(Commissioned by the Wall Street Journal Europe, 16/4/2012)

Tech is back and riding a new wave of popularity with European investors. It was the most overweighted sector among Eurozone fund managers in March according to a BofA Merrill Lynch survey.

But despite the attractions of popular tech stocks like Apple and Google, sophisticated investors may want to seek out less chartered waters and not follow the crowd.

Venture capital offers high-net worth individuals the chance to get in on the ground floor by investing early in businesses that could become tomorrow’s tech stars.

But it is not for the risk-averse — or those looking for a quick profit.

“It requires a 10-year commitment,” says Alex van Someren, a serial tech entrepreneur who now runs a GBP10m seed capital fund for Amadeus Capital Partners Ltd, a leading UK VC firm.

VC investing has traditionally required deep pockets. An investor who puts €1m into a conventional VC fund may face a total commitment of €5m over successive funding rounds. In return, investors expect annual returns of 20 percent or more, although performances vary considerably.

Because of the lengthy time frame and poor liquidity, HNWIs should view VC investment as an alternative asset class rather than as an equity fund, Mr van Someren says. Indeed, VC funds can help diversify a portfolio as research shows little correlation between early-stage private equity and public equity markets.

Investing early in a company’s life cycle typically leads to greater returns. But Miguel Valdés, CEO and co-founder of French software company BonitaSoft, says European VC firms are often wary of being too early and many prefer to put bigger sums into more established businesses.

BonitaSoft raised $6m from two French VC firms in July 2009, just one month after starting the business. It raised a further $11m last year.

Mind the Gap

But many start-ups are not so lucky and face a “funding gap” when the founders’ capital is exhausted but the company is too small to justify a conventional first round of VC funding.

Business angels may fill the gap. In the past, European tech entrepreneurs complained of the difficulties connecting with tech-savvy angel investors. This is now changing thanks to angel networks and web-based “crowdfunding” initiatives such as Seedups.

Indeed, seed funding is now one of the most dynamic investment areas in Europe and the VC industry has woken up to the trend.

Mr Van Someren’s two-year-old Amadeus & Angels Seed Fund is one of new generation of seed-stage VC funds, which usually have lower minimum investments [than traditional VC funds] making them accessible to a broader investor base.

Fifty investors have committed a total of GBP3.5m to the GBP10m Amadeus fund. The remainder comes from the Enterprise Capital Fund, a UK government initiative to back entrepreneurs.

Despite the buzz around social networking, Mr Van Someren prefers businesses with “rich intellectual property” and avoids most internet start-ups.

“We are not willing to invest in areas that are oversubscribed,” he says. “There are a very large number of mediocre businesses in social networking.”

UK-based Passion Capital also sees rich opportunities in seed capital. Unlike Amadeus, it has no fear of internet companies as the three founders are key figures in Europe’s internet industry.

It has investments in 19 early-stage companies in areas such as social micropayments, academic social networks and website analytics .The average investment is around GBP200,000.

A third of the GBP37.5m fund comes from HNWIs with the ECF supplying the remainder.

“The ECF is a very tax-efficient way for HNWIs to invest in tech,” says Eileen Burbidge, a partner at Passion Capital.

She says similar initiatives [to the ECF] in France and Germany show Europe is finally waking up to the need to do more to encourage business angels to invest in tech startups and so close the funding gap.

Five Dos

  • Do choose the right stage of investment. If you like the excitement and understand the risks of backing early-stage start-ups, then become a business angel. If you want to shorten the odds by backing growing tech businesses that have passed the scrutiny of professional fund managers than choose VC funds. If you are looking for more predictable returns and a liquid investment that lets you sleep more easily at night then choose quoted companies or, for more diversity, tech-focused equity funds.
  • Do your research. If you don’t understand terms such as social micropayments, cloud computing or business process management, you cannot make an informed decision on businesses that operate in those areas. “Tech is difficult stuff to understand and it changes all the time,” says Stuart O’Gorman, director of tech investments at Henderson, a UK asset manager. Angel investors considering an opportunity should seek the opinions of customers, rivals and analysts and ask the executive team lots of questions. What are the barriers to entry in the market? Does the business own intellectual property? What happens if the CTO leaves?
  • Do have an exit strategy and stick to it. Even seasoned investors have great difficulty knowing when to take profits — or cut losses. Tales abound of wealthy investors buying hot stocks, happily watching them rise, and then hanging on to them too long when the bad news hits. Microsoft co-founder Paul Allen lost an estimated $400m when shares in InfoSpace collapsed in last decade’s dotcom crash. In the case of unquoted companies, be prepared to say no to follow-on funding if you think the company is no longer such a good investment.
  • Do spend lots of time looking at potential opportunities. A common mistake among angel investors is not looking far and wide enough to source good deals. Alex van Someren of Amadeus Capital, says his firm will typically invest in one of every 100 business plans it receives. This time is not wasted because by looking at many opportunities, investors notice trends, hear what their rivals are up to and can get a better understanding of how the industry works.
  • Understand your tolerance to risk. A decade ago, tech fund managers loaded up their portfolios with huge risk for fear of underperforming their peers. “They got dragged into hot sectors just when they got overpriced,” says Mr O’Gorman of Henderson. Today’s tech funds pay much more attention to controlling risk – his Henderson Horizon Global Technology fund has been less volatile than the general equity market over the last 3 years. Unquoted investments carry much more risk and are illiquid, which means investors must accept they can lose all their money.

Five Don’ts

  • Don’t put all your eggs in one basket. When investing in startups, spread your capital across a sufficient number of investments to minimize the damage by the inevitable failures. Novices to angel investing often make the mistake of investing too much in one “hot” company. Statistically, the odds of one start-up becoming successful are very low. A better strategy than putting €600,000 into one opportunity is to divide half the money evenly across five start-ups and hold half back to fund successive funding rounds.
  • Don’t follow the herd. Investors are only human and it is easy to see the attractions – and more difficult to evaluate the risks — of a stock if everyone else is buying it. But popular tech stocks can rapidly fall from grace and are more likely to suffer a big sell-off by panicky retail investors. Former high-fliers Nokia and Research In Motion have dropped 44 percent and 78 percent respectively during the past year as investors realize the smartphone boom has losers as well as winners.
  • Don’t throw good money after bad. To avoid having their seed stake watered down, angel investors may get first-refusal in additional funding rounds. But if a start-up has not been able to demonstrate that it has added value to an angel investor’s initial investment, there’s no guarantee that it will perform better in the next round. It makes more sense to focus follow-on funding on investments that are doing well.
  • Don’t ignore quoted tech stocks. For novices to tech investing, the easiest way to get exposure is buying a handful of large-cap tech stocks. If you want instant diversification, buy a tech-focused equity fund or an ETF. While the European universe of quoted tech stocks is much smaller and less diverse than the US, it includes established industry leaders such Germany’s SAP or Arm of the UK, as well as less-followed young contenders, such as Sweden’s Transmode Holdings, which specializes in optical networking. After ten years of VC support, Transmode had a successful IPO last year and is currently trading 43 percent above its IPO price.
  • Don’t be impatient. It can take five to ten years before a start-up is ready to IPO or a trade buyer makes an offer it cannot refuse. If the climate for tech IPOs is hostile, the company’s VC backers will sit it out rather than see the company sold cheap. Investors in quoted tech companies should also be prepared to take a long-term view.