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Mitigating risk through early stage companies

Mark Bower-Easton, Business Development Manager, at Oxford Capital talks us through the risk levels, due diligence and investment strategy needed for positive investment returns.

 

All EIS funds are high risk. Since the UK government restated eligibility criteria back in Autumn 2017, EIS has reverted back to its original and purest form. Gone are asset backed EIS – if you want to take advantage of EIS tax reliefs you now need to be prepared to invest in early stage companies, with the potential for significant gains, but also for significant loss.

Many VCs in the UK offer EIS qualifying funds. However, not all approach risk, and risk management, in the same way. If you are looking to introduce your clients to EIS, it is important that you look at EIS providers that take risk, and risk mitigation seriously.

Risk is an inherent component of investing, and risk levels are particularly high with early stage investing. However, there are some risks which can naturally be mitigated by investing into early stage, unquoted companies, rather than investing in to established, stock market listed companies.

Systemic Risk is the risk of collapse of a whole market or sector, as we saw in 2000 and 2008. As early stage companies are unquoted, they are viewed as longer-term investments, and market dynamics and sentiment are less relevant. There is minimal correlation between the performance of an early stage business and an established FTSE 100 company, for example. Typically, if a negative global economic event occurs, the value of stock market listed companies will fall, regardless of sector or financial strength.

Liquidity Risk is the risk of not being able to access your money in the event that you need to. A lack of liquidity is, and always will be, an issue in early stage investing due to the shares not having an active market to be traded on. However, every investor who invests in EIS should be aware of the lack of liquidity available, so shouldn’t be in for any nasty shocks further down the line. My own personal view is that if a client or potential client mentions liquidity or foresees any need for the funds in the short to medium term, then an EIS won’t be for them, and it shouldn’t be recommended.

Specific Risk covers the risks associated with the individual companies being invested in to. This could include the risk that the technology being created becomes quickly outdated, or simply doesn’t work, or that there’s no market for the product or technology being created. Specific risk is the largest risk component of VC investing, but it is also the risk a well-managed and diligent VC can have the most control of.

A VC should look to mitigate the specific risks during the initial due diligence process to determine if the prospective company is a viable investment, but also manage the specific risks on an ongoing basis, during what we at Oxford Capital call our “period of maximum influence”. A VC can look to manage specific risk in four ways: Investment Strategy, Effective Sourcing, Portfolio Construction, and Portfolio Management.

Investment Strategy – it is important to have a clearly defined investment strategy and it is even more important that a VC firm is disciplined enough to stick to it. There should be a clear vision on the sectors they invest in, and the types of businesses in which they look to invest. For example, at Oxford Capital we are looking for bold, energetic founders, with dynamic capability, who are creating high impact businesses that can touch millions of lives, in sectors where the UK is recognised as a global leader.

Discipline is important too. Going “all-in” on a company at the outset is too high risk, although some VCs do it, and do it successfully. A less risky approach is to invest small to begin with, then as conviction in the business increases, to increase exposure by making follow-on investments. It is essential to see exactly what is going on in the business by taking a seat on the board, which gives the opportunity to conduct continual due diligence, and to leverage years of experience to shape the business in a way that will give it the greatest opportunity for success. Typically, when an early stage business fails, it fails early. This disciplined approach enables VCs to cut their losses when a company struggles. It is important to take emotion out of the decision-making process, to not throw good money after bad, and to never invest in a company simply to keep it afloat. The aim should always be to lose small, and to win big.

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