest   in   Israeli   and   U.S.   technology   companies   and   actively   participates   with   their   management.  Through  a  unique  investment  structure  enables  investors  make  separate   investments   directly   in   each   tech   company   and   receive   both   a   current   stream   of   cash   flow  and  long-­‐run  upside    
  5. 5. Alternative Technology Investment;             The  blog  is  for  general  informational  purposes  only  and  does  not  constitute  an  offer  to   sell   or   a   solicitation   of   an   offer   to   buy   any   security   or   any   financial   instrument   or   provide  any  investment  advice  in  any  jurisdiction.     We  do  not  represent  that  the  investments  described  at  the  blog  are  suitable  for  any   specific   investor.   Attendees   should   make   their   own   inquiries   and   consult   an   independent   tax,   legal,   investment   and/or   other   advisor   of   their   own   choice   before   making  any  decision  on  the  products  and  services  described  at  the  blog.    

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