[Editor's Note: This is a “Part II” guest post on the subject of high risk investing. I've written before on investments for accredited investors here and here. This is written by DJ Verret, MD, FACS, plastic surgeon. I have no financial relationship with Dr. Verret.]
When considering an accredited investment, due diligence is essential to determine if the investment is right for you. There is no set formula that will work for every company and even with the best diligence there is a still a reasonable risk that the investment will fail to return what is promised. The first step in the process starts before you even go looking for investments. Set up a framework to evaluate what investments you are looking for. Consider risk, area of investment, expected return, and timeframe for return. For instance, risk tolerance may be an issue so you want a relatively safe investment with recurrent dividends and 5-10% per year return. This thesis would be appropriate for real estate investment. On the other hand, if you have a high risk tolerance and want a 2-5 times return on investment in a 5-10 year timeframe, look for startups to invest in. Once you have decided on an investment objective, now it is time to evaluate potential investments. For this discussion we will consider equity type investments in non-real estate ventures.
D.J. Verret, MD, FACS
When you go to buy a car you are looking for a reason to buy one car over another. In investing, even though you have made a decision to invest in a certain area, due diligence should lead you to why you should NOT make an investment and if there is any reasonable reason that you should not invest, don’t. There will be more opportunities around the corner.
When I look at equity investments, I consider four areas during first review: product, competition, management, and business plan.
Product
For this discussion, product is a broad term which can mean an actual product or maybe a service that the company is offering. The product should be something this is desired and understood. When starting, look for investments in your field of expertise. This will make the product easier to understand and the potential market easier to determine. If it takes more than 30 seconds to understand what the company is trying to accomplish, move on. Unique ideas should seem unique on face and a company should not need to convince someone in the field that the product is a good idea.
If the product seems like a good idea then ask what is the barrier to entry for other products, basically what prevents a bigger company from doing the same thing once the product becomes known. The answer may lie in the intellectual property of the company, patents or trade secrets, or the particular knowledge of the founders. Beware if the answer is that the company relies on the special knowledge or ability of one person. In a solo doctor practice, if the doctor is incapacitated, the practice dies regardless of the previous size. Similarly if a key man is incapacitated in a company the company may not succeed.
Market
If the product seems like a good idea, the next question is what is the market for the product? Consider who is going to be buying the product and how many might be bought? What is the potential market price for the product? Can the company make a profit given their cost of production and the potential sales price? Companies will invariably give a rosy picture of the market for the product but you have to ask yourself, “Is it even possible to capture that market?”
Competition is another part of any market evaluation. Competition may be someone who does exactly what the company does, like a restaurant, or it may be someone with a similar technology that achieves the same result. Determining the competition is important for a number of reasons including determining how difficult it will be to enter a market and who may be interested in buying the company once it is successful. Determining who and how strong the competition may be is only the first step. Next is to determine if the competition is a barrier to entry. For instance, Beverly Hills has a lot of plastic surgeons because there is a lot of demand for plastic surgeons. Could Beverly Hills support another plastic surgeon even with significant competition? Likely. On the other hand, there is no competition for plastic surgery in Pampa, Texas. Even without anyone there, could Pampa support a plastic surgeon? Not likely, and this explains why there is no competition.
Management
Even with a great product, bad management will sink a company. Learn as much as you can about the management – previous experience, personal relationships – and like any job interview get and check references. Now with social networking programs like LinkedIn, contact associates for information about the person. Beware of inventor CEO’s and anyone who is not 100% committed to the company. If the person has a day job and only works for the company part time, run the other way.
Business Plan
Any good company will have a good business plan which outlines each step of the development process and ultimately how the company will repay its investors. When evaluating the business plan asks for specifics. Who is going to make introductions to target markets? Where are additional fund raises going to come from? What contacts will be able to make introductions to potential buyers? If the path to success is not clear, don’t invest.
Finally, when evaluating any investment, do your own homework and ask questions. Rely on the company and other people to a certain extent but do your own research. Search for competitors. Talk to market and scientific experts. Don’t trust that the company even knows everything about its market or potential opportunities. If company management does not want to be transparent about the operations, finances, or cannot answer questions about the business plan, don’t invest.
What do you think? What steps do you take when doing due diligence on an “accredited investor only,” small business, or start-up investment? How have you done on investments like this? Comment below!
Interesting article, thank you Dr. Verret for writing this and WCI for publishing this.
These investments do represent an opportunity to make above-average returns. This is because the number of investors who have access to this investment is more limited. In the stock market, there are millions of participants who are able to correct any market inefficiencies very quickly. In investments like these, you may be one of 10, 1,000, or 10,000 investors who have access to the product. You may be the first person a friend or family member discusses a new start-up with. In this situation, if you do your homework and due diligence on the investment and can value the investment better than the person selling it to you, you can make excellent returns.
While I have not participated in an “accredited investor only” offering per se, in my previous life on Wall Street, we traded financial products that were not publicly traded. These markets had only a limited number of participants. I liken it to a game of poker, perhaps with more than ten people at the table, but fewer than the millions at the stock market table. If you are smarter or more savvy than everyone else at the table, you’ll win all the chips. But don’t be the “sucker” at the investment table. If you are not careful, you the doctor will be the fish in a tank full of sharks.
I’m not saying you can’t make money on investments like these, but I think it’s far wiser to reach the full “independently wealthy, don’t need to work another hour” level before dipping your toe. I’ve made many, many angel investments over the years, and I think it’s best to really get to the point where it’s “play money” that you are investing and that you really will be 100% fine with losing 100% of the money you spend on your whole portfolio of investments. They are pure lottery tickets, purchased because it’s fun to interact with young entrepreneurs and help provide them with advice and feedback to build something great.
If you get to that point, making $10-25k per company investments, 1-4x per year, is a hobby. An expensive hobby perhaps, but maybe you get lucky and one of the 20-50 investments you make returns such a substantial amount that it will end up being statistically better than if you had simply left in a total market index fund all those years.
I surely wouldn’t put more than 1-3% of your net worth in these investments.
Anyway, that’s how I approach this.
I’d take your comment about management one step further. Also make sure they are trustworthy. Back in the 80s my father invested in a small business. Ultimately the original owner cut bait, sold all the assets and took the money with him. My dad ended up with nothing. If there is a sign of an unscrupulous owner then you also can’t trust financials. Run away.
Pampas, Texas. Nice. Good article, thanks for WCI publishing and author for his input. I think it would be interesting to hear “when a typical white coat investor would invest in these products.”
I have been offered two different opportunities like this, both problematic. One was a group that put on marathons. The financials looked great and I understand the product well. I had my accountant review the data, which looked sound. However, then she noted that the financials while sound were on velum without a letterhead. She searched the investments accounting firm and found it did not exist. Love my accountant for allowing me to avoid that pitfall. Do NOT be afraid to defer to your team of experts (e.g. lawyer, accountant, priest, rabbi.) If I get an offer now the response is ALWAYS that I need my financial team to vet it before I can make any comment. That shuts down 99% of offers. The second opportunity was to invest in a stock in a private orthopedic company that makes spinal equiptment. There the investment was legit. However, the promise of returns were very high and dependent on the FDA to approve their device -which never happened. Avoided this one as my financial team discovered that the company had great adoption by surgeons but had been shopping the shares of stock very aggressively (a bit too aggressively suggesting a desparation that eventually led me to avoid the opportunity.) The company has a great product but to date never got FDA approval. That opportunity was about 10 years ago…
If someone is considering these types of investments, reading David Swensen’s other book, “Pioneering Portfolio Portfolio,” management would be a really good next step.
Swensen, BTW, suggests that the median return in private equity investment is negative.
I have a very hard time throwing my money at these investments. I see myself on a good path towards financial independence as long as the stock market returns 5% over long term. 4% would also work but have me working just little longer. Although I have the ability to take on more risk, I do not need to and stick with my current index fund portfolio.
Another thought about these investments. How much of my portfolio should I allocate? 5%, 10%. Lets just say 10% which I think is a bit high. How much extra can I potentially make if instead of 5% every year I make 10% every year on that part of my money? It is a 1% boost. Although an extra 1% a year would be nice, the extra 1% would not change my life in any drastic way. Appears the risk is way too high for the reward.
You probably wouldn’t invest in any high-risk deals based solely on financial returns. This audience falls primarily into what I’d call the “lifestyle angel investor” crowd. I’ve raised private equity for many deals (real estate & software) and successfully pitched countless angels and angel groups. The underlying motivation is rarely financial (surprise!!!). These folks already have made their fortune and winning or losing a few more dollars isn’t go to change anything for them.
Why invest? It’s far more often an interest in developing a specific technology, providing mentorship and guidance to young entrepreneurs, bragging rights at the country club (no joke), supporting something of personal interest (e.g. adult literacy program), charity and giving back to the local community. Those are the primary reasons that that got people to actually write checks, not dreams of astronomical returns. It’s an entirely different mindset than investing someone else’s money (venture capital, hedge fund, private equity).
For sure a boring old index fund portfolio, funded adequately and stuck with for the long term, is adequate to meet your goals. But 1% extra can make a difference.
The takeaway from the Kaufman Foundation report mentioned in the first article shouldn’t be that average angel investor returns are 2.6x over a few years. It should be that 90% of cash returns come from about 10% of the investments. Almost all the others generate negative investor returns (i.e. lose some or all of your money). The implication is that having less than 10 high-risk investments in your portfolio is basically buying a lottery ticket. My personal experience leads me to think that 15-20 high-risk investments are needed to provide enough diversification to actually see those 2.6x returns.
A few people mentioned getting returns of 20-30% over the first 2-3 years. Those are great numbers, but you can’t truly calculate ROI until the original capital is completely returned. Investing $100K and getting $25K annually for three years is fantastic until the company goes bankrupt in Year 4. That’s a pretty common scenario for startups relying on private equity (outside of real estate deals). Unlike a brokerage, it’s extremely rare (as in never) to give an investor the option of cashing out the original investment on demand.
I think you need more than just simple diversification in order to make this work.
The top quartile, median and bottom quartile annual Swensen gives are 28.7%, -1.4% and -14.5% for a set of venture capital funds formed during last five years of 90s…
So the average VC fund (run by professionals not by angels) earns on its slightly diversified portfolio -1.4% annually.
Nice article. However, I would have to make one proviso with regard to the management team description. I am a full-time academic physician, and developed a medical software that led to the creation of a Delaware C-corp. Startups in the very early phases of development do not yet have the capital to pay full-time salaries for CEOs, physician CMOs, COOs, marketing personnel, etc. My partners are serial entrepreneurs who still run their other companies until they are acquired, while at the same time, are developing our product into a commercial ready version. I still maintain my academic practice, at least until we get our VC funding.
Nice article. I would add that if one has a little longer time horizon (say 15 – 20 years), then 2-3X growth is achievable in a broad diversified portfolio (70-75% equity, 25-30% bond) with less risk. The aggressiveness of one’s savings habit will play a larger part in wealth accumulation over time for most folks. Consistently save and maintain a long term perspective!