Dumb money burns, smart money learns

By Justin Hall November 20, 2015

Traditional investors are finally jumping on the startup bandwagon
Unfortunately they come with their own assumptions and practices

Dumb money burns, smart money learns AS we close out 2015, it’s remarkable the progress South-East Asia’s tech ecosystem has made in the last year.

Startup formation, especially in places like Malaysia and Vietnam, is rapidly accelerating. Thanks to the influx of new Series A funds, rounds are becoming larger and more frequent; and financial returns, albeit much of it unrealised, are nevertheless making venture capital as an asset class in the region much more attractive.

A positive iterative feedback loop is genuinely coming into focus across South-East Asia: More funds are entering local ecosystems, driving more startup formation, which in turn generates greater returns, subsequently bringing in more money.

Just look at the new funds being raised by Venturra Capital, NSI Ventures, Sequoia Capital, and Golden Gate Ventures.

This trend of new fund formation is not exceptional. On the contrary, it has been the norm for the past year.

So it should come as no shock that traditional investors are finally jumping on the startup bandwagon. These high net-worth angels are wealthy individuals who, instead of investing in conventional industries like real estate or commodities, are opting to invest in technology startups.

And given the density of millionaires and multimillionaires in Singapore, this shouldn’t be a surprise.

These are obviously bright, ambitious individuals. They’ve made their fortune in traditional industries. Surely they can easily replicate the same success in technology investments, too, right?

No. Not even close.

Dumb money burns, smart money learns Although it might seem obvious, angels who made their wealth from traditional industries are handicapped by one glaring flaw: They’ve never actually invested or worked in tech.

Technology companies, especially startups, are simply a different beast, and this goes doubly so for investors from more traditional financial or investment backgrounds.

It’s one thing to ask a first-time investor to commit money to a venture, it’s quite another to expect them to know the technology stack, the competitive landscape, and the exit potential.

The clearest difference is in revenue: While technology investors are comfortable investing in a company that operates in the red for prolonged periods of time (indeed, almost all early-stage startups do, often even years), this is anathema to more traditional investors, who often take a far more conservative approach in assessing potential investments, especially loss-making ones.

That conservatism will almost always manifest itself in one of two ways: A traditional investor owning too much of a startup, or the imposition of onerous financial terms, such as guaranteed loan paybacks in the case of default.

(To be fair, the convertible notes issued by institutional investors say variations of the same thing, but actually enforcing those terms would irretrievably destroy that investor’s reputation).

So why is that so significant? Because bad terms result in even worse investments.

Bad terms signal a red flag to later-stage investors, especially institutional investors with presumably far better experience investing in tech.

Too much third-party ownership? Too much founder solution? Burdensome economic terms or investor controls? These all can – and have – irreparably harmed the ability for startups to raise further rounds of funding.

And given the likelihood, indeed, the necessity for startups to raise two or three more rounds of funding at minimum, the potential for startups to collapse under the burden of an awful term sheet is significant.

Combine that with the difficulty in differentiating the one good tech startup from the ninety-nine bad ones, and it’s no wonder why many first-time angels get burned.

And so what happens? These angels either leave the ecosystem, never to invest in startups again, or they come back with even more protections and more control, which is guaranteed to destroy the future value of any investment … until eventually they too exit the ecosystem.

The most important thing for first-time tech angels is to understand the companies you’re investing in, understand startup formation, and understand the fundamental needs and growing pains of technology companies in South-East Asia.

Understanding these things comes with time, something many angels will preemptively cut short if they're burned on a deal – which, for first-time investors, is likely.

So what’s the best thing first-time angels can do?

Invest with people smarter than you.

I cannot stress the importance of this strategy enough. For first-time investors, learning will ultimately generate better returns than trying to sift through hundreds of startups for the region’s next home run.

By investing into funds, you become intimately knowledgeable of how funds work, where they find deals, and what they do to close and manage them.

By co-investing alongside more experienced investors, you’re not only tapping into their deal flow and benefiting from the halo effect of their reputations, but you’re also developing your own reputation as an investor who has finally been-there, done-that.

And it’s the track record that angels leverage to get invited into the really competitive deals – the RedMarts, the Tokopedias, and the GrabTaxis of South-East Asia.

When Japanese corporate funds and first-time angels sought to enter South-East Asia in the mid- to late-aughts, many eschewed direct investment in lieu of writing small cheques into funds. They had relatively little experience investing across the region, and preferred to hedge their risk by investing in funds with a better track record of finding and managing local companies.

In so doing, they not only developed a positive reputation within a given ecosystem, they also received intimate knowledge of conditions on the ground, so to speak.

The result? Many of these investors then went on to create their own dedicated funds several years later.

That same gradual learning process can and should be emulated by first-time investors looking to enter the space.

These angels not only endeared themselves to investors who came to rely on them to close out a round, but they eventually became valuable angels in their own right. Golden Gate Ventures’ proprietary deal flow is so strong thanks in large part to the networks and experience of angels we work with.

It might not be sexy to co-invest, and the glory might not be there, but at the end of the day, investors want to see the best financial returns on their investment and time.

Those investors would do well to follow the adage: Dumb money burns, smart money learns.

Justin Hall is a principal at Golden Gate Ventures, an early-stage fund based in Singapore. You can reach him via Twitter at @JVinnyHall. This article first appeared on his blog and is reprinted here with his kind permission.

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