Entrepreneurial Leadership and Management . . . and Other Stuff

RSS
Aug
17

Ignoring Red Flags in Investing

I’ve been an active angel investor for about 15 years now.  Like most non-professional investors, I go into each investment fully and unrealistically expecting it to return some huge multiple of my original money.  While I’ve certainly made enough investments to know better, having high expectations for every investment I make is only one of the relatively frequent mistakes I make when investing.  I’m a slow learner.  Very slow.

Don’t get me wrong, in the end, my investments have delivered relatively nicely.  Way more failures than successes (way more), but with enough successes to more than cover losses and provide a reasonable return. Some might even say a good return.  That said, I’m pretty sure that no one who knows what they’re doing in terms of investing is gonna ask me for advice any time soon.

Back to the mistakes part . . . this week, we closed down the company I most recently invested in (names will be withheld to protect the innocent, not that anyone involved is innocent).  Looking back, there were loads of signs that the company was going to fail or, at least struggle, from the beginning.  I ignored them all.  In the end, I can only blame myself.  Not for the company’s failure, of course, but for being involved in the first place.  If you have stumbled on this post via a search or have read this far and actually think you can learn something from me or my experiences, here is a list of obvious red flags that I ignored in making this investment that resulted in my losing a bunch of money relatively quickly.

  • I fell in love with the technology – this one is a classic.  I saw the technology (image processing), did a minor amount of due diligence and thought it would change the world.  My passion for photography drove me here.  That, by itself, isn’t a bad thing, but as soon as you feel love, you better find someone who knows what they’re doing to look at it and give you an objective perspective.  I didn’t.  At lest not enough.
  • I didn’t have a solid grasp on the market – while this was a software play (broadly, something I actually know a  little about), the target market was cell phones.  Cool, right?  Made sense.  A zillion devices sold every year, cell phones replacing compact cameras, more processing power moving to phones, etc.  Life looked good.  I didn’t understand what a dog-eat-dog world the mobile device ecosystem is.  Handset producers, carriers, sensor manufacturers, it’s a mess out there.  I shoulda found all this out before I wrote the check.
  • The valuation was too high – duh!  Well, I suppose that is a red flag, but there’s nothing subtle about it – it’s more like a fact.  In investing, one runs across valuations that are out of whack all the time.  Depending on the situation, you pay the price or not.  The real red flag was something more subtle.  The other investors in the deal (all with more money in it than me), who had already set the price, were all relatively unsophisticated investors.  That’s not to say that they weren’t good business people, but they were newbie investors.  Note to self, avoid deals crowded with investors who have not invested much before, especially when they’re taking the lead on terms.  Stupid, just stupid.
  • When I invested and took a board seat, the other two outside investors were from the same company as the two lead engineers, making 90% of the employees coming all from the same place –  let me be clear, each one of these people was excellent and the company never experienced the problem that I initially feared of the group steering the company’s direction.  The issue here is simply a judgment call by the CEO which I disagree with.  If you’re trying to do something new, why load up with something old?  Maybe involving one person from the other company would make sense, but four?  I questioned this when I came on board and chose to let it slide.
  • While being “recruited” as an investor and board member, the team made some claims that they couldn’t fully substantiate when questioned about them – now you’re saying, “well you’re an idiot for investing if that was happening,” and you’re right.  See the first bullet.  Shame on me.
  • The founder/CTO was unproven – A bright guy with an unremarkable credentials.  Not that every startup CTO should have cured cancer before their new endeavor, but for a guy his age (not a kid any more) he should have had a track record of successes, even if they weren’t entrepreneurial.  This one’s not a slam dunk, but it was another flag that occurred to me and I chose to ignore.
  • Company management didn’t see startup activity the same way I do – work hard, juggle lots of plates without dropping any, take pay cuts when required and sacrifice most of the rest of your life while getting the enterprise going.  From the outside, the management team seemed to treat their work in the company like a job, not a commitment.  To be fair, I really didn’t see this, and other problems like it, until after I had made the investment.
  • I had previously invested in a company founded by the CEO where I had lost a load of cash – again, itself, not a reason to avoid the opportunity, but it should have created more dissonance in my thoughts than it did.  I didn’t even spend time to consider the causes of the previous failure and how they related to the CEO.  In retrospect, it’s still a little hazy, but taken in concert with all the others, it should have been a bigger deal to me.

Yeah, yeah, I’m an idiot.  It’s not unusual to run across a red flag or two when looking at a new venture, but when the list is long enough to enumerate, well . . . In the end, it was easy for me to dismiss each of the issues individually.  I neglected to look at them as a whole.  My bad.

Obviously, the sum of the issues and their meta-meaning wasn’t quite as clear to me before I made the investment.  My point is, though, that it should have been, especially given the number of investments I’ve made.  I feel like an moron.  I suppose the only good thing about it is that I didn’t let it run its course.  The company will return its remaining capital to its investors once all obligations are paid out.  It’ll be a small percentage of the funds invested (less than 25% of what was invested), but at least it’s not zero.  I just hope I learned something from this experience.  As my good friend Brad Feld likes to say, “I’ll only make that mistake three more times.”  I’ll tell you next time if I even learn that quickly.

Can anyone else you know use this information? Please share . . .
Share on Facebook
Facebook
Share on Google+
Google+
Tweet about this on Twitter
Twitter
Share on LinkedIn
Linkedin
Buffer this page
Buffer
Email this to someone
email
 August 17th, 2009  
 Will  
 Investing  
   
 9 Comments

9 Responses to Ignoring Red Flags in Investing

  1. If it were only that easy, carefully look for the red flags, hold steady to your convictions and analysis, then miss the 1 in 1,0000 superstar. The problem is there are always the examples of exceptions to the rules. Let’s face it red flag numero uno is: “it’s a startup”. So once you make the leap of faith past that red flag, the rest probably become even easier to overlook, cause, well, this one is going to be the exception to the rule.

    We are not wired all that logically. As a kid I remember the arguement that people made for NOT wearing seatbelts, everyone seemed to know someone who “was miraculously throw from the vehicle to safety”, this completely overlooks the unlikely occurance of highly unlikely impact vectors, a windshield or side window that was suddenly no longer there, no objects to hit once you are flying from the vehicle, and somehow landing such that you don’t snap bones, your spine or skull. Hey while we’re at it, let’s jump out of a plane without a parachute, a few people have done this and survived…

  2. If it were only that easy, carefully look for the red flags, hold steady to your convictions and analysis, then miss the 1 in 1,0000 superstar. The problem is there are always the examples of exceptions to the rules. Let’s face it red flag numero uno is: “it’s a startup”. So once you make the leap of faith past that red flag, the rest probably become even easier to overlook, cause, well, this one is going to be the exception to the rule.

    We are not wired all that logically. As a kid I remember the arguement that people made for NOT wearing seatbelts, everyone seemed to know someone who “was miraculously throw from the vehicle to safety”, this completely overlooks the unlikely occurance of highly unlikely impact vectors, a windshield or side window that was suddenly no longer there, no objects to hit once you are flying from the vehicle, and somehow landing such that you don’t snap bones, your spine or skull. Hey while we’re at it, let’s jump out of a plane without a parachute, a few people have done this and survived…

  3. The really great startups, the life changing, gazillion X return, investments, usually look terrible – that’s why you’re able to get the good price in them. How many people turned down eBay?

    And markets are either very competitive, very small, or non-existent. Free enterprise feels about big, empty, fast-growing markets the same way nature feels about a vacuum.

    But the mentality of the management team is important: I don’t want to invest my money in something where the people involved don’t consider the success of the venture the most important thing in their lives. Unfortunately, it’s hard to find that out before you write the cheque.

  4. The really great startups, the life changing, gazillion X return, investments, usually look terrible – that’s why you’re able to get the good price in them. How many people turned down eBay?

    And markets are either very competitive, very small, or non-existent. Free enterprise feels about big, empty, fast-growing markets the same way nature feels about a vacuum.

    But the mentality of the management team is important: I don’t want to invest my money in something where the people involved don’t consider the success of the venture the most important thing in their lives. Unfortunately, it’s hard to find that out before you write the cheque.

  5. John,

    All so true. The thing is, it’s not like there was one or two, there were a dozen that I could see. I looked at each one individually and chose to dismiss it without ever thinking about the flags as a group. *That’s* the stupid part. AND, I should know better, it’s not like the first time you ignorantly and stupidly take apart a Stromberg carb while ignoring the fact that there are 42,000 vacuum lines connected to it. 🙂

  6. John,

    All so true. The thing is, it’s not like there was one or two, there were a dozen that I could see. I looked at each one individually and chose to dismiss it without ever thinking about the flags as a group. *That’s* the stupid part. AND, I should know better, it’s not like the first time you ignorantly and stupidly take apart a Stromberg carb while ignoring the fact that there are 42,000 vacuum lines connected to it. 🙂

  7. Lorne,

    You’re right. If you’re swinging for the bleachers, you often have to look past the blemishes. In this case, though, I was only looking for a double or triple – I still looked past the blemishes. Shame on me.

    You’re so right about the management stuff. Even though I suspected a couple of issues, I discovered a different order of magnitude once I witnessed how tings were done. Still, I should have asked more questions.

    The best lessons are the most painful ones. Right? . . . Right?! 🙂

  8. Lorne,

    You’re right. If you’re swinging for the bleachers, you often have to look past the blemishes. In this case, though, I was only looking for a double or triple – I still looked past the blemishes. Shame on me.

    You’re so right about the management stuff. Even though I suspected a couple of issues, I discovered a different order of magnitude once I witnessed how tings were done. Still, I should have asked more questions.

    The best lessons are the most painful ones. Right? . . . Right?! 🙂

  9. Never fall in love with any of your investments