A little liquidity would encourage early-stage investors.
If you’re a tech entrepreneur, a friend or family member of one, or if you’re an angel investor, you know that the investment math is harshest at the risky early stages of a new venture. Companies often don’t get off the ground; some get a few customers and then never get meaningful traction. For taking that risk angel investors may get a large reward at the end, but in the meantime their money could be tied up for a decade or more.
More disconcerting is the fact that those who take the risk early may end up diluted to oblivion and not get a return even if the company is a success. What’s needed to encourage more venture funding is early-stage liquidity, which has proven elusive in local venture-capital investing. It’s worth taking a look at some reasons why.
Despite the “overnight” success stories fuelled by the media, these are not short-term investments. Local successes like BuildDirect.com Technologies Inc., Make Technologies Inc. and Layer 7 Technologies Inc. started over a decade ago. Few investments exit through a sale within a year or two of investing. If they do, the returns are usually not spectacular.
Early-stage investments involve many layers, and there is a rule in private-company investing: last money in is first money out. If there are three or more rounds of venture investing after the angels, it will take a very successful exit to clear all the layers of shareholders ahead of the angels before they see their cash.
Investors here in B.C. might not be prepared for the patience it takes to back an early-stage tech venture. Here, in the land of mining and energy, when investing in junior public markets a quick-exit mentality is pervasive. Angel investors need to realize it takes time and they need to support entrepreneurs, rather than push them to an exit. Forced early exits for shareholder liquidity is one reason we don’t have huge technology companies in B.C.
The province’s Eligible Business Corporation (EBC) program, which gives angels a 30-per-cent tax credit on their investment is a good start, but it isn’t enough; without investor liquidity, these early-stage investors won’t be able to hang in long enough to allow young companies the time they need to mature. We need a way to give investors liquidity sooner.
A solution is emerging in the market for secondary investment south of the border. A growing number of U.S.-based funds get equity pieces of growing technology companies by buying part or all of the positions of early investors. Two websites (SharesPost and Second Market) facilitate individuals and institutions looking to buy shares from insiders in these private companies. If we can’t have a similar market system in Canada, we need our own system to value those Canadian private company shares and facilitate a sale of some or all of the investor shares (obviously compliant with the securities commissions, which might take a while).
Until such a system emerges, investors coming into later rounds of these companies should not be averse to seeing 10 to 20 per cent of their investment going to provide a little liquidity for early investors. If a company raises $10 million for growth five years after angel money was first injected, let those early investors take some money off the table. VCs in later rounds and private equity funds should have no problem with this as these investors may even sell at a discount.
I see this as a win-win-win. Investors get a chance to invest in companies when there isn’t necessarily a round of financing being done. Entrepreneurs and those that do not sell won’t be diluted by secondary sales. In fact, they may get rid of grumpy or passive shareholders. And the early investors get some cash. With more secondary sales of shares, more angels have money to invest sooner. This speeds up the cycle of investment into more companies in B.C.