What industries do investors in start-ups currently prefer?

2019 | roadmap

From pre-seed to exit, start-ups are chronically in need of money to ensure their steady growth. Due to lack of access to bank financing start-ups are typically financed by their shareholders via equity finance or debt. But there are also hybrid instruments that can be used to bridge the gaps between financing g rounds or to overcome valuation issues. We interviewed Ivaylo Gospodinov, one of the managing partners of the investment fund BlackPeak Capital.

Q: What industries do investors in start-ups currently prefer?
A: In Bulgaria, everything connected to information technology is interesting. Engineering companies, anything that has an added value and potential to develop outside of Bulgaria. Different segments of the economy are interesting for different investors. Investment funds like BlackPeak look at the whole market and decide by means of different indicators where to invest, but what we are looking at are tech companies, not necessarily just software companies. This also includes online trading, innovations, basically anything which will be relevant for investors over the next few years on a global level. In Europe, there is a plan under which a lot of money will be invested in fields like robotics, artificial intelligence, and the like.

Isn't the real reason for such investment the fact that these companies are investing in intellectual capital, meaning they don't have to make huge investments in installations and machinery?
Yes, the more developed parts of the world are focused on innovations. This is the interesting sector – innovations, artificial l intelligence, robotics – things that drive progress and move society forward. This is applicable for Bulgaria, too. Recently, a lot has been said about blockchain technology. The question is how this technology will be applied, in what sectors and in what form. Cybersecurity is also interesting in this segment, due to the development of information systems.

How do you find out about the companies you invest in? Do they cold-call you? Does someone introduce you? What is the source of deal flow?
As a team we approach this in several ways. Knowing the local ecosystem, we communicate with the other participants and we look for smaller companies that one of the other funds have invested in and these companies have developed. Another approach is knowing the people who develop various projects or who are at a stage in which the company has a product or service and a good management team, there is some progress in relation to business development, whether in Bulgaria or on a regional or even global scale. We try to follow these companies and to communicate with them.
There are also companies which come to us. There are people looking for financing In Bulgaria, and in other countries, small- and medium-sized enterprises at an early stage of development are rarely financed by banks, especially if they are tech companies. These companies must therefore search for other sources of capital. Here in Bulgaria, they often turn to funds like ours. We all know who these funds are.
In the last few years, I have noticed that more and more individuals and established businesses and corporations are setting capital aside and investing with us. They are trying to diversify in this way. These entities have their own main business, have set aside several millions, and are exploring new areas to invest in. Private capital should be used, there's no point keeping money in the bank. This is good, because it helps the economy grow.

There are many co-investors and other entities in this ecosystem. Why is that?
There are many reasons. One of the main ones is generational change. For instance, a man grew a business in the 90s, but now the business is being taken over by his son or daughter who is more familiar with the economic trends in Western Europe and the USA.

How do you go about deciding what to invest in? What is your due diligence process?
We stick to well-established practices. At BlackPeak Capital we have something like a matrix in which we try to fit. Firstly, we are looking for companies with an established business model, not just an idea. The product or service should be sufficiently developed and already be on the market. We also seek out enterprises that have the potential for growth outside Bulgaria, because our market is very small. The third aspect is whether what they are doing has a niche, if it contributes to the development of some other things. Another crucial aspect is people – the founders and managers who have laid the foundations of the business. We make a subjective evaluation, asking "Could this person fulfil l the relevant plan?" So we are analysing personal qualities and the qualities of the team, because at the end of the day, nobody can work alone. What is this person's vision? Does he have the capacity to apply innovative corporate practices aimed at structuring the company in such a way that it will have the chance to grow? We gather a lot of information and then decide. The analysis of the company, including structuring the actual relationship and all the legal and financial aspects, can take six to eight months. We never rush to complete a deal. Our most recent deal concerned a Bulgarian company operating in India – a successful business model – and it took us about six months. And this is not an asset-heavy company, but it has added value concerning the services it deploys on the market. Sometimes you have to use experts. Actually, we don't act as experts in most of these companies. We put our trust in people who are experts in the relevant area.

Given that the cost of professional legal advice is often too high for a start-up company, what would a cost-efficient model of cooperation be?
We search for it constantly, because this is unavoidable. With some companies, we reach an agreement to use more reputable law firms which have more experience. But with other companies we cannot do this for purely financial rea-sons. We look for the proper balance, not only with regard to legal services, but also financial services. We can perform good financial analysis too, but we also need third-party confirmation for objective reasons. We are able to find a lot of partners in the industry and ways to reach a balanced agreement. This is a daily routine, as everyone is trying to protect their own interests.

Are these expenses usually borne by the start-ups or do you share the costs?
There is potential for conflict. By definition this should be an expense for the investor. But we try to share them. We are not a huge fund, and if we constantly bear all these costs, eventually we will go out of business. Funds, especially those that work with institutional capital, aren't allowed to receive income from other activities, including sitting on the board of a company, pro-viding consulting services, and so on. It is deductible from the management fee. So, you are restricted with a very clear resource, which you should allocate very carefully for the next 10 years. And there are also administrative expenses, which are not insignificant.

Is that the principle behind management fees? Is the principle the same for a large fund, for instance Blackstone? Do they have a fixed management fee?
Depending on your deal with the fund, how fast you invest or how fast you exit, the parameters for calculating the management fee vary. Generally, there is an upper limit. When you are mainly working with private capital, you can probably agree to add an additional charge towards the company you work with, because the truth is that 80 % of my time is dedicated to the company I work with. It's not only attending board meetings and making decisions, but also conducting m&a, hiring or dealing with suppliers. For instance, we do a lot of work for two companies engaged in the construction of a pair of factories – financing the construction, dealing with the banks, advice on corporate governance, implementing new systems, basically everything. This is a permanent engagement, which other funds would in principle charge additionally.

What do you do immediately after making the investment?
We are quite an active participant. This is why sometimes we are also shareholders, because there are companies which do not need an additional investment of capital, but need a partner. They want someone to help them develop the strategy, fulfil l the plan, check their ideas, build an internal structure. If you don't do it, at a certain moment you reach a limit after which you can't grow anymore. Our role is to evaluate these aspects, to determine what should be done in the next two years. We actively participate in the fulfilment t of this plan. Some companies grow not only organically, but also make acquisitions. And we participate actively in the m&a process.

When do boards replace CEOs?
It happened to us only once, actually. I don't have much experience replacing CEOs, but it could happen in case of a total lack of understanding of the business or failure to do something important. This reflects badly on us as investors, because it means we have not made the correct evaluation. Fortunately, we haven't had any events like this. Or there could be gross negligence by the founder – lying, stealing, failure to honour an express agreement. We are minority shareholders, but we try to protect ourselves, if possible, and to establish influence We have the respective provisions with our fund, but we never enter into any dealings with the feeling that we will have to fight with someone.

Bulgarian start-up investments started a few years ago (2011 – 2012) and a normal investment cycle is between three and five years, sometimes seven years. We have seen very few exits recently. Could we now expect to see a series of exits or are Bulgarian start-ups not there yet?
It's different for different funds. For some funds – those who are early stage, who invest on an idea level, on an early development level – the hit rate is low. From 10 companies they will manage to realise one; the rest are most likely going to die. If you succeed with two or three companies, that means you've done well.
For investors who look at more developed companies, the idea is to actualise the potential of these companies. The statistics show that you cannot succeed with all of them. The reasons can be many: conflict with the founder, change of market circumstances, a new competitor emerges and destroys you, something happens in the industry and your product is no longer relevant. You can't know all these things. You are looking at potential, trying to make an educated guess that in four to five years' time you will look like this, on this market, with these clients. The only guarantee is the old saying "work hard and work smart", which can potentially lead you to a successful exit. Companies that work well, develop well, whose management have a common vision and are consistent, have a good chance of success.

Are there any companies that are ready for an exit right now?
Yes, there are. Speaking of our investments, there are several companies which offer some interest. For some we have started the process of exiting, which also takes time. For others we are waiting a little bit, because we know that the interest will not dissipate in time, but further development is required. In these cases, you have to make an assessment. Sometimes the founder says, "Wait a second, don't rush, I still have plans that I need to develop". So you adjust to the circumstances. Now people are talking about a new financial crisis on the horizon. I hope it doesn't happen, because when it does, the deals just stop. Everyone stops doing what they are doing and waits for the crisis to pass.

Thank you for the interview.  

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This article was up to date as at the date of going to publishing on 10 December 2018.

Ilko Stoyanov

Ilko Stoyanov

Local Partner

T: +359 2 93310 72
i.stoyanov@schoenherr.eu

Katerina Kaloyanova

Katerina Kaloyanova

Attorney at Law

T: +359 2 933 10 74
k.kaloyanova@schoenherr.eu

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corporate/M&A

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