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Investing in tech startups: How to separate the wheat from the chaff

Special to The Globe and Mail

Investing in technology startups is a high-stakes game.

Your capital can grow into a fortune, or it may evaporate like a puddle on a hot day.

Still, the potential for those with cash to risk is difficult to overlook. Investment options are plentiful in Canada, says Jason Gray, managing general partner with Pioneer Fund, which invests in early-stage tech companies.

A recent report by PricewaterhouseCoopers shows that venture capital funding in Canada exceeded US$600-million for the first two quarters of 2018 for internet firms alone, almost exceeding investment for all of 2017.

Tech startups are attracting more cash for good reason, Mr.Gray says. "It's an asset class where you can see significantly higher returns than you see in public markets."

Here's what potential investors should look for as they survey the industry.

LEARN ABOUT THE FOUNDERS Lots of entrepreneurs have great ideas for new products and services. But will they be successful?

Ideally, the founders have previous experience with a successful startup, says Sophie Forest, a managing partner at Brightspark, one of the longest running venture capital players in Canada.

Or they have a long résumé working as a skilled employee in the industry. PhD-level expertise can also be an indicator of future success. "The one 'must,' however, is having an underlying drive making them like a bulldozer," she says.

Investors in the high-tech field need to be able to determine the difference between an expert with meaningful market intelligence and a dodgy tech-preneur throwing around buzzwords, says Mark Skapinker, also a managing partner at Brightspark.

"They had better know what they're talking about," says Mr.Skapinker, a sector veteran.

But it's about more than finding company founders with knowledge of their product and its target market. "Startups are a huge roller coaster, so you need people willing to stay in when it gets tough," he says.

Also, check whether the founders have skin in the game, says Peter Kinkaide, managing director with Raintree Financial Solutions in Edmonton, a private capital market dealer.

"Have they put their own money into this business, and how do they anticipate being compensated going forward?" says the former investment banker, who has worked with early-stage tech firms. "Not having much money invested says when the going gets tough, they're not going to be as motivated to resolve problems," he says.

CHECK OUT THE TEAM Another crucial characteristic of a potential startup is whether its founders surround themselves with the right people.

"They need a team who has done it before," says Mr. Skapinker. Often founders have tremendous technical prowess but lack expertise in sales and marketing, for instance.

Yet investors should not be too concerned about an early stage firm building a board of directors, Mr. Gray argues. "Not until they get into millions of dollars does setting up a formal board add a lot of value."

Still, he notes, founders without much entrepreneurial experience must seek help. It's often a good sign if some of those people are angel investors - high-networth, experienced, startup investors - bringing their expertise on board. This often guarantees a higher level of assistance, he adds. "You want to see someone doing more than earning compensation for fielding a couple of phone calls every month."

Of course, it doesn't hurt for potential investors to enlist help, too. Mr. Skapinker says venture capital organizations such as Brightspark can provide access to later-stage startups for accredited (higher-net-worth) investors. But another option, he adds, are angel investing networks such as AngelList, which connect investors to fledgling companies.

LOOK AT THE NUMBERS Business fundamentals are just as important with tech startups as they are for established firms. The big difference is that profitability metrics for startups are more forward-looking than focused on a track record, Mr. Gray says. "It's much more art than science, because you often don't have previous numbers," he says. The company might not have any revenue, either.

"It's more likely you're looking at assumptions, so you're putting trust in the founders that they have a good handle on how their product will grow," he says.

Having sales and customers certainly adds to the case for investing, Mr. Skapinker says. "This can help you gauge whether the market is ready for the product," he says.

Otherwise, the risks are plentiful. For example, the company may have a "good idea and product, but if the market isn't ready yet, they may run out of money" before their target customers actually need what they're selling.

Investors can't just take a founder's word for it, either. They need to examine the business plan to determine whether the assumptions are realistic, says Montrealbased angel investor Brian Karol, one of the more than 5,000 investors with Brightspark.

But it's not just whether the market is ready - its size matters, too. "Depending on how specialized the product or service is, I usually will ascertain that there is a large enough marketplace," Mr.Karol says.

Some products require a long growth runway into substantial markets, he says. That trait increases the likelihood your investment will prove fruitful.

WATCH FOR RED FLAGS Startup founders are naturally optimistic, so investors should be aware of the potential for oversell, Ms. Forest says. Founders often "believe it's going to come together much faster and require less money. Or sometimes they haven't done their research properly."

This often requires experience of having vetted startups in the past and working with founders, both good and bad. "When the person starts off by talking about how Google is going to buy them, that's usually a bad sign," Mr. Skapinker says.

Optimism these days, he adds, should be much more muted given the current stage of the economic cycle, he says. "We're in the back end of the longest bull market in history."

A recession is likely coming, and a startup will have to endure it to survive. Consequently, he says, economically sensitive products are likely not the best choice at the moment. Rather, look for companies developing a product or service that will sell, even in a downturn.

"We have an investment in a company that finds the cheapest travel, so even in a recession, we believe it will be a well-received product," he adds.

Even in good times, however, startups with the most promising concepts can fail, or just break even. That's why Mr. Gray says you need to pore over dozens of startups before investing. Furthermore, do not invest in just one. Diversify by investing in at least five companies. "If you have $100,000 to invest, don't put it all in one company," he says.

"One or two will be your winners and hold up the portfolio, while a bunch may go to nothing."

Associated Graphic

One trait that entrepreneurs must have is 'an underlying drive making them like a bulldozer,' says Sophie Forest, here with Mark Skapinker. Both are managing partners at Brightspark.

MICHELLE SUI/THE GLOBE AND MAIL

© The Globe and Mail

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