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Practices and Patterns of Informal Investors

Nature of Informal Investments: Canadian Informal Investor Behaviour

How Investors Learn About Potential Investments

The primary means by which investors learn about potential investment opportunities is through referrals from business associates. A majority of participants in discussion groups in all parts of the country mentioned that professional contacts – including accountants, bankers, lawyers and other investors – are key sources for introductions to potential investments. Investors in each discussion group also count the local CCIP site as an important source of potential investment opportunities.

Many investors also note that investment opportunities find the investor – the individual becomes known as a potential investor. Potential investors are approached often with a wide range of investment opportunities; however, few opportunities are well-prepared for investment.

"Nous pouvons avoir plusieurs choix de projets mais peu de projets qui sont bien préparés et prêt à l'investissement informel. Nous faisons face à beaucoup de projets boiteux et n'ayant pas de profondeur."

A number of direct quotes taken verbatim from investors participating in discussion groups further illustrate these conclusions:

"Peu de succès avec les groupes professionnels. J'ai fait le tour des notaires, agents immobiliers, avocats".

"Its networking and who you know. When you've been around for a long time, your phone rings, you get business plans through people in the business community, bankers are frequently a good source..."

"Par le bouche à oreille et aussi par le CLD (Centre local de développement). Le CLD a été la source de plusieurs contacts."

"Government is frequently a source, we have a bit of an unfortunate practice in the Maritimes. We tend to drag entrepreneurs across provincial borders, by giving them grants. Then the government thinks about how to turn these ideas into real businesses,... so if you've got contacts with these governments, you'll get contacts with these businesses."

"Once you start looking, then word gets out and more things will start coming along... whether it's the right thing or not, that's a different story, but...even my accountant said look at this and look at that..."

"I get a lot of people phoning me, I guess they know that you've got some disposable cash – so I get direct phone calls from people I don't even know, or someone has referred them to me. Or somebody I know phones me up and says 'I think this is a good investment, do you want to take a look at it?' Some calls are from people I've invested with before, some are cold calls."

"The ones I run into are generally referrals from business associates ... or a guy I've invested with before is interested in investing and wants to know if I'll take a look at a proposal. For most of us it's a matter of having more guys [investors] looking at the proposal 150 trying to reduce our risk."

"I'm new here and don't find I'm plugged into the business community — I didn't find there was a whole lot of business opportunities — maybe because I'm out of the loop, this is where the CCIP site helped me out."

"C'est très difficile pour un immigrant d'investir puisque nous n'avons pas de réseaux. Je n'ai pas eu de suivi à mes démarches et souvent les projets présentés ne sont pas bien structurés. Il y a de la résistance de la part des promoteurs de partager l'information privilégiée."

Evaluation of Potential Investments: The Due Diligence Process

Private investors across Canada consistently mention that they are looking for investment opportunities (a) with the right people, (b) with market potential, and (c) where they can add significant value. These three factors were mentioned as key in every discussion group held during the course of this project. While there is strong agreement on these points, there are a wide variety of approaches that Canadian investors use in evaluating potential investments.

At one extreme, a number of investors indicate that their due diligence process is fairly informal. These investors report that they:

1. go over the financial statements and projections that are available re: the potential opportunity;
2. meet with the principals and get to know them over a period of time;
3. conduct informal reference checks on the track records of the principals.

Then they make a decision based on the results of these evaluations. Many investors using these informal approaches indicate that they use a 'gut feel' and have to feel that they can trust the people involved in potential deals and would like to work with them. Examples of comments illustrating this informal approach include:

"I want somebody who is honest — I don't really know how to determine that, but I check backgrounds and just get a feeling."

"Ma démarche est rigoureuse mais aussi instinctive. L'élément émotif prédomine sur l'élément rationnel. Il faut être excité par le produit et aussi par les promoteurs."

"You look at the people who have put the plan together, you look at the success of the people, the industry, divide the forecasts by 10, that is a start"

"I have certain red flags: ... I have identified similar patterns repeating in people's lives. Therefore I look for a pattern because I expect to see it emerge again in the venture contemplated. For example, failed relationships with close business associates most always repeat."

"Il faut tenir compte autant de la connaissance qu'a l'entreprise de son produit, dans sa capacité de gérer et aussi de mettre en marché le produit. Les trois éléments sont essentiels."

At the other extreme, a smaller number of investors (these tended to be larger scale investors) indicate that their due diligence process is very sophisticated. These investors report that they use checklists, hire assistants to examine all documentation and search out other evidence re: the principals seeking investments.

"The available information varies but in every case I hired a data research company to turn individuals who play with my money inside out and I've learned some startling things along the way."

"It is frequently boring and not necessarily productive but necessary to get my head far enough into whatever I'm doing so that I have developed a very keen understanding – the best understanding I can have – of the opportunity, the market, the people, [and] all aspects ... I work from a due diligence questionnaire that I have developed over the years...it's probably 50 pages."

"Il faut faire une analyse en profondeur pour voir si le produit ou le service est viable et peut attirer des investisseurs."

"[I use] ... the stock exchange sophisticated computer system to do due diligence on the people just to make sure they haven't been involved in fraud."

Il faut s'impliquer directement avec l'entrepreneur pour analyser les potentiels d'investissement, faire la pré-analyse, faire le montage financier. Il est aussi important avant de rencontrer le promoteur et de pouvoir faire enquête sur la crédibilité et la solvabilité de ce dernier.

"...it depends on the scope and [whether or not ] you have the resources. When you're looking at a large operation, what we used to do, we'd go hire the best legal people and then we'd hire the best accountants and we'd turn them loose and put them together. ... I had five professionals whose total job was to savage any business plan which came across their desk. ... [but] if you are looking at smaller companies they don't have the resources to do that, I think that's different."

Exits and Exit Strategies

Expectations of Returns and Exits

Investors usually expect to sell out their share in investee businesses, either to the original principals of the firm or to third parties (for example, to an acquiring firm, to follow-on investors in subsequent rounds of financing, or as part of an IPO). Most investors anticipate rates of return on their informal investments of the order of 20 to 40 percent.

"Nous attendons des retours sur notre investissement d'environ 30 %."

Investors generally acknowledge the reality that most firms will not succeed. They understand that it will take from three to seven years before the firms in which they invest will reach the stage where exit can be expected, and that entrepreneurs do not often anticipate investors' need to exit.

"La plupart n'ont pas de stratégie fixe de retrait de l'entreprise."

"Exits aren't quick and anybody who looks at these things like it is a two or three year cycle I think that every now and then that happens, but I don't think it happens, not if you are doing this in an ongoing basis. You end up living with the companies for a long period of time."

"Tout projet a un cycle de vie. Il faut profiter du plateau de profit pour se retirer. Mais il faut toutefois voir comment l'entreprise peut croître à long-terme et dans certains cas il est avantageux de continuer sur une plus longue période."

"That's the fun of being an angel investor – staying in and watching that company grow."

For most investors, exit provisions are negotiated with business owners at the outset and are usually specified in the shareholders' agreement. Several forms of exit provision were described. Charts 5 and 6 present, respectively, the distributions of private investor's rate of return expectations and exit time expectations.

Chart 5: Private Investors' Expected Rates of Return

D

Chart 6: Private Investors' Exit Expectations

D

One example of an exit provision was described as a "retraction clause". According to this approach, the investor maintains the legal right to force the business owner to repurchase the investor's shares at an agreed and pre-specified price at particular points in time.

"We've used a model in a number of cases which have in effect treated the money put in by the investors as ... an equity position which has a retraction feature that after 2, 3, or 5 years is exercisable by the shareholder. The theory is that it places the management of the company under the discipline that if they re not doing well then people do have a mechanism by which they can vote with their wallet, and if enough people vote that way then in fact you've voted to dissolve that company."

"In one case it worked particularly well there were three, no there were two retraction dates and about 10% of the shareholders retracted, so there was a payout and it was for a dollar in two dollars out so you could look to double your money. It provided that safety valve."

This approach also has the advantage of adding a 'discipline' on the business owners. The owners recognize from the outset that they might be obliged to come up with the cash necessary to buy out the investor(s) upon the investor's demand. Thus, this discipline provides incentive to generate the requisite amount of cash. Alternatively, this clause provides incentive to the principals to build a business in which the investors would prefer to continue as principals.

Investors also understood that if they were to invoke such a retraction clause, they might well place the firm in jeopardy. At the extreme, if the business or its principals could not generate the requisite buyout cash, exercising a retraction clause might force the firm into liquidation. The inclusion of a retraction clause, therefore, is no guarantee that the firm will ultimately be able to accommodate investors' exit intentions.

"It's a setting where you re a minority shareholder and you say to them [the principal owners] 'We have the right to ask for our money out based on the accountant evaluation and has to be a fair market value and without a discount for being a minority shareholder', and you grab it all at once and the business goes under and can't pay you anyway so its usually a slow tedious way to get out."

"I would take back the loan and then you exit with everybody."

"The laws of insolvency and bankruptcy prevent you from acting on retractions because it would put the company further in debt and of course you can't do that."

Exits tended to be triggered according to whether or not the firm had met predetermined milestones.

"The initial shareholder's agreement created around this company described a number of milestones and those milestones either being hit or missed by certain dates triggers the sale of the company or a decision to alter the plan ... I think exit strategies need to be determined. We are also working with people and people need clear and common expectations about what the exit strategies are."

Other exit provisions included use of debt, secured by assets, with equity kickers such as warrants or conversion options.

Actual Exits

As noted in the previous quotation, exits were important to the roundtable investor participants:

"... they won't go in unless they know how they're going to get out."

Il faut se retirer quand nous sentons que notre investissement a aidé la compagnie à fructifier. Il ne faut pas devenir le gestionnaire de l'entreprise.

"I think the greatest fear is to be in an investment that is successful and you're not getting a return. ... if you don't put any controls in and you don t have a proper exit, and you don't have the right to control management. [For example], what if we made a million dollars this year and he took five hundred thousand bonus and you took five hundred thousand bonus. "We are really sorry, we can t declare any dividends. And if you can't get out, they can do that to you forever. So that's where you have to be very cautious on that, how you get out, how do you protect yourself. You can tie up management or you can be guaranteed a return, but you've got to do something."

"Si l'entreprise a des projets d'investissements et de développement de nouveaux produits, ou que le promoteur a identifié des nouveaux marchés,ces différents éléments pourraient justifier de maintenir notre investissement à plus long-terme."

Several potential means by which private investors could exit were identified from the literature and are summarized in the following table.

Private investors certainly mentioned IPOs as a frequent means of exit:

"... a lot of companies are turning out very solid returns, [have] very good management, [are] well run, and are trading at ridiculous multiples of earnings – but it is a way out. Going public is one way of getting out ... if you can find a good broker and there are a few companies out there that will help you go public at a reasonable rate."

However, concerns were expressed about one form of IPO, those made using the Junior Capital Pool (JCPs) vehicle historically available on the Alberta Stock Exchange (now available on the Canadian Venture Exchange and called Capital Pool Companies, CPCs).

"... if you look at the listings at the Canadian Venture Exchange there are 35 pages of failures ... what used to be called the Junior Capital Pool. ... they [the firms] raised $400,000, $500,000 and if you look at it about $150,000 to $200,000 is scooped ... by the brokers and the accountants and the lawyers and unfortunately, some of the consultants as well. ... They come out of it with significantly less money than what they need in order to survive. ...Their stock broker pumps the stock, gets it up, unloads it, and the stock goes down to $.06 a share, $.03 a share, so they have no way of raising additional capital without some incredible dilution. ... There have been too many companies that have gone that route, a lot of companies with a lot of potential. They should have raised the half-million privately, but there just aren't enough sources."

"I'd like to comment because you've mentioned Junior Capital Pools. Junior Capital Pools from my perspective are a waste of time. You can't swing a cat for $500,000."

"I feel ... the best exit strategy is to actually take funds. My big concern is that the Junior Capital Pool is ... getting far too many companies into it too early. ... I deal with young companies, start ups, ... looking for venture capital and they are already looking to expand into global markets ... [yet] in many cases, its still too early to go public."

Investors generally recognized that IPOs were rare. Accordingly, the most frequently mentioned exit mechanisms were through acquisition.

"We do see in this market is more acquisitions of companies from outside the jurisdictions than companies going public."

"You either go public or get acquired. If a potential acquisition comes along that looks good, that certainly has a lot of appeal depending on the valuation you get."

Investors also identified various types of buy-backs as exit mechanisms.

"Another exit strategy that is an extremely valuable one is an employee buyout strategy and employee share ownership program that allows for acquisition of the company by employees over time."

"With my engineering business I transferred my assets internally to long term employees."

However, such exit mechanisms can take a long time before the investors realize their gains:

"We always have a big window to get out... you have to because, as the business changes the relationship changes and certainly sometimes it had been a long slow tedious buyout. [For example ] where ... it's a family business you've invested in and you know you re not going to become part of the family and you want your money out, you know you can t pull it all out at once."

Another investor provided an example of a secondary sale to other investors:

"There were four partners and we had the opportunity to buy each other out based on the traditional shotgun ... to assess values and that sort of thing, so that is in place. We haven't gone the next step in terms of what we will do with the company as a whole but it will be based on a business valuation, conducted by a third party and under the terms of a shareholder agreement that compels the company to be sold against certain milestone events, made or unmade."

Certainly, the write-off was well known as an exit mechanism:

"Never ever had anybody ask me how do you exit? <everyone laughing> It's just done for you."

Networking and Syndication Patterns of Canadian Informal Investors

Investors report three modes of operation with respect to syndication. Approximately 37 percent of respondents are "lone wolves" in that they do not syndicate at all. At the other extreme are those who always invest as members of a pack (23 percent of respondents). The remaining 40 percent of investors reported that they syndicate some of the time, but not in all instances.

The role of networks is twofold for informal investors. First, networks play a significant role in helping to form and preserve syndicates so that investors can participate with other investors in 'doing a deal'.

Second, networks are critical in helping investors learn about investment opportunities. Even though many investors tend to be 'lone wolves' in terms of their deal patterns, virtually all investors view informal networks as critical in learning about investment opportunities. As noted elsewhere in this report virtually all investors discussed the importance of referrals from business associates and from others in learning about potential investment opportunities. In the words of the investors themselves:

"I think that perhaps this has come back to what we initially started on discussing which is how you find an angel investor or an investor. It is word of mouth, it is networks, it is developments... Maybe it is at a golf course, a service club. It maybe meeting someone through someone or hearing about someone who does something and you phone them up ...".

"Its networking and who you know. When you've been around for a long time, your phone rings, you get business plans through people in the business community, bankers are frequently a good source..."

A number of investors commented specifically about differences between formal versus informal syndicates or networks. As one investor noted, if the investor does not find the formal networks useful, he will simply not use them. In general, Canadian informal investors do not find that formal syndication works nearly as well as informal, fluid, project-based syndicates:

"When I was talking syndication I was talking about something considerably less formal. If I'm going to go and put a little bit of money in something, I work with a couple of people, I know. I trust with them, and I just call up a couple of my buddies and say, 'Oh listen, here's the deal. Tell me, am I... missing something here? Does this make sense? Okay, I'll put some of my money if you put some of your money in.' It just means that I can take my money and spread it a little bit further and get a second opinion."

"...in essence you are trying to syndicate a venture capital group and you are putting together a whole bunch of different investors with different points of view. It is not easy."

"If you have a formal venture capital pool you'd scare people off. You have a meeting and get together ... that helps and so simply making the connections from one person to another so that they end up doing some deals later on. That's all it really takes is a simple introduction and a lot people would carry it on from there."

"I'm not sure what the definition of syndication is. If it means another overhead level that concerns me."

While networks are extremely valuable and play critical roles for Canadian angel investors, a number of disadvantages are also evident. The problems inherent in working with others on investment deals include the problem of differential expectations and valuation regarding each investor's involvement and work, the problem of angels micro-managing businesses they are invested in, as well as the problems of managing groups of very strong willed people:

"The idea was the group would put in money and we would look for deals. It just did not work because one, I find whenever I'm in with a large group ... that there is different amounts of effort put in and the result is that some of the guys within the group will work, some the guys will throw their money in and just complain. Depending on the project different personalities will come to the front so I don't think that having a group set up and then finding the projects works. I think you find the project attracts certain groups, and the project may maintain their interest both in terms of dollars and in terms of input. But I don't know of any sort of investments groups that really function well... maybe they are there but it hasn't been within our crowd."

"The other pitfall I have found in groups is that because you are attracting very successful individuals by definition, they all believe that they know their business. And because of that, not unlike doctors, they believe they have the divine right of knowing everything about every business. So now you have six or seven great entrepreneurs all deciding the menus of the restaurant you just opened up. It can be a nightmare – we've been through it, and we're witnessing another group in town going through it. Yeah, with great delight (laughter). Yeah been there done that."

"But as far as syndication is concerned I think the smaller the group the better. That s my personal experience."

"So it means either you continually expand beyond the initial group because there is a burn up factor in the person who is doing of an investment project. You get tired of trying to drum up investors and you can' t point to your last success because its way back there."

Most investors speak about their networks as being very informal, having a core group or a leader who "rounds up the usual suspects" to look at a deal. It is also clear that syndication deals reduce risk for the investor:

"It is sort of plasma like ...the same group sort of follows along, people come in and go out, it is reasonably ad hoc. The way it works with me is that if I get involved in a project to the point that I'm content to be a lead investor, it doesn't take very long before you drum up the usual suspects to come along. There is a nucleus."

"Every syndication needs a leader and I think that, that's how it starts. I am involved in a variety of these and typically there is a group who have followed my investing, and it all comes down to networks I think."

"We do business with people who we know, and have done business with. We will take a yield less than we can from a stranger to do business with a friend just because we know that everyone's going to keep their hands on the table and are not taking the risk."

"The ones I run into are generally referrals from business associates ... or a guy I've invested with before is interested in investing and wants to know if I'll take a look at a proposal. For most of us it's a matter of having more guys [investors] looking at the proposal – trying to reduce our risk."

"Je me suis bâtie un réseau informel de personnes qui investissent et qui acceptent de communiquer leurs informations. Ces personnes font souvent les analyses préliminaires de la valeur des projets et nous investissons soit seuls, soit en groupe."

"Syndication is something that I love to do. Many deals I won't even do unless they're syndicated, because that way I get other people who not only money, but have an opinion. And it's a way I can sort of get the most important deals."

But, it is important to realize that for many investors across Canada, a syndicate can be a lot of fun for the investors. A number of investor comments show that this aspect of investing is really important to them:

"But one particular fellow has close contacts in other cities ... they sort of invite each other in and it's like a club and they have some great fun. They go in heavy in all kinds of different deals and they go and have a fancy dinner and laugh about it... and if it doesn't succeed they get involved and ... they have a lot of fun."

"The investors in this group really have to have kind of the same culture. As Andy says, it's fun money for them. They were in it looking for a big deals and some excitement and ... all of those things. But they don't float around with a whole bunch of different partners they just have one or two partners and it's always the same guys in that group."

While the notion of having fun as an investor was a strong theme in the discussion groups, it must be noted that some investors believe that involvement of unprofessional investors can cause significant problems. The view of some investors is that unprofessional investors can cause more harm than good by establishing unrealistic valuations at an early stage and from the provision of bad advice. This causes problems for the more serious investors who typically come along afterwards and has to try to clean up the mess.

"The casual investor who not only does themselves a disservice but kind of clogs up the system as well in terms of moving things positively forward. As a result of some availability of that money and source I think that entrepreneurs often get off to a bad start so that it would be very nice if there was a mechanism to take the casual investor's interest in investing and make it professional."

One finding that was specific to Quebec was a "club d'investisseurs" described as an investment fund structured with three professional managers and 2,000 small silent investor participants. The fund managers sought a rate of return of 34-40% on its initial investments.

"Je fais partie d'un réseau d'investisseurs (2000 investisseurs et trois gestionnaires) et c'est ce réseau qui me donne les contacts pour des projets valables".

^{Footnote 2} D. J. Cumming and J. G. MacIntosh, "Venture Capital Exits in Canada and the United States", Working Paper, University of Toronto Law School, 2001.

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