A step-by-step guide to investing in early stage technology companies in 2017

What defines a great investment opportunity?

At Right Click Capital, we have a strong thesis around what defines a great early-stage technology company. Having started, run and exited technology businesses over the last twenty-plus years, we have come to realise that a strong founding team is critical. Great companies often have the perfect concoction of business, domain and technical experience, creating a sustainable competitive advantage. We believe a founding team should possess each of these characteristics. Given the rarity of these attributes in a single person, we find great founding teams are made up of two or three talented individuals who, between them, boast this winning combination.

We ask founders to take part in a Founder DNA Assessment that helps us determine their entrepreneurial potential. Factors that correlate to entrepreneurial success include experience, intelligence, openness, willingness to learn and most importantly, perseverance.  

Founders who have their sights set on chasing large markets are also key. We like founding teams who have the potential to scale their businesses. Given the size of our domestic market, this means we preference founders who are chasing global opportunities.

We also like founding teams that demonstrate market momentum. For earlier stage startups, high customer acquisition rates and a solid pipeline of deals in negotiation are key indicators. We also take into account the number of current customers as well as the total customer growth month on month. However, it’s also important to distinguish between registered and paying users if the startup is running under a freemium business model.

Now, how do you start investing?  

There are typically two methods to investing into a technology startup, either directly as an angel investor or indirectly through a venture capital fund such as Right Click Capital.

Becoming an angel investor

You may be aware of the “buzz” surrounding angel investing where there’s the great potential for significant returns in backing early-stage businesses. Since the introduction of the Australian Government’s National Innovation and Science Agenda reforms in July 2016, a number of informed investors have taken the opportunity to support early-stage businesses, thanks to a ten-year capital gains tax exemption and a 20 percent non-refundable carry-forward tax offset on investments. To be eligible for these incentives, an investor must meet the “sophisticated investor” test under the Corporations Act, or have total investments in qualifying companies under A$50,000 for that income year.

Under the scheme, eligible companies must be non-listed and have been incorporated within the last three income years with total assets not exceeding A$50M. They must have less than A$1M in business expenses and income under A$200,000. Further criteria require they have demonstrated potential for high growth and scalability, and address a large market with a significant competitive advantage. A similar scheme in the UK for early-stage companies raised over A$500M in the first two years for approximately 2,900 companies.

While angel investing requires a greater level of involvement, the advantages include greater control over capital as well as bypassing the management fees of fund managers. As an angel investor, the investment process involves sourcing, assessment, due diligence and management of deals.

Joining an angel group is a great way to source deals as it gives you an opportunity to not only connect with founders but also seek advice from an experienced network of angel investors. Some examples include Sydney Angels, Innovation Bay and Business Angels. It’s important to develop your network and learn from those who have previously invested in your areas of interest. Visiting industry specific publications such as StartupSmart and StartupDaily will also keep you in the loop, along with startup databases such as Crunchbase, Index.co, Angelist and e27 for startups headquartered in Asia.

For those who are time poor, subscribing to Right Click Capital’s publishing arm, Internet DealBook, is a great way to keep across an extensive global database that tracks angel, VC, and private-equity investment and M&A activity in Internet and technology-related companies.

The next step involves assessing deals. Every investor should develop their own criteria, depending on their preferred and specialised sectors. It’s best to draw on company facts and statistics that will make the screening process faster, whether it be skewed towards quantitative performance figures or qualitative factors such as team composition or competitive landscape. Before getting in contact, the company website and LinkedIn profiles of the team will also give you an overview of the vision of the business. It is also important to check for media mentions across a range of news outlets.

Once potential deals have been refined, due diligence involves reviewing the finer details to negotiate a term sheet to be agreed upon by both partners. Variables to be decided include the investment amount, pre-money valuation, maximum round size, any pre-conditions around founders and, finally, the capitalisation table. It’s helpful to engage a lawyer to develop these legal documents as part of the term sheet process. Detailed due diligence involves assessing the business’s commercial prospects, their competitive environment, technical capability, and ESG factors.

As an investor, providing money is one thing, but providing additional value is another.

Supporting a portfolio company with coaching and mentorship in your own areas of expertise is critical. Introducing portfolio companies to business contacts in your professional network can also set them up for success.

Indirectly investing through a venture capital fund

If you like the idea of investing in early-stage businesses but don’t have the time to be an angel investor, it may make sense to invest through a venture capital fund. Reputable funds will follow a process similar to the one outlined above. When assessing potential funds, include the background of the fund’s principals, the value proposition to both investee companies and investors, and the fund’s history and track record.

As with angel investing, screening the founders of a VC firm is a crucial step before committing to an investment. If the fund focuses on specific sectors, you should note whether the management team has relevant technical knowledge to review potential deals and add value after their investment. Some VCs have a founder background, where they have had extensive startup and operational experience. Other VCs have a financial management or investment banking background. Either way, you will want to make sure that the VC you choose has personal experience in building or leading their own companies along with the ability to provide critical feedback to investee companies.

Investors should consider a VC firm’s investment thesis. Investors should agree with the core ideas that will drive investment decisions on a macro level. A firm’s thesis will determine how they go about providing returns to investors. It should also be made clear how they will exit their investments.

While prior accomplishments don’t guarantee future success, screening a VC firm also involves reviewing the firm’s track record and historical investments, all of which can provide an indication of future performance. Sites such as Crunchbase or Index.co will provide a view of a fund’s previous investments.

So there you have it.

Whether you choose to invest directly or through a fund, by asking the right questions at every step of the investment journey, you will have a greater chance of success.

Contributed by Ben Chong, Founder, Right Click Capital: (VIEW LINK)