Low Level Venture Capital

by Mr. Cheap

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For those not familiar with it, venture capital is typically a firm that provides early stage funding for new companies (Paul Graham has extensive ideas about funding startups). Think of the TV show “Dragon’s Den” if you’ve seen it. Venture capital firms like to “swing for the fences” and would rather have a small chance of owning part of the next Google instead of a good chance of owning part of a moderately profitable company (which is at odds with the perspective of most founders).

A while back I wondered if there was a way to invest in something like this at a lower level. Instead of trying to fund the next Google, might an interesting investment be helping people start small, traditional businesses (like launching a McDonald’s franchise or opening a bed-and-breakfast) in exchange for shared ownership (instead of a straight loan).

I’m not talking about something like Kiva, this would be an investment, not a donation. Instead of being paid back, the investor would retain ownership of a percentage of the company and collect that percentage of the profits.

I’d be shocked if people aren’t already doing something like this, but I haven’t heard of it if they are. Arguably I’m doing this with the building I’m a silent partner in, but I’m more thinking of a person or organization who does MANY deals like this every year, not just a one-off with a friend. Basically you come to me (an investor with money), show me your plans for the business and convince me you’ve thought this through and are making a commitment to launch. We both put money in (ideally) and work out some sort of shared ownership of the resulting enterprise.

A while back I bounced around the idea of starting a Subway franchise. It seems like most franchisees save or get a bank loan to purchase the franchise, apply to head office and then carry through with launching. For someone who couldn’t qualify for a bank loan but nevertheless had the interest and abilities to start it, it seems to me that friends and family would be their only choice to raise the cash.

The obvious downsides for the investor would be that the business owner might not be able to profitably run the business or that they might lose interest before it got to the point where it was making money. The downside for the owner is that they would obviously pay out the investor far more in shared profits than they would have paid on a loan (since the investor should be compensated for the extra risk).

What would you do if you wanted to start a business, needed money, and were turned down by banks, friends and family? Is there anyone or anywhere that you think you could present a business case to them, show them the figures and get funding in exchange for shared ownership? Do most communities just have rich, old guys that fund stuff like this? Is it hard to get money out of local, rich, old guys? If you met some young go-getter who wanted to start a busines, would you want to the a rich, old (wo)man and fund them?

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{ 20 comments… read them below or add one }

1 MillionDollarJourney

I think that in most cities, there are groups called “Angel Investors” which are basically what you are describing.

2 WhereDoesAllMyMoneyGo.com

FT is right, you can either find an Angel Investor or look up the local Angel Investor Syndicate – which is a group of Angels.

Sometimes they have meetings (monthly) that you can show up to and present your pitch. If you wanted to be an AI.

One thing: Angels typically want significant ownership and may request significant control. It is very much a two way street – not a silent partner at all!

I’ll try to dig up some links and post them later today…

3 WhereDoesAllMyMoneyGo.com

Sorry – amend that: “If you wanted to be an AI, you could contact the syndicate and express your interest to BE an AI, as opposed to seek capital.”

4 FourPillars

Not exactly on topic but is Kiva a donation? I thought it was an interest-free loan? If that’s the case then I guess you are donating the interest.

Mike

5 MillionDollarJourney

Preet, I would also be interested in hearing more about the angel investor syndicate. Do they have a list of angel investors across the country?

6 MM

How about starting a Canadian PF AI syndicate :)

I’d have some $ to put towards something like that

7 MillionDollarJourney

That would be an interesting project.

Another thought is when community lend comes online, we should create a Canadian pf blog group.

8 January

Happy New Year, Cheap. Back here in Nigeria, what we have are venture capital firms who also own part of the business. It’s not a silent partner arrangement and to your questions, if I had a business idea, need startup capital and banks, friends, family have turned me down, i’d probably pitch my tent with the micro-finance banks (for small -medium scale enterprises). I’d get more funds through them.

9 telly

Good post. I’d be very interested in reading more about AI.

10 WhereDoesAllMyMoneyGo.com
11 abcstocks

Hi,

I have similar expereince with starting Subway frenchise. We owned 3 stores, just sold 1 few months back now 2 left. We are 4 partners in it and finance arranged from bank as well our own money. Owning Subway in Toronto can get costly now a days roughly around 300k to 500k for good average store. when we started our 1st store, we partners didnt knew each other very well but we kept trust in each other and prepared business plans and operation structure. It is working out well so far. We are always looking to grow more opportunity now.

12 Mr. Cheap

MDJ & Preet: Hmm, I always assumed angel investors we’re very early stage VC (and were mostly for innovative, potentially huge new businesses). I didn’t think they’d fund things like starting a B&B.

Good to know, thanks for the info!

ABC: If you don’t mind me asking, how did you share ownership and profits for the people who were working in the business more and the people who weren’t?

January: happy new year! I hope you enjoyed your trip.

Mike: Yes, its an interest free loan. Which isn’t guaranteed (all of the downside of an investment and none of the upside). People put money into Kiva to help out people, not to make money (currently there’s no way to make money with it I don’t think). Smells like a donation to me :-).

MM: We should do it! :-)

EDIT: Wikipedia seems to have a view of angel investors similar to mine:

professional angel investors seek investments that have the potential to return at least 10 or more times their original investment within 5 years, through a defined exit strategy

This is different than what I’m talking about…

13 WhereDoesAllMyMoneyGo.com

Yes, you are correct – sorry if I led you to believe otherwise. The other major function of an Angel is their significant political and networking “currency”.

Something like a B&B or a franchise would be bank financing kind of stuff.

14 plonkee

The guy I sit next to at work is providing some of the financial support for a hairdressing salon. The capital is coming from the sale of one of his investment properties I think.

15 Mr. Cheap

Plonkee: That’s cool! What’s his relationship to the person who will be running the salon?

16 Mr. Cheap

WRT Angel Investing Network, they charge to put you in touch with investors. I’d be nervous dealing with any organization that charges me to seek funding. Paul Graham is with me on this one: “Some angel groups charge you money to pitch your idea to them. Needless to say, you should never do this.”

17 MM

Great link to the Paul Graham article!
Most of the website are geared towards investing in “new” companies. But for things like B&Bs or franchises you might have discovered a potential niche.
It’s definitely appealing to a different crowd since there’s not much chance of returning 5 times your money in 5 years with a B&B investment.

18 Gates VP

Hey man, just a heads up if you do get into this “angel investor” / VC-type funding. It’s nuts!

As in, like “omg you wouldn’t believe what happened to me!” daily blog post, drive-you-up-the-wall incompetence, “I-can’t-believe-they-made-that-law” type of nuts.

Most of these people aren’t actually “high-risk” investors, they’re “aggressive” investors that want significant shares or control of the company. Some VC firms actually maintain a body of high-end professionals just for managing their “assets”, they’ll sign on small guys and bring in their own team of accountants, lawyers, business managers, technical experts, etc. And then they’ll review 1000 business ideas and reject all but one, just b/c they can.

Of course, there’s a reason for all of this. 20 minutes of Dragon’s Den made it pretty obvious to me. Lots of people simply have limited business sense. One lady makes great x-mas tree stands but completely overvalues them. It’s a seasonal, limited-market item. The steps with something like this are simple: patent & license to a bigger fish. One of the Dragons even mentions Noma. But she’s just dead-set against the whole thing.

And fundamentally, that typefies the problem with this “Angel Investing”.

The people with the most profitable ideas and the best business generally don’t need you: they’ll fund it with a loan or with money from a day job or money from a previous venture. The people with the least profitable ideas are more than happy to take the money and then run the business into the ground anyways.

So you (somehow) have to find the people with great ideas and a great product and great business sense and a really desperate need for money that can’t be sated elsewhere.

19 thickenmywallet

In order of expected return and control ceded, this is generally the hierarchy of lenders (from least to most):

1. Love Money
2. Traditional bank
3. Angels
4. Mezz financing
5. VC

I spoke to the head of the Toronto Angel Club when I use to practice law. They have a very tech bent and their exit strategy is typically to have a VC take them out. VC’s want you to go public so they are looking for “scalable” businesses to take to market (to use their lingo).

Then there’s free money- government grants and NGO programs. If you live in Ontario, you are dead out of luck but for targeted groups and geographical locations, Industry Canada lists grants.

If you are under 35 in Canada , you could try http://www.cybf.ca. However, their maximum loan is $15K which, given burn rates of operating a business in a big city, gets you 2-3 months operating capital or one piece of modest capital equipment.

Careful about investing in franchises unless the franchisee has ambitions to own 3-5 of them, most franchises pay the owner-manager about $100K-$120K in salary and that’s about it. Operating costs are high for bricks and mortar franchises and the franchise takes 5-7% gross right off the top in addition to other fees. It is often commented upon that franchisees do nothing more than buy the owner a job (read the E-Myth in what it truly takes to build a great small business).

Finally, you have to have someone with significant skin in the game- where is their money? This is why in commercial real estate the lender needs to see 30%-40% down payment. Its the same principle with investing in a business- the owner-manager has to be discouraged not to walk away with little loss at the first sign of trouble.

Most successful businesses I use to represent grew organically unless you are in tech then you have to swing for the fences given no pricing power and your competitive advantage disappears quickly. Lenders only pop out of the wood work AFTER you have made it.

20 fathersez

Timely post.

We are just starting our rounds of meeting banks for funding a project we got in Indonesia. AI never crossed our minds.

Let’s see how it goes

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