There’s an increasing trend in the real estate industry for owners of real estate businesses and the people that work in them to invest in the latest real estate app or “game changing” piece of software aimed at the real estate industry.
It seems to make a lot of sense. As an industry insider, you invest $50k or $100k into a new piece of technology for the real estate industry. You not only provide capital to fuel growth but you also provide industry expertise and connections.
In fact, this very model is the basis behind the Real Estate Industry Venture Capital Fund run by PieLAB Venture Partners.
But the reason it doesn’t make sense for real estate agents to invest “directly” in early stage technology businesses, is that success requires a specific skill set and knowledge base. The lack of information and performance history in early stage businesses means that the legal structure, and incentive alignment between investors and founders is more important to success than specific industry expertise or money.
Here are 4 mistakes commonly made by inexperienced early-stage investors:
They focus almost entirely on trying to work out if the valuation presented by the founder is fair
It makes sense that working out how much a business is worth is the first step to making an investment right? … Wrong! Valuing an early stage technology business accurately is actually impossible. With a conventional business, you have several valuation methods, like multiples of earnings or discounted cash flow analysis, and you have historical information and comparisons to help guide your valuation decision. Most early stage tech businesses have no history, no profit, often no revenue and rarely any comparisons. Strangely the valuation is less important than the legal structure of the investment, the alignment of incentives between the founders and the investors and the size of the potential opportunity.
Inexperienced investors try to get the biggest shareholding they can
Once again it sounds counter intuitive, but often taking too big a shareholding in an early stage start-up up increases its chances of failure. Taking too much of the equity up front results in making the investment unattractive for future investors. Early stage tech start-ups need cash and without it they die. I recently saw an early stage tech business that had given away almost 50% of its equity to a group of strategic investors who were able to provide a large customer base for the business. However, like most early stage tech businesses it will need multiple rounds of financing to be successful. Each subsequent round of financing will dilute the founders to the point that they have no incentive to spend every waking moment working hard to grow the business. In short there is little upside for them, so why would they bother. By negotiating such a great deal for themselves up front the strategic investors have doomed the business to failure as it is now unattractive to subsequent investors to provide more capital to help it grow.
Inexperienced investors don’t do due diligence
Early stage technology businesses have a horrific failure rate. If you’re investing $50k in a new real estate tech business, chances are you won’t do much due diligence on the business. But you can significantly increase your investing success if you conduct a thorough analysis of the business opportunity. Here are just a few items you should be looking into:
- Does the technology work, and more importantly is it scalable?
- What platform is it written on, is the development code popular amongst developers to ensure a reliable source of employees to help develop it down the track?
- Who owns the Intellectual Property? If the software was developed by a contractor have you reviewed the contract? If it was developed by employees have they signed a release of any ownership?
- How big is the market, are there any competitors, and have you spoken to them all to ensure this business is likely to be the market leader?
- Have you done background checks of the founders, do they have a history of entrepreneurial success?
- And then of course there’s the legal, financial and tax due diligence on the business itself.
The main reason real estate agents don’t do due diligence is that they don’t have the time, they don’t know what to look for and the cost of getting others to do it is prohibitive. After all there’s no point spending $50k on due diligence in order to make a $50k investment. The problem is, not doing thorough due diligence significantly increases the chance of making a losing investment.
Inexperienced investors buy common shares in the business
Typically, experienced early stage investors will not buy common shares in a start-up. It’s one of the most common mistakes. The following example illustrates why:
Joe Geek has a great idea for a new start-up. He develops some basic software to demonstrate it works and approaches Mary Money to invest in the business. Joe and Mary agree that $1.5 million will fund the project to breakeven and they agree to split the ownership 50.05% to Joe / 49.95% to Mary. Mary is an inexperienced investor and gives the money to Joe in return for common shares. The business now has an implied value of $3 million (since Mary paid $1.5 million for roughly half). The business has $1.5 million in the bank, one employee (Joe) and a basic piece of software.
The next day Joe runs into his mate Bob who is the CEO of realestateportal.com who likes Joe’s piece of software and offers to buy it for $2 million. Seeking a quick return on the time it took to write the basic piece of software, Joe agrees and sells the business to realestateportal.com for $2 million.
Since Joe and Mary own half of the common shares in the business each, Joe gets half the money ($1 million) in return for his time and effort and is very happy. Mary gets the other half, also $1 million and is not very happy because overnight her $1.5million investment has been turned into $1 million.
Mary could easily have avoided this situation by structuring her investment differently, using preference shares, a convertible note or placing vesting restrictions on Joe. All three of these investment structuring provisions are easy and cheap to implement and would have saved Mary’s investment.
There’s no doubt that technology is going to change the way the real estate industry operates over the next 5-7 years, and as a real estate professional it makes sense to be investing in these opportunities.
Unfortunately, these are just a few of the common mistakes made by inexperienced investors and I’ve spoken to dozens of real estate professionals that have invested and have lost (or will subsequently lose) much of their investment, because they didn’t understand the dynamics of early stage investing.
The good news is that the Real Estate Industry Venture Capital Fund which is managed by PieLAB Venture Partners has been set up to tackle this exact problem. By investing together as an industry, we get all the benefits of the upside, but can pool our resources to significantly reduce downside risk.