The Road To Hell Is Paved With Good Intentions



Recently, the SEC approved early stage investment to unaccredited investors via Title 3 of The JOBS Act (aka equity crowdfunding). Now individuals with annual income or net worth less than $100,000 can invest up to 5% of their income or net worth or up to $2,000 (whichever is greater) in a 12 month period while individuals with higher incomes can invest up to 10%. While the goal of opening up early stage investment to everyone is noble, the illiquidity and deficiency of information for diligence will prove fatal to these investors; be forewarned.
I have been formally involved with early stage investments for two years as co-founder of Sand Hill East, a venture capital advisory and investment firm. Previously, I worked at Goldman Sachs as an analyst and as a portfolio manager for a few high profile hedge funds. I have had my share of success, such as being an angel investor and selling my stake to a16z for a hefty return. But in making the transition from being a professional institutional investor to being a venture capital/angel investor, I learned a few valuable lessons:
Lesson #1 Early stage companies have little, if any history for an investor to evaluate:
Early stage is a broad term, but in my experience consists of companies having been around between 0 to 3 years. At this point in a company’s lifecycle, there is little if any revenue. Further, financial documentation is typically lacking as resources are tight and many companies don’t have money for a CPA or bookkeeper. In my role at Sand Hill East, I help these companies build a financial model that displays expenses by line item and financial projections. The financial documentation that I have seen from these companies before becoming involved resembles the financial budget my college fraternity might have put together over a weekend.
Even when well-funded, there is little financial history because many are still pre-revenue or have little revenue to note. Financial projections for most startups are 90% guesswork. And there are examples of successful startups that existed for years and raised substantial amounts of money without a business model at all (e.g. Twitter, Facebook). The purpose of the financial model is to see how the company thinks of the main drivers of their business and how business may scale in an ideal world. Unfortunately, for even the most successful startups the ultimate direction of a company will look drastically different than the original plan/model set forth by the company in the early days.
Lesson #2 Failure is Likely, Very Likely:
The well-known industry standard is that 90% of startup companies fail. Failure of startups has been well documented for a host of reasons- funding, lack of product market fit, turnover, etc. But the main point is that 90% of startups fail. Failure means that an investor’s money goes to zero. Unaccredited investors’ history of investment in public equity markets will give them a very misleading stance on startup investing. If an individual invests in Microsoft and gets the timing or thesis wrong, the investor can admit he/she is wrong and easily trade out of the position, losing 10%, 20% or maybe 30% of his/her investment.
Even in the 2008 financial market collapse, the Dow Jones declined 55% from peak to trough. Investors remember how painful that time period was and the result was many investors have yet to return to the stock market.
Losing 100% of their investment (at a 90% probability) will not sit well with unaccredited investors. While the investment of an unaccredited investor is capped at $5,000 in a 12-month period, losing post tax dollars of $5k in a year will hurt. The issue here is that if an individual takes the plunge into angel investing, he/she will likely make at least a handful of investments.
It’s not one and done when it comes to investing in early stage companies. These companies will need many rounds of financing, both to fuel growth or to extend the runway for the company to develop the product or find the right customer(s). Making an investment in a startup is a bit like taking on a child. Children need constant nurturing and support, oftentimes monetary. Similarly, startups need nurturing and support that does not end when you write the first check. When you write the first check you become a parent of this young startup, so be prepared for the child to come back and ask for money quite a few times. According to CrunchBase the average successful US startup raised $41 million and exited at $243 million while the average successfully acquired US startup raised $29.4 million and sold for $155.5 million equaling 7.5x return, assuming no dilution.
Lesson #3 Illiquidity:
Even if you are smart and lucky to be involved with a successful startup you may not be able to cash out of your investment. I have personally experienced the illiquidity of venture/angel investing firsthand and it’s quite painful. I have been successful in investing in early stage companies’ seed rounds at very appealing valuations that are then marked up considerably in subsequent rounds. In a few cases, I have invested in a company at a $2 million valuation, which then gets subsequent funding at $10 million and then $25 million, etc.… On paper these gains look incredible and make me look smart, a big feat. However, the reality of the market is that these paper gains are illusory. I can’t pay my mortgage or college tuitions with this equity nor pledge them to borrow against at these valuations.
The median life of a successful startup based on studies I have seen is 8 years! That’s a successful startup, i.e. the top 5-10%! Usually, the only time to liquidate your position is at the time of exit. As successful startups stay private longer (see Uber, airbnb) there are fewer IPO opportunities to exit positions.
Lesson #4 Dilution:
Startups need capital to grow. Even the least capital-intensive companies need capital to hire developers, sales, marketing, etc. As companies raise capital, seed investors’ stakes are reduced unless they decide or even have the rights to invest more. If all the seed investors in a successful startup, let’s say company xyz, invested $1 million at $4 million pre money valuation they held a 20% ownership stake in the company. If the company does a follow on Series A round raising $5 million at $15 million, the seed investors’ stake is reduced to 15% of the company, not too bad but that’s not it. The Series B round takes in $15 million at $35 million reduces it further to 10.5%. The Series C taking in $20 million at $60 million reduces the position to 8.4%. So in effect the initial 20% stake is reduced to less than 1/3 of its initial level despite being done at very healthy valuation levels.

Lesson #5 Selection Bias:
The most plugged in and active investors will have access to the best deals.  High profile startup founders with a successful track record have a rabid following of investors who will invest in anything that the founder does. Other top startups are often sniffed out by top notch VC’s who have teams of people whose primary job is to scour the earth for top startups. Once VCs and high profile angels get involved in startups, the rounds go quickly and it’s unlikely that the average public will be let in.
The sad fact is that the best deals will go to VC’s and or high profile angels. As an individual, it’s unlikely that you will see the top deals vs. VC’s whose entire existence and value proposition states that they have exclusive access to these high profile founders.
I am not a pessimistic person, rather one whose background as a hedge fund manager looks at investments with a risk/reward mentality seeking to find out if I have a true edge in an investment. Individual investors need to be acutely aware of the massive risks that are involved with angel investing before jumping in.

Image credit: CC by Moyan Brenn

About the author: Josh Burwick

Josh Burwick is a Managing Partner and CoFounder of Sand Hill East Ventures. From 1998-2002 Josh worked at Goldman Sachs in the technology sector for the Investment Research and Institutional Research Sales departments. In 2002, Josh made the move to the buy side joining Moore Capital to help run a technology portfolio. At the portfolio’s peak, Josh managed a $1 billion long/short technology portfolio. Josh also managed technology portfolios at Pia Capital and Glg Partners. At Sand Hill East, Josh leads the investment effort and partnership with early stage transformative technology companies.

Josh graduated Phi Beta Kappa, Magna Cum Laude with a Finance degree from Lehigh University.

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