There are two kinds of businesses you can invest in:
Those with a variable cost of sale (consulting firms selling hours or retailers selling stock), and those without a variable cost of sale (IP businesses).
The former brings returns that are a function of capital employed, whilst generally carrying a lower risk.
The latter brings returns that are uncorrelated to capital employed, whilst generally carrying a higher risk.
In other words, IP businesses generate revenues that are independent of the investment in hours or stock. Because your upside is not a function of your capital invested, profitability is unlimited.
To dumb it down:
If you are scared of losing money, focus on businesses that sell hours or stock.
It you want to get crazy rich, focus on IP businesses.
This post is about getting crazy rich investing in IP businesses in South Africa. Typically this means tech startups trying to inject themselves into an inefficient industry and “clip the ticket” for every transaction they handle, thereby generating annuity revenues for perpetuity that have no corresponding cost of sales (i.e.: Microsoft, Google, Facebook.)
The trick is not finding opportunities; there are startups everywhere nowadays. The trick is to reduce the risk so you attain the Xanadu of angel investing: High reward, low risk.
Warren Buffett has the best checklist for vetting CEO’s: “Integrity, energy, intelligence and competence. Without the first one the other three don’t matter.”
Integrity can also mean “similar values.” Do you look at the world in the same way?
When looking for integrity, a good actor can fool even the most experienced investor. Follow the adage that never lies: “Birds of a feather flock together.”
Check the jockey’s social network (Facebook, LinkedIn, real world). If he/she hangs with people with whom you don’t share the same values, he/she is someone you don’t share the same values with.
Energy, intelligence and competence can be judged using tests, references and track record. Focus on integrity.
Accepted wisdom is that the best jockey will make a success of even the worst business. But why take a chance? Just like catching a wave on an outgoing tide is very difficult, so is making money on an outgoing trend.
Rather look for ideas trying to catch the wave on an incoming tide. Today the biggest trends are FinTech, eCommerce and Cyber Security. Invest in ideas on these waves. Not only is it easier to get traction, its easier to exit.
Yesterday’s waves were social media and online music.
Don’t fight the current.
- Local competitive advantage
In the world of tech you can’t rely on geography to protect you from competing with the best and brightest (i.e.: Silicon Valley.)
The Internet removes geographic barriers to entry. If you’re going to compete with the rest of the world you must establish some local competitive advantages.
What can you do that Silicon Valley can’t or won’t do? Some examples:
- Localisation – Developing apps in the vernacular, like Xander Apps. Not many companies in the USA are chasing Afrikaans, Zulu, Xhosa and Sotho customers. Same applies to localization of educational content for the South African curriculum, Paper Video.
- Enterprise sales – Find a product like Order Cloud that requires strong on-the-ground customer relationships, assuming there is no globally-recognised brand already offering that solution, i.e.: Salesforce.com, Oracle, SAP.
- Unique environment – Micro-mortgages for RDP housing improvements is not a product anyone in Silicon Valley can envisage. RDP housing is non-existent in the US, whereas it is a dominant feature of the SA housing market.
- First-mover-wins categories – GoMetro integrates with public transport providers to offer commuters scheduling information. It is unlikely that public transport providers will integrate with more than one reporting platform; therefore GoMetro can beat Silicon Valley by simply integrating all local providers before competition arrives.
A SA startup competing head-on with a Silicon Valley startup is the equivalent of standing in a gale and tearing up R100 notes. (This applies to a startup anywhere in the world competing with Silicon Valley. Don’t go head-to-head.)
- Exit opportunities
Some startups go on to become cash machines, generating profits and dividends that provide a fantastic return to angel investors. (This happened to me once thanks to @mobivangelist and 6th Line 1.0. It was an awesome investment, albeit a “selling hours” business.)
Success like this sometimes leads to founder-angst. The memory of the importance of the angel investment becomes progressively hazy as the founders make dividend payments that dwarf the original angel cheque.
Future founder-angst aside, a business that generates dividends is the best path to a profitable investment. This path requires a business plan from day one.
The only other reasonable path to profitability for an angel investor is an “exit”. Who will buy the startup you’ve just put your cash into?
Lets start by ruling out Facebook, Google, Yahoo or any other Silicon Valley company. Americans invest in Americans, with few exceptions.
If the plan is to sell to an American company, then make sure you have US-based investors & advisors from day one. Some South Africans based in USA you may want to consider: Mark Bartels, Vinny Lingham, Malan Joubert. If you feel like shooting for the stars try Roelof Botha, Elon Musk, David Frankel.
To get into Silicon Valley you must have a foot in Silicon Valley.
In all likelihood you will have to rely on exiting to a South African company.
Before investing you need to know exactly which local companies you can credibly exit to and then immediately start raising your product’s profile at those companies.
If your startup has a poor jockey, follows an outgoing trend, boasts no local competitive advantage, or cannot produce a credible business plan nor a likely exit to a local company, then you will probably never realise a positive ROE (Return On Equity) on your angel investment.
That’s why you should always invest in exciting startups. You can then at least be guaranteed of a positive ROe (Return On ego).