Why do investors keep pumping in money when most start-ups fail? To an extent, it’s blind faith, but a lot can be attributed to the EIS tax avoidance system. This was perfectly illustrated in a recent presentation I attended.
This isn’t exactly what was said, but I think it’s a fair illustration:
- An investor puts a total of £100,000 into 100 startups – £1000 each – making the following assumptions:
- 80 will fail, so that £80,000 will be lost
- 10 will trade successfully (but not phenomenally) and the investor will get their money back eventually, let’s assume with no premium.
- 8 will be sold at an average multiple of 3x the original investment
- 1 will sell at a multiple of 10x
- Just one – the nascent “unicorn” – will sell at a multiple of 50x, netting the investor £50,000
So overall, the investor will get back £94,000 – which looks like a loss of £6,000 on the original investment. But in fact, through the EIS scheme, the investor immediately recovers 30% of their investment as a tax rebate, so the original outlay is only £70,000. Assuming the above scenario takes 5 years to realise, that’s the equivalent of 6% compound interest. But it gets better, as there is no Capital Gains Tax to pay on the eventual sales – so, assuming a CGT rate of 20%, the equivalent average interest rate is 7.5%. Right now, with interest rates at an all-time low and fears of another stock market crash, that’s a very attractive return.
On top of that, even for the hardest-headed investor, the excitement of gambling comes in. If fewer investments fail and the ones that succeed sell at higher multiples, then the potential gains are far greater.
Most Angel investors wouldn’t recognise it as gambling. Some will study the business propositions, talk to the principals and feel like they are making sound business decisions. Others will accept the recommendation of “funds” or angel investment groups, and assume that the startups have been thoroughly vetted by others. Often, though, they’re deluded.
Throughout my own business life, I was always told that it was essential to have, and maintain, a Business Plan. Apart from needing it to show the bank and any investors, it was held out to be essential as a thought-out road map that would help focus and drive the directors of the company. I became a True Believer. I’m told that it’s still described in the same way and taught in MBA courses.
So why do so few start-ups arrive in front of investors with no Business Plan – or perhaps, at best, an inadequate one? The belief seems to have been fostered that all that’s needed is a “Deck” – a set of PowerPoint slides. This may be a US-driven concept; certainly it’s quite common for executives in the USA to only read Executive Summaries and only look at slide decks. That would be fine, if the financial numbers displayed could be justified by studied facts – but what’s common now is simply to present the high level, with numbers that could have been (and quite possibly were) plucked out of thin air.
In the next article in this series, I’ll expand on my thoughts on business plans and initial valuations.