27.11.2009 21:56:53

Investors Network Team

I've been involved with a number o f businesses and finally I've found the the recipe for success when investing in start-ups

Veteran entrepreneur and now business angel shares his experience on getting his kicks from investing in new businesses.

For me, there's nothing like it--the excitement of seeing a business rise up from nothing. I can't even explain the feeling. There's just something unbelievably thrilling about seeing the growth, watching the numbers go up, getting the business to stand on its own. I've done it myself a number of times, and I can't get enough of it.

And now I'm having the same experience with David's business. I'm seeing it all unfold through his eyes. I see the same spirit, the same perseverance. I know exactly how he feels, coming home at night, not being able to sleep, thinking, "Oh my God, 145 meals! I broke a record!" You can't wait to go back and set another one. It's incredible. It's the greatest feeling in the world.

It's also one of the greatest payoffs you can get as an investor, or so I've realized. Yes, making money is important. I wouldn't go into a deal unless I thought I could get my capital back and earn a good return. But I really don't do this type of investing for the money anymore. I'm more interested in helping people get started in business. Whatever I make is a bonus on top of the fun I have being part of it and the satisfaction I get from helping people like David succeed.

I wish only that I'd figured out how to play this game sooner. It's taken me 25 years and a lot of bad deals to get it right. Not that there weren't opportunities to make money along the way, but somehow they got screwed up. Even when I did make some money, I seldom felt good about it, and I never had much fun. Something always came along to spoil the experience.

In the process, however, I developed a few rules of angel investing, which I've finally been able to bring together in one deal. They may not be right for everyone, but at least they've allowed me to find what I've been looking for all these years.

Rule 1 ?Invest in people who want your help, not your money

If I'm going to invest in a new venture, I want to play a role in its success. I come in as a partner, and I expect to be treated like one. Not that I want to run the business or make the key decisions, but I like my opinions to be heard. That means investing in someone who wants to listen. The problem is, people always come across as good listeners when they're asking you for money. So I prefer to give my financial support to those who don't expect it.

David Schneider, for example, came to me looking for advice, not money. He was the manager of a restaurant near my office. My wife had given him an article about my work with a couple I knew who were just getting started in business. He asked me if I'd mind looking over a business plan he'd written for a restaurant he wanted to launch. I said I'd be happy to.

The new place, it turned out, would be located in Greenwich Village. David intended to take over space that had been occupied by another restaurant, now defunct. It was clear from the plan that he knew a lot more about running restaurants than he knew about business. I told him it would never work. For one thing, he needed more money than he was asking for, and I didn't believe he had the ability to raise it. For another, he was paying too much for the space. Beyond that, he would be starting up in the heart of the most competitive restaurant market in the world, and he had no niche, no unique angle, nothing that would give him an edge.

I advised him to try something less ambitious for his first venture, preferably outside Manhattan.

What happened next was most important. He listened to me, took my advice, and--a couple of months later--came back with a new proposal. This time he had found a place near his home in the Cobble Hill section of Brooklyn, an up-and-coming neighborhood with tree-lined streets, old brownstones, and lots of high-income, two-earner families. There were other restaurants in the area but nothing great. The space he had in mind had previously housed a Middle Eastern restaurant that had been around for 24 years. He figured he could lease it at a reasonable price.

I looked over the proposal and went with David to view the location. He asked me what I thought. I said it looked perfect; he should go ahead and negotiate the lease.

"Don't I need to raise some money first?" he asked.

"No," I said. "I'll give you the money."

"What do you mean?" he asked.

"I mean that I'm your new partner."

He must have been shocked. We'd never discussed a role for me as an investor. He didn't object, however, and I felt very confident putting my money behind him. I knew that he'd listen to me and let me help him achieve his goals, and that's all I really wanted.

Rule 2 ?When possible, go it alone

I don't do large-scale, limited-partnership investing anymore, but I used to. During the 1970s and 1980s, I invested in everything from flat-screen-TV technology to glow-in-the-dark toys, usually with groups of 5 to 50 people. I can't recall a single deal in which I made money. In most cases I wound up losing my shirt, or at least a portion of it, and I often had to sue to try to get something back. It was extremely frustrating. I'd see people making decisions that I knew would be disastrous, and yet I had no power to stop them.

There was one deal, for example, in which I helped finance a business that was marketing a new type of toilet seat, called "the American bidet." Believe it or not, it was actually a good product. The problem was that we had seven partners, each of whom wanted to market it his own way. It was like having a ship with seven captains. We kept going around in circles. In the end we wound up selling the rights and the inventory. Of the R35,000 I'd invested, I got back at most about one-third.

By the early 1990s I'd had it with passive investing in groups. The only way I'd ever made any real money was with my own two hands. If I was going to back any more new ventures, I decided, I had to be a player, not a bystander. Somehow I had to make sure I preserved my capital and retained some influence over what was done with it.

The result is that I've wound up going it alone. In all the deals I've done since then, I've been the sole outside investor, and it's turned out better for everyone concerned. Granted, I have to stay away from deals that require more capital than I can come up with on my own, but that's a trade-off I'm willing to make. I'm a headstrong person. I have my own ideas about how to build a business, and they sometimes differ from other people's ideas. I don't mind trying to work out those differences with the person who's running the business, but I have no interest in getting into debates with other investors. Better that we go our separate ways.

Rule 3 ?Take a majority stake until your investment has been repaid

Most people build their investment strategies around achieving a certain rate of return on their capital. I take a different approach. My number one goal is preservation of capital. Not that I don't want to make money, but I focus first on getting my investment back. Toward that end, I insist on owning a majority stake in any new venture I finance. The deal is that as soon as I've been paid an amount equal to my initial investment, we'll issue new stock, and my stake will shrink to 25%.

Usually, I take 51% of the stock in the beginning. In David's case, however, I took all of it because the restaurant didn't open for business until mid-October, and so we knew there were going to be significant losses in the first year. I wanted to use those losses to reduce my taxes, and I couldn't get the full benefit unless I owned 100% of the stock. Nevertheless, the principle is the same. Once my initial investment is repaid, my share will go to 25%.

I do this for the obvious reason: I want full control of the company while my principal is at risk. I'm careful, however, about the way I exercise that control. I give advice, but I don't interfere. I don't make decisions.

Not that I keep quiet. Early on, David told me he intended to hire a public-relations firm at R1,500 a month. I wasn't thrilled. I generally advise start-ups not to waste their money on PR. We talked about it. He said that in his experience you needed a PR firm to get reviews, and reviews were critical to a restaurant's success. One good review could generate enough business to cover a year's worth of PR expenses.

Who was I to second-guess him? I know business, not restaurants. As long as he had a reasonable rationale, I wasn't going to stand in his way.

David hired the PR firm, and it turned out to be a great decision. Within weeks of the opening, the restaurant's name began popping up all over the place. There were good reviews in the Daily News, the Times, and various city magazines, all of which helped the restaurant get off to a fast start, far exceeding our initial projections.

Of course, I wouldn't hesitate to use my authority as majority owner if I thought the entrepreneur was acting irresponsibly, but I almost never have to. People understand and accept the arrangement, and I always get my investment back, usually in a short period of time. I haven't lost a dime on a venture deal since I began to apply this rule.

Rule 4 ?Retain the right to force a payout

Nobody invests in a new venture just to avoid losing money. If the business is successful, I expect to make a good deal of money--more than I would make by putting my capital into a bank or bonds or publicly traded stocks. My goal, after getting my principal back, is to earn 33% of my initial investment every year for as long as the business is in operation. Of course, I don't want to bankrupt the company or leave it undercapitalized. Nor do I want to deprive the person running the business of the opportunity to make money as well. So I'm prudent about what I take out.

But I want my partners to understand up front what I hope to earn by putting my capital at risk, and how I expect to get it. Unfortunately, I had to learn the hard way how to keep from being burned.

The lesson came in a deal I did in 1991 with a guy who wanted to buy a chain of franchised transmission shops out of bankruptcy. I put up the capital, about R100,000, with my usual understanding: I'd own 51% of the stock until he paid me back, whereupon my stake would drop to 25%. After that we'd split every dollar we took out of the business until I earned my 33% return for the year.

Everything went smoothly at first. We bought the company, contacted the franchisees, and started collecting the money. Within a few months we had 22 stores generating net pretax profits at a rate of R80,000 a year. It was a wonderfully simple business with one employee, no real estate, and virtually no debt.

Then the guy I financed came to me with a plan to leverage the business, expand rapidly, and do various things I considered reckless. I said no. He said, "You can't stop me. If I pay you back, I'll become the majority shareholder."

He was right, of course. There was nothing I could do. He borrowed the money to pay me back, reduced my stake to 25%, and started expanding. The company grew and--despite my misgivings--continued to be successful. I said, "OK, when are we going to start splitting the profits?"

He said, "What profits? We're reinvesting everything. There won't be any profits for a long, long time."

I received about R2,000 on my R100,000 investment over the next six years. I should have been earning more than R30,000 a year, but I had no way to force him to pay me. I couldn't make him declare dividends, and I had no control over what he paid himself in the form of a salary. I felt helpless. It was a very bad experience.

But I did learn a lesson. Now I make sure that the entrepreneur and I agree in advance on how each of us is going to get paid.

For openers, we settle on the entrepreneur's salary. Any other money that comes out of the business goes first toward paying back my initial investment. After I've been repaid, I continue to get a dollar for every dollar the entrepreneur takes out (beyond salary) until I've received my 33% annual return. What's more, I make sure I have a right to force the entrepreneur to take money out, up to an agreed-upon amount--say, R600 a week. That way I'm more or less protected if we have a falling-out.

Understand, I'd greatly prefer not to exercise that right. My hope is that just by having it, I'll reduce the chance that I'll ever have to use it.

There's one more rule I'm still working on. It concerns the perils of success. What do you do when the business takes off and the interests of the entrepreneur diverge from those of the investor?

That happened on my last deal, in which I backed a friend of mine who was privatizing a municipal golf course. It went so well that he decided he wanted to privatize golf courses all over the country. I could understand his enthusiasm, but his plan was too aggressive for me. Besides, under our agreement he was supposed to be focusing his time and attention on the first golf course. I complained enough that we eventually sat down and negotiated a buyout of my contract, which satisfied both of us. We're still good friends. We talk every week.

I'm not sure that I can draw a rule from that episode, but there certainly is a lesson here. It has to do with the importance of figuring out in advance how to tie up the loose ends of a deal--how to part company in a way that will leave all the parties feeling as though they've been treated fairly.

I never worried much about that when I was investing for the money. I just wanted to make as much as I could on every deal--and I wound up making nothing. Now I have different goals. I do these deals because they offer me the opportunity to teach other people some of the things I've learned over the years and to share with them the excitement of bringing a new business into existence.

But even though making money is not my primary objective, I can't ignore the financial aspects of the deal. Like everyone else, I have limited capital. I want to control what happens to it. I want to use it in ways that bring me satisfaction and happiness, and then I want to be compensated fairly for the results. When I don't earn a fair return, I feel as though I've been cheated, which ruins the whole experience for me. It spoils the reward I value most as an investor, namely, the good memories of all the fun and excitement we had along the way.

Sooner or later, David and I will have our own loose ends to tie up. I'm optimistic that if and when we do part ways, we'll be able to part as friends, taking with us some terrific memories. By then David should have some capital of his own that he may want to invest in future ventures. I hope he'll also have the confidence, the knowledge, and the experience to start businesses again and again.

And perhaps someday he, too, will flap his wings and become an angel, lending a hand to another generation of entrepreneurs. For all of us, that would be the greatest payoff of all.

Interviewed by Bo Burlingham from Inc magazine

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