Informal Capital Markets

Short guide on creating sustainable informal capital markets in emerging economies

by Nils de Witte, May 2010

This guide is a very simplified version that only mentions the most relevant elements that determine the development of an informal capital market. No explanations are given. However the guide is bases of 15 years experience developing these markets in Europe and developing countries.

Emerging markets need entrepreneurs to create meaningful jobs and middle class prosperity;
Entrepreneurs need finance to start and grow their businesses;
Traditional debt finance providers (Banks and MFIs) can only cover part of the entrepreneurial finance requirement;
High potential businesses need Venture Capital. Capital that is provided as equity and shares in the risks and returns of the business.

Venture Capital is typically provided by either Informal Investors, Venture Capital Funds or Private Equity Funds. In the “First Matrix” the different equity providers are positioned according to deal size and development stage of the business. Depending on the required deal size and development stage the proper delivery method can be chosen.

Informal Investors = Business Angels + Friends & Family;
Angels Investors = what the investors like to call themselves.

Angel Investors are very useful in early stage investments. Angel Investors typically provide amounts between 50.000 and 500.000 USD against a minority share in the company. Angel Investors preferably have an entrepreneurial background and build portfolio’s of 5 (lead) to 20 (syndicated) investments. Depending on the country, Angel Investors syndicate their investments, appointing one of the investors to be the “lead investor”. The lead investor takes care of due diligence and investment management and is rewarded with a carried interest.

Every country has “high net worth individuals”, who can provide venture capital, so why don’t they?

Why do informal capital markets not emerge spontaneously?

Inherently entrepreneurs and investors have different interests. Whereas entrepreneurs prefer to get their money for free, investors like to have their returns guaranteed. Lack of consideration and mutual respect creates the equity gap. Investors do not trust the entrepreneurs to take good care of their money and entrepreneurs do not trust the investors to share their interests in the company.

To make the market work, “faith” needs to be established. Entrepreneurs need to have faith in themselves, faith in their business and faith in the capital market. Entrepreneurs are required to invest a considerable amount of their time and effort in preparing themselves and their business for an investment, without any guarantee that this will ever happen. This requires a huge leap of faith from them. The first question in creating informal capital markets is: ‘Who is going to give entrepreneurs the “faith” in themselves and the capital market, to really commit themselves’?

Investors need to have “faith” in the system. There are easier ways of making money then investing in start-ups. First investments usually fail. Informal investing is a skill that needs to be developed. Especially “guiding entrepreneurs” is a skill in itself. Entrepreneurs need to be in charge and get the chance to learn from their own mistakes. So the second question in creating informal capital markets is: ‘Who is going to give the investors the “faith” to give their money to someone they don’t know and let them do their thing’?

Creating these informal capital markets is a delicate matter. Its easily overdone. Some European countries have been investing in these markets for many years and still to get the private money flowing. Some definite don’ts are:

Don’t trow money after entrepreneurs who are not ready, they will fail and enlarge the equity gap;
Don’t help entrepreneurs to much. They need to take action, its their business;
Don’t make entrepreneurship and informal investing a “public affair”. It’s business and the networks need to be run by business people.

Entrepreneurs should help themselves and each other to get ready for investment and investors need to help themselves and each other to master the art of informal investing and work together to exchange ideas and build portfolio’s and to iron out flaws in the investment pipeline. Government people and consultants hardly play a role.

What can be done to stimulate the growth of informal capital markets

Challenges:

Depending on local circumstances, one of the following requirements for a healthy informal capital market might be lacking:

Entrepreneurs lack knowledge on business administration skills;

Solution: training, coaching and consultancy;

Entrepreneurs lack courage and determination to start their own business and make it a success;

Solution: Peer networking and entrepreneur/investor meetings;

Potential investors lack the funds to invest in new businesses;

Solution: Syndication and side-car funds;

Potential investors lack the courage and the patience to invest in new businesses;

Solution: Peer networking among investors;

Investments in new businesses do not make acceptable returns;

Solution 1: Improve entrepreneur/business quality;
Solution 2: Fine tune financial engineering subsidy/loan/equity/royalty;
Solution 3: Leverage investments with soft loans and guarantees;
Solution 4: Take fiscal measures to improve returns;
Solution 5: Stop investing until returns are acceptable again;

Investors and entrepreneurs do not trust each other;

Solution 1: Peer networking and entrepreneur/investor meetings;
Solution 2: More effective expectation management by network managers;
Solution 3: All of the above motioned measures may help create mutual understanding between entrepreneurs and investors;

To increase the effectiveness of measures it is necessary to evaluate the local situation and identify the most urgent issues at hand.
Other factors that might inhibit the development of a healthy informal capital market are:

Lack of buying power. In very poor regions there might be no market for products and services provided, so creating new businesses is not going to relieve poverty;
Political unrest and lack of (communications) infrastructure. Business do not thrive in war zones and cheap broadband Internet connects the entrepreneurs to the rest of the world;
Restrictive legislation and bureaucracy, how long does it take to register a business, can staff be readily hired and fired, can profits be transferred?
Corruption and extortion, are entrepreneurs harassed by local officials and big guy’s to share in their profits?
Social pressure, are entrepreneurs under pressure to hire friends and relatives or pay money to them, without receiving value in return?
Cultural inhibition, is it cool to be an entrepreneur, is it cool to put all your efforts in a ventures that might fail, is it cool to work hard an not get rich right away?

These factors can not always be eliminated. They should be reckoned with and they will inadvertently influence the performance of the businesses and therefore the performance of the informal capital market.

Solutions:

Pre-start infrastructure, entrepreneur side (publicly funded)

Helping entrepreneurs to understand the business

Community activities for entrepreneurs (on-line and off-line)
Entrepreneurial courses for students and entrepreneurs
Business plan reviews, coaching and monitoring services
Business plan- and pitching competitions

Helping entrepreneurs get started

Incubator like activities
Pre-seed funds
Small Business service providers (private legal, financial and business development)

Pre-start infrastructure, investor side (privately funded)

Helping investors understand the business

Peer networking among investors
Workshops and pitch events

Helping investors manage their investments:

Deal flow and deal flow management;
Sharing due diligence and documentation (agreements);
Syndication and side car funds;
Leverage and guarantees
Toolkits for due diligence, investment and investment management;
Network of service providers

Intermediary services

Depending on the local situation, intermediary services may take the following forms

New Markets: Traditional “Business Angel Networks” or “SME Centers”. The main tasks of these organisations are to (help) prepare entrepreneurs for investment. The main reason for entrepreneurs to join the network is the fact that they can meet investors and might even get funded. 80% of time and effort of the network operators is spend on sourcing businesses, preparing entrepreneurs AND investors and managing expectations. The actual matchmaking activities are limited to an introduction service. Actual deal structuring and due diligence services are provided by private service providers. Training and consultancy services are provided by third parties. These networks are usually publicly funded but the operators need to be “business people”. These networks need to limit their hours spend on one entrepreneurs (4 to 8 hrs total).
More sophisticated markets: When entrepreneurs know how to prepare themselves and investors are more experienced, markets become more transparent. The need for an expensive business introduction service lessens. Entrepreneurs will make use of available resources like incubators, support organisations etc. as they see fit and investors will associate in “Angels Groups” or “Investors Clubs”. These groups are run by investors. A small part of the resources is spend on socialising, hardly any resources are spend on preparing entrepreneurs, except through pitch events. Angel groups typically form around one or more very active investors. These are the “natural leaders” of the network. Between 20 to 200 investors might join the group. The workload is shared among all the investors.

Investment services

To support deal flow, investment and investment management, the following services and service providers are useful. Most of these services are provided by “commercial” service providers:

A networks of “Partners” like banks, MFIs, incubators, SME centers, etc. to provide potential deals;
Sourcing and assessment system and a network of assessors and coaches;
Verification and due diligence methods and a network of service providers;
Template term sheets and investment agreements and a network of service providers;
Banks or MFIs to manage the “loan part” of the investment
Investment managers (could be investors) to manage the investments and take a seat on the board of the company if necessary.

The workings of an Angel Group

An Angel Group is typically started by one or more lead investors. These lead investors are very important. They are not only leading the investments, but they are also the moral leaders of the group. Other investors will follow their lead and the performance of the entire group depends on their views and actions. Leading an investors group is a demanding task. Hiring someone to lead the group has not been a success so far (new business models are tested on a regular basis).

The leaders of an Anglel Group need to position their group clearly. This helps attracting the right investors and the right deals. The greatest threat to an Angel Group is lack of action. When the group is not focused, they will either not come to a decision or make bad investment decisions. Positioning criteria will be provided later.

The group activities start by receiving and reviewing business plans. Business plans that do not meet the requirements are rejected. Entrepreneurs who’s business plan meets the requirement are invited to give a presentation. These presentations can either be held before the entire group or an appointed committee. When the presentation is accepted one or more investors are appointed to “prepare the deal”, they do basic due diligence and work out a term sheet with the entrepreneur. This “deal” is presented to the group. Investors might decide individually or collectively who is going to invest and who will lead the investments. Variations are possible with pooled funds and side car funds. The “lead investors” (which might be any of the groups members) closes the deal and manages the investment.

Positioning an investment activity

First of all, the group need to decide whether they prefer asset based investments (real estate, machines, inventory etc), R&D investments or working capital. Then they need to decide whether they prefer majority investments (mergers and acquisitions) or minority investments (venture capital). Furthermore it’s important to focus the investment activities on a limited range of development stages (pre-seed, start, early growth, etc) and investment amounts (see First Matrix above).

*	Secondly it is advisable to focus on a limited range of sectors or industries, whether it will be high tech, low tech or no tech and what kind of technologies. The Second Matrix might help group the choices.
*	It is also important to express the motivation for the investment activities. Is the motivation purely financial, or are there some social and/or environmental aspects involved. Experience teaches us that the most successful Angels Investors are slightly socially and/or environmentally motivated. The Third Matrix might help to position the investment activities in that respect.
*	Last but not least, it is advisable to choose a clear “service model”. Who is being served, the entrepreneurs, the investors or both? How far will the involvement go? Traditional Business Angel Networks should not be too involved otherwise they might dominate the market and crowd out private sector providers.

How can we help

Step 1: Evaluate the local situation

What’s available:

Entrepreneurs (successful and emerging);
Support and intermediary services;
Professional services;
Formal capital market (Banks, MFIs, Funds and investment programs);
Informal capital market (Friends, family and Angel Investors);
Motivated stakeholders and passionate individuals to fund and lead the activities;
Deal flow and participants.

What are the challenges:

Political and economic circumstances;
Legislation, bureaucracy and safety;
Social and cultural inhibitors.

What might the solution be:

form of activities and proposed positioning;
results to be expected;
conditions for success:

What needs to be done;
How much will it cost;
How long will is take;
Who needs to be involved;

Step 2: Implementation proposal:

What goals need to be achieved;
What need to be done to achieve those goals.

Step 3: Implementation support:

Sourcing support (challenges);
Assessment and feedback support;
Training of network operators and matchmakers;
Ready for Equity training modules for entrepreneurs;
Training modules for investors;
Tool kits for entrepreneurs:

World wide community of entrepreneurs
Business Plan Templates
Lists of funds and support organisations
Network of coaches

Tool kits for investors:

Investment guide
Innovative investment methods
Innovative Due Diligence methods
Template Term sheet and investment agreements

IT Infrastructure for:

Sourcing
Deal flow management
Assessment and feedback
Coach matchmaking
Investor Matchmaking
Peer networking for entrepreneurs
Knowledge base and tool kits for entrepreneurs and investors

On site implementation support.

Step 1 takes a two week on site evaluation and one week to prepare a plan of action.

Note: Creating a sustainable informal capital market is a private affair. It takes years and a lot of effort to get significant results and the first returns. Therefore the initiative must be taken by local stakeholders and carried by local entrepreneurial heroes.

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