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Home > Nanotechnology Columns > Pearl > Nanotech Investing Due Diligence

Pearl Chin
Managing Director
Seraphima Ventures

As nanotech becomes more attractive as an investment, in both the public and private equity markets, the investor who wishes to invest in such emerging technologies, as well as any investment, should be asking the right questions. There is a lot of money involved and a lot of opportunities for investment fraud and scams. Here we explore and understand why any investor needs and how to conduct their own due diligence in any investment whether it is nanotech related or not.

March 21st, 2007

Nanotech Investing Due Diligence

How do the experts know how to invest in general? How do you separate out the people who really know and those who don't? And what about those who used to know but don't know now? Who is good and who is really good and who is just average? How can an investor invest wisely in nanotech if those who are currently the experts investing still do not understand what nanotechnology is to invest in? Can you depend on the experts in the large (or even small) investment firms to make good decisions on your behalf with your money? I suppose if all the investment firms knew what they were doing investing in technology in general, we would not have had bubbles bursting in and biotech several years ago. Did those investors, both large and small, learn from their mistakes or do they instead prefer to blame the companies in which they invested for their failures instead of their lack of investment due diligence and portfolio and company management strategies?

At what point do you, the investor, abdicate your due diligence responsibilities to someone else like an investment advisor to make decisions about your money? I have heard stories from a young ex-stockbroker from big name investment firms tell me how little they knew about investing and were given charge over millions of dollars of people's life savings. That same stockbroker also told me how little training he and his stockbroker friends got, how they made money calling people to buy public stocks they knew very little about so they could make money on the commission or transaction fees. This sounds an awful lot like "churning" which is a frowned upon practice by the SEC. That same stockbrokers also told me he and his cohorts lost millions of dollars of people's life savings because they did not know what they were doing but were just doing what all the other more experienced stockbrokers were taught them and selling what those other stockbrokers recommended and were selling to their own clients. People who thought they could retire comfortably now had to worry about paying their kids college or making sure they could remain gainfully employed as a senior in order to pay the bills or keep the house. At this point, I would be asking, more experienced stockbrokers experienced more at doing what? Investing or using their clients' money to pad their own pockets? That's not to say all stockbrokers do that but this situation is probably more pervasive than we would like to believe. Some people are teaching young stockbrokers to do it this way and are being rewarded for doing so and they in turn are teaching the newbies to do the same.

The Investment Act of 1940 says investment brokers and financial advisors cannot be compensated based on the performance of an investment, which is considered special compensation, for which they make or advise for a client which is why their services are fixed fee or asset-based which means based on the total assets in account held with the broker-dealer. This of course seems to make no sense but it exists mainly to discourage preferential treatment or advice to large investor accounts and conflict of interest because some of those firms that make markets and do investment advisement and can influence the markets in their favor. This is somewhat more complicated than this and the SEC continues to review it as recently as April 2005 with regard to instituting the Advisers Act to regulate these financial advisement and dealer-broker activities. In venture capital, we also have similar incentive problems but reversed because there are management fees which they charge investors that are not performance based so even if the investment goes awry, they still get paid. So there are problems with both compensation systems for middlemen.

In investing the process of qualifying or doing research and screening a deal is called "due diligence". Information, usually negative, discovered after investment is underway will nearly always reduce its perceived potential profitability or valuation. A due diligence process should be rigorous and hands-on. You need to start by understanding the management team, philosophy, process, and track record. You need to frequently communicate and visit regularly with company managers in person and by phone and supplement communication with regular monitoring of performance. To say that you have completed the due diligence process means that you have assured yourself that you understand, as much as humanly possible yourself, the investment, the risks of the investment, and the potential return of the investment.

From here then on, the decision to invest is purely of your own making and you should not blame your investment advisor for a bad decision. The buck should stop here. How does one know the investment adviser really did their due diligence or really understand the market and the company? You are either dependent on their track record or reputation. However, a disclaimer that everyone has seen on all investment materials is that - "past performance is no guarantee of future performance".

What are all the risks of this investment? What are the tax consequences of it? What is the mechanism of this investment vehicle (minimum investment, ongoing commitments of funds, penalties if you want your money out before you originally planned, commissions and other expenses, when is income paid out, etc.) Can you afford to lose this money? Of course, afford can be a subjective word. Many of those funds are invested by third parties who are people or companies other than the owners of the investment company itself. A really good question is how much of their own money have they invested? How can the small investor trust that his or her investment is viable just because a large investor invests, if they cannot be sure that the large investor understands what they are doing? This is why some of you have heard the saying that you should not invest in something you do not know anything about yourself. You have to be responsible for asking the right questions and assessing whether or not their experts are really expert. These are questions you must ask about each investment that you investigate.

The guiding principle for all business ventures is that any investment must earn more than its cost of capital for it to be worthwhile. Therefore, the more potentially profitable the venture, the greater the reasons for putting the capital at risk. Making a return on an investment usually requires investors to take risks. There is no reward without risk. As the risk of a potential investment increases, there is an increased probability for both higher profits as well as losses. So the risk is losing all that money. Hence the question, "can you afford to lose that money?". The goal of the investor is to select those projects where the probability of obtaining a large profit is greater than experiencing a loss.

When a business venture is conceived, a description of the proposed business and model is constructed and presented to potential investors in a document called the Business Plan. The authors of this document should take great care in developing their business model, creating a Pro Forma, which are financial projections, and writing the final business plan. However, just because a company has a Business Plan does not make it a good plan or strategy. There is the business plan document and the business plan itself and inexperienced investors tend to believe the two are the same. The business plan document is also their sales document so it may be biased due to their strong belief that the project is a fundamentally sound investment.

Financial projections can also be overly optimistic based on similarly rosy assumptions. As estimations in a business model are moved further out in time, their uncertainty will most likely increase. And then there are the financial projections which are all based on assumptions of revenues and growth rate. Those that rely mainly on numbers are going to have a problem if those assumptions are wrong or the market environment changes and the assumptions are no longer valid. Cost estimations will most likely be underestimated, rather than overestimated. Income estimations will most likely to be overestimated, rather than underestimated, and competition discounted or ignored. Hence financial projections should be questioned in much detail. Untested early stage technologies (without proof of concept) automatically have a significant risk or uncertainty because significant cost of R&D to scale the technology. The added costs due to the use of new technologies must be offset and much lower than the expected increased sales or profits and can result in higher up-front expenses such as required capital or construction costs that may not be factored in.

Some people believe that if a company is publicly listed, does that make it more viable? Is a company more credible or stable if they are publicly listed? Stock prices usually go up or down depending on what news releases regarding new technology is happening so share price is more linked to public perception and demand. Again, from my previous article, companies go public or list publicly to raise cash, offer liquidity to their investors (exit) or raise their profile and credibility to increase their perceived value. Also, for those of you who invest, either small or large scale, I may have mentioned before that by the time an investment has gone public, it has already lost much of its value. The reason for this is that by the time the general public can buy public stock, most all the money to be made has already been made by the private investors. This is one exit strategy by early investors to liquidate returns from their investment. An IPO is considered an exit strategy for investors. Did anybody see the BBC article about the London AIM being like a casino and that 30% of the new listings on AIM are gone in a year? Coincidentally, that article came out a couple of weeks after my article about unstable publicly listed companies and "Over-the-Counter" markets like the AIM. If not, here is the BBC article link:

Now about assessing management? How does one determine if an investment firm knows how to manage a company they have invested or even know what is considered good management to be able to recognize it? Does track record here have some weight and is a guarantee of future performance? Same question to a different aspect.

Emerging technologies, like nanotechnology, are exceptionally risky because of the potential for great returns so is an investment area which will continue to grow and earn a huge return on investment (ROI) for the right companies. To make money, you have to take educated risks. Increased knowledge reduces risk, but not necessarily profitability. Usually, more information gives you a more realistic assessment of the potential success of a business. The less you know, the more risk and uncertainty about the business and thus the investment.

How do you know the investors are asking the right questions to qualify an investment? If they are asking the right questions, you would probably expect a higher percentage of successes as well as a lot of money. You can make a lot of money but not have too many successes if the successes you do have are big. If you're not asking the right questions, then it's probably closer to gambling and luck. Then the monkey throwing darts at a stock list is as good at picking successful investments. Perhaps you should ask the investors what kind of questions they are asking for their due diligence and what answers they are hoping to expect.

2007 Pearl Chin - All rights reserved.

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