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Tuesday, May 29, 2012

Business angels: hurdles to overcome and alliances to look for

We talked a few weeks ago about how important business angels are. Everybody seems to understand it here in this country. But there’s no explosive growth in this investor class in Russia’s regions; and a major disconnect between achievements in research labs and their market applications still exists. Why? To see an answer we might have to view this from an international perspective.

The problem that we’re discussing was already visible more than twenty years ago in the United States. At that time, business angel investors were primarily start-up entrepreneurs who developed their projects in IT. And all of a sudden the technologies began to get more and more complex. This process of exponentially advancing knowledge in biotech, nanotech, material science and things like these made it harder and harder for angel investors to dive in and do what they can do best: form a team, assess the market, and so on.

Part of the reason was that a horizon of how long it took to develop a technology project became longer and longer. For example, when you’re developing a medicine project you have to go through all sorts of government regulation, you have to have FTA approval, you have to have clinical trials, and so on. So instead of just being able to start a new company, develop it for two or three years and then sell it, with advance technologies you might have a six-seven-eight year horizon to develop that technology to a point that it could be sold to a strategic buyer or a VC fund.

One of the mechanisms that came to bridge this gap was the first proof-of-concept center at the University of Colorado initiated by a man whose name is David Allen. His idea was to create a form of a consulting center which would assist tech-transfer offices that typically assess at universities the legality of a technology by doing patent search. David decided to create a center which would help understand the commercial viability of the technology.

The goal was to be able to explain that to investors so that they were not just worried about how long this process would take. If you can map out and show that this is a market worth $20bn a year and within five years you can take 6% of that market and the market’s growing at 27% annually, then you can understand how to value that technology. If you don’t have anyone in the technology team that can understand that, and if the angel investor isn’t clear on it, then you have no way to strike a deal.

So proof-of-concept centers came out of the idea of how to bridge the gap between the advance fundamental science innovators and the angel investors. This system has evolved remarkably in the last 20 years. Today there are several dozen proof-of-concept centers, advance incubators, accelerators, etc. They vary in forms. One of the most highly publicized and successful is the Deshpande Center at MIT. Others include the von Liebig Center in California or University of Utah’s proof-of-concept center. Their main idea is to develop the infrastructure and mechanisms to help scientists and innovators create their commercialization strategy.

Jointly investing is the way they reduce risk

We just had guests here in Nizhny Novgorod, including Brigitte Baumann, president of EBAN (the European Trade Association for Business Angels, Seed Funds, and other Early Stage Market Players), and Frank Peters from the Los Angeles business angel club. I asked Frank: “Why are you here? Are you looking for angel-level deals here in Russia to invest directly in?” And he said: “No, I’m not looking for deals. I’m looking for Russian angel investors to partner with.”

Angel-level investing has become its own investor class representing more than 250,000 individual angel investors across the United States in hundreds, if not thousands, different clubs with a total investment of between $20bn and $30bn a year in start-ups. There are many syndicates of angel investor clubs; for example, Frank’s club in LA has more than 250 members, and he himself belongs to five other clubs around the country. Let’s say that as an angel investor each member should invest not less than $25,000 in a given project. With a technology project that requires $500k, for example, 20 different people get together to each contribute $25,000. Jointly investing is the way they reduce risk.

This is an absolutely amazing phenomenon to me, and I’m very excited to see that because I think that that type of mechanism would work very nicely in Russia.

As Frank Peters explained, they advise their members that those should develop a portfolio of around 30 projects, about $25,000 per project or $750,000 of their personal money to invest in 30 different ones. Out of these 30 projects, a big percentage will go bust; some of the projects will probably struggle along and may pay some money back. And Frank set an example of one project he was involved in that went public and all the investors got 117 times their money. Each investor who invested $25,000 received back almost $3m.

If out of your portfolio of 30 projects you’ve invested between $500k and $1m, and one project goes public, you will have made a million-dollar profit. In the meantime, you will participate in mentoring and advising dozens of different projects along the way. And the reason to do that is to make an interesting life and to change the world.

Today’s business angels feel that their territory is the world

One problem that Frank raised, however, was that they feel that they are not getting enough advance science projects. Most of the projects presented to angel investors are quick turnover IT projects. Advance fundamental technology coming from universities is reviewed by tech-transfer offices, packaged by proof-of-concept centers and then immediately sold to corporate strategic investors for further development.

Why? Because the super-high fundamental technologies are too risky for most private investors.

There are always exceptions, and the dream of every angel investor is that they’ll actually get this exception—a super-high-performing, exotic disruptive technology project. But that’s not as often as they would like. And that’s the reason that Frank Peters came here. Today’s business angels feel that their territory is the world, and they are looking for alliances. A business angel in LA can’t do a deal on his own in Nizhny Novgorod or Novosibirsk; he needs to have a local angel partner.

So the beauty of what happened here four weeks ago was that Russia’s business angel community grew up and achieved a certain milestone where the EBAN members decided to have their major event in Moscow. I would congratulate Konstantin Fokin, the president of the Business Angels Association of Russia, and Eduard Fyaxel, the chairman of the board of the Association, for raising the profile of Russian business angels to international business angel groups, to attract them here to Russia, and encourage them to first come to Moscow and then go out into the regions. And it’s a great encouragement for Russian business angels who’re looking for partners, who’re looking for advice, who’re looking for allies.

In this world, the people who want to do investing into technology take on a tough burden, and it’s important to always look for sharing risks. Russia as we all know has a very cyclical economy. If the European Union has a sneeze, then Russia gets bronchitis. If America has a recession, Russia goes into a depression. Whatever happens in the global economy will impact Russia very dramatically. If you’re a technology investor and you’re investing in this highly risky, highly cyclical, high-inflation system inside the Russian Federation—as it exists now as a commodity economy—then the best hope you have is to take your technology and immediately find an international partner.

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