By David Stevenson on Monday 8 February 2016
The failure this week of crowdfunded business Rebus has stirred up a debate that we suspect just won’t go away i.e whether equity investments via the crowd are worth the obvious risk of failure. Here on the Crowdview column at AltFi Investor when talking about equity crowdfunding we tend to focus more on the concept of Return On Capital (how much money might I make versus the stake on offer) rather than Return of Capital (do I have any hope of getting my money back). The latter idea tends to dominate discussion about Debt or Loan based instruments such as mini bonds or P2P loans. The chief challenge here is to make sure that you a) receive enough income to b) justify the risk that your debt might not be repaid at maturity.
With equity based investments most investors assume that there is risk but focus instead on how much one could make. And because the risk profile for crowdfunded businesses is high – we should expect failure rates to be at least 50% although there is some evidence that these businesses might be more resilient than ‘traditionally’ funded alternatives – we thus go out of our way to bet on what are in effect moonshots. By this we mean early stage businesses that could grow exponentially in size, potentially making returns of as much as ten times the initial investment. ie harvesting ten baggers to make up for the large lump of failures.
Sadly this focus on tracking down moonshots tends to produce a strange investment blindness amongst early stage investors. They forget about traditional notions of what constitutes good business practice and focus instead on the big fat pitch i.e the world beater that will make them lots of money.
But equity investment – an old and venerable institution – has much to teach us about picking the right businesses. Crucially there's a whole school of investment thinking that teaches us to make sure that investing in an equity maximises the concept of Return of Capital. This school of investment thinking is called value investing and although over time it has evolved it holds certain concepts dear. It tends to work best with more mature businesses, where the balance sheet is robust. It also works well with concepts such as the margin of safety where the intrinsic value of a business is hopefully more than the market capitalisation on a stockmarket.
These ideas have, at the moment, limited currency with crowdfunded projects but there’s also a core body of ideas and practises that CAN help crowd investors make better decisions – and hopefully work towards avoiding failures like Rebus which has just lost CrowdCube clients around £800,000.
Three simple ideas stand out.
First inspect and constantly validate the cash flow. For many investors this simply means making sure the business has enough money to last for a year. This is of course an excellent notion but you also need to inspect the flow of cash through a business and understand how quickly a sale is translated into hard cash on the balance sheet. Many perfectly sound businesses fail because the sheer size of receivables (owed invoices) is so monumental that the business falls over.
Next up consider the quality of the management. Have the senior staff had success in the past ? More importantly have they managed their way through failure or at least a close call with corporate death. We cannot emphasise enough the need for at least a portion of the senior management to have had experience of properly managing people and teams. We also think that a very experienced chief financial officer is incredibly important.
Lastly one of the earnest value investors of all time, the Sage of Omaha himself, Warren Buffett has constantly emphasised the need for what he likes to call a competitive moat of advantage I.e a series of hard to copy corporate advantages that make the competition shy away. This is really easy to explain with very big companies where the brand for instance is a huge advantage with consumers. Unfortunately building a brand is hugely expensive – talk to most marketing folk and they’ll suggest that the tab will probably be £100m of more. But that moat might also consist on what's called intellectual property I.e some clever technology or trademarks. This stuff is really important and justifies why some venture capitalists get so enthusiastic about tech stocks. Whatever that moat might be allows the business to build one crucial advantage – a high profit margin. Now at this stage it's important to say that this wisdom doesn't apply to every successful business. Amazon for instance has incredibly low margins and is leaking cash but it is using that process to build a global brand. My guess is that we won’t see fat margins for Amazon for at least another five years (if at all).
But for most normal businesses you need to see a set of unique competitive advantages that will allow fat margins to appear. If you look at a business and you see yet another me too concept that has simply been quick enough to ask you for money faster than its peers – and where margins are rock bottom – run away. Commoditised business propositions rarely work. Yet the crux of this debate is that if you see a moonshot business which could produce an amazing global moat of advantage ask whether it has enough capital to properly scale up in the next two years. Great IP amounts to nothing if no one has heard of the business because it is not adequately capitalised. Frankly we’d rather a potential rival to a global brand be arrogant enough to ask for a million or two rather than be modest and run out of cash within a year.
All of these concepts are nebulous. They can’t easily be turned into simple numbers such as cash flow burns. They require you to research a proposition, ask awkward questions and kick they tyres of the proposed product. But if properly used they might help you avoid loss of capital in the future – and maybe even make a profit.