The Five Critical Mistakes of RegCF Investing
Invest in founders building the future
Investing has risks: it’s often bulldozed over by opportunity, but it deserves attention. Herein, we look at the five big mistakes investors make in evaluating their investments.
The risks around investment were so large that the governing bodies created accreditation for investors as individuals, focusing mostly on those whose income proved that they could sustain losses, more so than their worthiness to be investors (there’s no series test for accreditation, just earnings criteria).
Crowdfunding offers a unique opportunity, particularly in risk management, because you are able to invest in companies that are sufficiently small to have manageable and understandable risks: unlike major conglomerates which are subject to a variety of market forces and dynamics requiring weeks of study and insight from analysts, Crowdfunding companies are generally seed stage, and their drivers are subject to some simple forces you can gauge.
Growth and customer acquisition is typically the largest risk. While we have seen factors like the collapse of SVB in particular upend the startup industry, these are few and far between. How a company grows and particularly its path to profitability represents the great risk of failure in early stage: most companies are able to show artificial growth for example. They have identified a number of customers, raised some money, and appear to be operating profitably. Are those customers recurring? Friends and family? Were the customers acquired through sustainable channels? This is the meat of where we want to dig in.
Mistake 1: Not understanding expenses as they relate to scale
Are expenses reflective of scale: seed stage companies can often bury the true costs of business by not having founder salaries on the books, or by obfuscating account management costs. There are costs in operating the business at greater scale which may not be reflected in the financials currently. One of the things we advocate is to look at expenses across the “chevron” or the “production line” of the business, from marketing, through sales, to the end of account management. If you are able to identify all the expenses associated with acquiring and servicing a Unit of Revenue, then you can be reasonably sure that the important expenses are accounted for.
Mistake 2: Not understanding customer acquisition
Where do the customers come from: the source of customers is important for a number of reasons including repeatability and scalability. Many companies purchase their customers from paid media which is a massive risk – fluctuating costs of media are outside the control of the business and not standardized. It is often the case that paid media acquisition becomes unprofitable, especially in certain segments of industry at certain times of year, like holidays, when the cost of media spikes and competition is high. Other customers use organic means to attract customers, like earned media, or their own channels, in which case repeatability becomes a concern. Can this be replicated at scale? A solid use case is someone with strong SEO that gets X amount of traffic from organic search, and converts that into emails, and ultimately sales. You can see conversion rates across time which show a performing growth funnel. While there is concern about diversity of traffic sources, and being a reliable staple to a third party, you can see how sales are created, and how the business scales.
Mistake 3: Missing defensibility, differentiation, or moats
Is the technology defensible: one of the largest risks is a lack of defensibility, especially in the AI age we now live in, where the advantage purported by many of these companies does not exist in the face of Artificial IntelligenceI. AutoGPT is able to acquire data and do many sales and marketing tasks that can easily erode an advantage a company has. Without learning all the many limitations and abilities of AI, the best thing to look at is the argument for defensibility from the tech team itself: do they make a cogent argument about building something essential, as a true “need to have” or does the material science of a company, or their relationships make it so. For example, Seamless (before Grubhub) had exclusive relationships with Banks and Law Firms in the top markets; no one else could get to that revenue. Algenesis created a biodegradable biopolymer for its shoe soles: everyone wears shoes, and the ability to have them not be plastic waste is a huge differentiator. Moreover, the absence of innovation in the market is itself an indicator: It’s relatively easy to note that other companies do not have that advantage.
Mistake 4: Not ensuring profitability through large margins
Does the company have large enough margins: the majority of the companies in SaaS or D2C products at seed stage should have 80/90% margins. Those with less have a product that is difficult to scale, or requires heavy investment to grow. For example, luxury DTC products often require revenue based or inventory based financing to grow, meaning in order to take the next step, large capital has to be invested. The best businesses grow quickly and smoothly, able to utilize cash flow from sales. This is also not the case for many venture backed SaaS companies that grow in stages, often requiring tremendous investment in technology to get to that next stage; the cost of the future technology required growth, often obfuscates the actual margins. If you build a piece of technology for 100 dollars, that allows you to capture a small percentage of the market, but have to expend massive amounts of capital to build for the rest of the market, then in reality you may not have a great investment! The unexpected is a part of doing business: those businesses without built in padding to their margins are less able to handle the unexpected and finance their way through it.
Mistake 5: Dependency on others for growth
Is the success of the company dependent on another company outside their control: the largest problem many DTC businesses have is that they rely on META or Google for their growth, via paid media advertising. Paid media costs fluctuate tremendously, causing companies to be unprofitable overnight. Some companies outsource core functions of their growth to other companies – if that company were to disappear, how would it affect profitability? There are a vast number of companies in the global economy that have good symbiotic dependencies: the key is to identify the bad ones, like paid media for growth.
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