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A Lesson In Startups with Steve Baxter, Transition Level Investments.

Steve Baxter, founder of Transition Level Investments spoke to The Constant Investor recently about his portfolio strategy and shooting zombies.

Steve Baxter has been an entrepreneur since the age of 23 and he’s now a ‘Shark’ on Channel Ten’s ‘Shark Tank’. The reason we want to talk to him is to get some lessons in investing in start-ups.

He’s invested 12% of his net worth in start-ups and he reckons that’s probably about right. Start-ups requires a different sort of approach to other things and you certainly need to be patient because you’re not going to get a lot of liquidity with them, you can’t sell easily and you can be stuck in there for a while but it can be really rewarding.

Here’s Steve Baxter to give us a bit of a lesson in start-ups.

Well, Steve, what’s the main difference between investing in start-ups and established businesses do you think?

A start-up as I would define them, and there’s a bit of a terminology issue here, a lot of small businesses think they’re start-ups and then whilst they can look similar they typically aren’t.  A start-up for me typically leverages technology to grow extremely rapidly across the globe so they can grow fast on a global scale, the only way you do that is leveraging technology or something similar.  How can you double your business twice a year for five years?  That’s, to me, a start-up.  It’s a lot of typically very technically savvy teams finding problems that they can use technology to solve and to create solutions that customers want to buy and then testing that market.  The biggest thing for me about a tech start-up and investing in start-ups is to have a big wide portfolio because it’s also what I call a reasonably high mortality business.  A lot of these ideas don’t work, a lot of the companies die and that’s sort of part of the natural cycle.

It sounds a bit like it’s not necessarily a company that’s just started up. 

Well, we prefer companies that have some form of traction so they’ve proven something in the market.  We’d love traction to be profit but it usually isn’t, the next sort of traction we love is revenue, it sometimes isn’t, but usage we have one company right now who’s signing up 100,000 users a week to their online service.  We’ll figure out in the fullness of time how to monetise that, we haven’t done that yet, but 100,000 users a week and 4 million users at the moment so it’s that traction that we’re after.  I’ve only actually funded one company from an idea and that’s a company using artificial intelligence to help kill prostate cancer, or to help make prostate cancer survivable in the very early stages I should say.

You said that you need a big portfolio of them, how big?

By the end of this month we’ll have probably 27, we’ve got 24 at the moment.  We plan adding sort of three to seven a year, I suppose is our goal.  We’ve been going about this for six or seven years now so it’s about on par, of those we’ve got about eight that we like.  We’ve got three clear winners that have probably returned the rest of it probably two and a half times over which is quite nice.  You can win but it takes a fair bit of a patience and you learn as you go.  I think some of the ones that haven’t returned for me are some earlier ones so we learnt some lessons along the way, that’s for sure.

Do you think start-up investing is more or less rewarding than just kind of investing in the stock market?

I think investing in start-ups to me is more potentially financially rewarding.  We’re yet to have an exit that proves that, our book value has increased which is nice.  We don’t get liquidity though until something sells and that happens very infrequently.  On a balance sheet basis it’s done very well but we’re waiting to, I suppose, get an exit and get that liquidity.

I suppose that’s the fundamental problem, isn’t it, the lack of liquidity and particularly for people who aren’t professionals like you, that you can just get stuck in a start-up where you’re not in control of what happens and you’re relying on them to actually sell the business in order to get liquidity.

You’re dead right.  We rarely take big stakes in companies but we’ve inherited some big stakes from founders who’ve left it.  One we got 40% but that’s unusual, we’re typically sub-10% on a company.  Liquidity is tough to get, you’re after that exit event, you’d like it if they got profitable and all the rest of it but typically in these high growth businesses they can’t take every last piece of cash flow and continue the growth so you don’t see much fall through the bottom.

Do you think it’s viable to look at start-ups that are listed on the stock exchange?  A lot of my subscribers are more inclined to invest in ASX listed companies and a lot of those are cash burning start-ups effectively.  Do you think that’s a viable way to approach start-ups?

It’s interesting, isn’t it, that the start-up industry coined the term cash burn, it’s a disgraceful term, isn’t it?  What it pictures.  There are start-ups on the ASX, I’ve listed one on the ASX, I’ve listed a couple I should say, one tech start-up, I suppose you’d call it is still there.  I think regardless of the mechanism you use to invest the portfolio approach still must count.  You’re going to allocate a certain part of your portfolio to this start-up sector, that’s it, and then in that allocation you need to have all your eggs not in one basket so you need to have between 10 and 20 investments effectively I think across a portfolio because of the other properties of this type of investment in order to make sure you’re doing things wisely.

You mentioned that you’ve only got a small proportion of your family net worth in this portfolio of start-ups, how small is it?  What are we talking?

Mark to market I suppose cash invested is about 12%.

And would you say that’s a good proportion?  I mean, obviously it works for you but would you recommend it for others?  10%-15% proportion of your portfolio?

It’s what we’re comfortable at so I don’t know the answer to that, for me yes, it’s comfortable.  That’s actually capital invested so when we actually gross it up it’s actually more than that, given the style of investment we do we looked at it as highly risky and we could potentially lose it all which I think is a healthy approach to have.  I hate to call it like a day at the races but you sort of bring enough money into this that you don’t need in some respects because it all could just turn to putty, we could have a GFC, we could have a dotcom crash, whatever it might be and then you’re left stranded.  I’m not going to comment, that’s an individual choice.

Perhaps you can just tell us a bit about how you go about finding good ones, what’s the approach that you bring to it?

Get yourself on TV then they come and find you, Alan.  We tend to have a lot to choose from now but initially I – I did hang a shingle out through the press, I’d had a bit of success in a couple of previous businesses.  We actually spoke many years ago regarding a submarine cable, Alan, I’m not too sure if you recall that, the PIPE Network days.

Yeah, I do.

When I sort of hung it out there that I was looking for these types of investments they do tend to find you but that being said the people who want investment and come knock on your door are not the best ones to get.  The best ones to get are the ones that don’t need the investment which is a bit of an old hack term but it’s true.  My best investment is one I heard about around town that these four kids, two of which were Rhodes Scholars and there was a lawyer there and an MD, had this amazing learning management business kicking it out of the park and doing this and that, I thought it couldn’t be true.  We hunted them down, we found them, we stayed close to them until they wanted money and we started investing in them.  You’ve got to build your own network so there’s no shortages in Brisbane as I know in Sydney and Melbourne as well for example, and Adelaide and Perth, I’ve been to all those places, of these start-up events every week or every night where you can go along and you can understand the market, you can see who’s doing what, you can understand their progress, what traction they’ve got.  You need to develop your own network and find these gems yourself.

I’m interested in what are your criteria for choosing what to invest in, how do you go about making those decisions?  Not just how you find them but then what do you look at to make the decision to invest?

The biggest thing that we decide on is the team.  We have to really believe in the team.  There’s a lot of less than honourable people in businesses, you’re probably aware, Alan.  We have to really believe that the team has got the right business ethic as far as we can see that, that they’ve built a team that can actually deliver and typically with a tech start-up it means that they need core tech skills in their business, that they’ve found a problem that really is a problem and potentially people will pay to have solved.  After that the idea doesn’t matter as much.  Now, that’s a lot of throwaway lines I use when I’m speaking but that’s the core that we go forward at.

The number one thing you mentioned was ethics, that’s very interesting.

Well, that’s the first thing.  The average time between starting a business and the successful exit takes 8.7 years according to CB Insights.  If you don’t want to sit across the table from the person that wants a quarter and have a chat because you don’t like them or you think they’re crooks that’s a long time to sit.  You’ve got to fundamentally be able to operate with a person.  You don’t have to be best buddies and have barbeques but you need to be on the same wavelength in that respect for sure.

I think the cliché is that one in ten of them fail, is that kind of right?

If it was only one in ten I would be stoked.

Sorry, one in ten succeed, I had it the wrong way around, I mean one in 10 succeed, is that right?

It comes down to the…test.  In our portfolio people sort of say how do you manage that with companies and the reality is that we only manage the ones in the middle.  The ones who aren’t doing well and really haven’t proven that they have probably got product market fear or there’s a problem they’re actually solving or the ones that are failing effectively we can’t really help to be honest, for the most part you can’t tell them they’re doing something wrong.  The ones that are knocking it out of the park at the top if you get in their way you’re just going to slow them down.  We work in that middle band in our portfolio where we sort of say okay, you’ve still got cash in the bank, you’ve tried this and it hasn’t worked, you need to try something else.  We’d try and get them to burst through that wall and either they’ll break through to the top group of companies which are succeeding or into the bottom group to failing.  That’s I suppose how we conduct our portfolio post investment anyway.

I suppose one of the difficult things is for those companies that aren’t quite succeeding but they’re not failing enough to give it away and so they’re in this kind of no man’s land.

Yeah, we call them zombies, you have to shoot zombies, basically they’re the walking dead.  It’s tough, you don’t mind them so much and I’ve had founders where you pull them in and say guys, you really need to close this up, your marriage is on the rocks, you’ve lost your friendship, this is going bad for a reason and you’ve got to give them that sort of verbal slap in the face to actually say you’ve given it a good crack, thank you very much but it’s now time to move on and do something else and clean this up.  We’ve got good mechanisms in Australia for corporate clean ups, especially since the safe harbours and other bits and pieces, there has been some really good work there.  Get in there, reorganise yourself and if you want to have a crack again we’ll consider investing again potentially.  You really want to make sure they don’t waste their life on a sideways nothing business and really strive for something bigger.

It’s been great talking to you, Steve, thanks very much.

No worries, Alan, have a good one, thank you.


This interview first appeared on The Constant Investor and has been republished with permission.