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How to invest in early-stage tech businesses

With the rise of crowdfunding platforms and the Australian Government’s new tax incentives, it’s increasingly attractive for private investors to seek the higher risk-adjusted returns in early-stage technology businesses. High-growth, early-stage tech businesses will drive jobs growth and economic prosperity according to the Australian Venture Capital and Private Equity Association (AVCAL).

What defines a great investment opportunity?

Having started, run and exited tech businesses over the last 20-plus years, we have realised a strong founding team is critical. For investors new to backing tech businesses, it’s important to remember the founding teams of great businesses should have the right balance of business, domain, and technical experience, allowing them to create a sustainable competitive advantage with their new and differentiated product or service.

Given the size of Australia’s domestic market, hungry founders who have sights set on chasing global markets are also key. Investors should focus on founding teams with the capability to scale their businesses and demonstrate market momentum by high customer acquisition rates and a solid pipeline of deals in negotiation. Assessing the business’s current customers and total month on month customer growth is also helpful.

How do you start investing?

High-growth early-stage technology opportunities arise in a number of ways:

Angel investing

Angel investors, typically affluent individuals, provide capital to early-stage businesses in exchange for equity. Since the introduction of the Australian Government’s National Innovation and Science Agenda reforms in July 2016, such investors can benefit from a 10-year capital gains tax exemption and a 20% 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 $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 $50 million. They must have less than $1 million in business expenses and income under $200,000. Further criteria include demonstrating potential for high growth and scalability, and addressing a large market with a significant competitive advantage.

While angel investing requires a high level of involvement, the advantages include having greater control over capital and the ability to practically support founders. As an angel investor, the investment process involves sourcing, assessing, negotiating, conducting due diligence and ongoing management of deals. Additionally, angels often support a portfolio business with coaching and mentorship in their areas of expertise.

Joining an angel group is a great way to source deals as it provides an opportunity to not only connect with founders but also seek advice from an experienced network of angel investors. Some examples include Sydney Angels and Melbourne Angels. I’ve found it helpful to develop my network and learn from those who have previously invested in my areas of interest. Visiting industry specific publications will also keep you in the loop.

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Crowd-sourced funding platforms

This year, a new method of investing in early-stage tech businesses has gained Australian Government support: crowd-sourced equity funding (CSEF). CSEF platforms allow investors to invest capital into early-stage private enterprises in the same way they would invest in shares on the ASX, by buying shares in startups and SMEs. Parliament recently passed legislation allowing unlisted public companies to advertise their campaigns on licensed crowdfunding portals and raise up to $5 million a year. Retail investors - those earning less than $250,000 a year and owning less than $2.5 million in assets - are limited to investing $10,000 per company per year.

In September 2017, Treasurer Scott Morrison introduced new CSEF legislation into Parliament, which will permit CSEF platforms to advertise offers from private proprietary companies, allowing the public to invest in a much larger range of businesses. Private companies will soon be able to raise up to $3 million through CSEF platforms before requiring an annual audit of their financial statements. These investments must be made through ASIC-licensed crowdsourcing platforms that can be accessed by both retail and wholesale investors.

The investment process for CSEF investments is similar to angel investments. It involves assessing the prospects of available deals on CSEF platforms, determining if you wish to participate on the published terms, and making the investment.

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 or CSEF investor, consider investing through a venture capital (VC) fund. Reputable funds will follow a structured process similar to the one outlined above. When assessing potential funds, consider the background of the fund’s principals, the value proposition to both investee businesses and investors, and their history and track record.

As with angel and CSEF investing, screening the principals of a VC firm is a crucial step before committing to an investment. If the fund focuses on specific sectors, consider whether the principals have relevant technical knowledge to review potential deals and add value to their investments. Some VCs have a founder background, with extensive startup and operational experience. Other VCs have a financial management or investment banking background.

Either way, make sure the VC has personal experience in building or leading their own businesses along with the ability to provide critical feedback to investee businesses. 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.

 

Benjamin Chong is Partner at venture capital firm Right Click Capital, investors in high-growth technology businesses. Right Click Capital also publishes newsletters and data bases on investment and M&A activity across internet and tech businesses. This article does not consider the circumstances of any investor.

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