In the first article in this series I offered a general definition of ‘investment grade’ and discussed the first issue that most investors look at. They generally start by asking are the entrepreneurs implementers or discusers? Most investors have had bad experiences with founders who are ‘all hat and no cattle’. The second screen that most investors use is a close evaluation of the value proposition that the company is based on. They are interested in sustainable margins and scalability. Investors want to see that the value proposition has been market tested and has resulted in a growing list of referencable customers. This helps the investors answer a series of fundamental questions such as:
- Is the company in a space that interests us?
- Are the founders dedicated to implementing the business plan?
- Do they understand the space they are working in?
- Do they have customers or markets?
- How adaptable and agile have they been?
- How determined to succeed are they – before they get our money?
- How compelling is their value proposition?
- How well do they understand their competition?
- What are the tracks in the snow and how do they augur for either success or failure?
Once those two screens have been passed, wise investors turn to evaluating the team that the founders have assembled. Strangely enough, this is one of the areas where founders fall down rather badly. Many teams are cobbled together out of the people who happen to be in the room. Sometimes these people receive inordinate amounts of equity in the company and they are almost always given titles that are far above their capabilities. Good investors are likely to analyze any team in a more exacting fashion than it has ever been assessed before.
Investors are looking for ‘investment grade’ teams and pay close attention to each member of the team. They work hard to identify these teams and will go an extra mile or two with them. Many entrepreneurs slap together a team out of people that are conveniently available. Often they focus on the part of the team that is closest to their own area of interest and experience. The other functions are ‘casually covered’ by amateur add-ons. They then often try to cover the weakness with high-sounding titles; Chief Financial Officers who are really controllers, Vice Presidents of Human Resources who are really recruiters. Investors generally sense if this is the case and avoid serious discussions. Their aversion is easy to understand. Entrepreneurs who take this approach are more likely to be gamblers who take the easy way around unfamiliar challenges. A highly professional team is the mark of founders who have taken a serious approach to seeking out and bringing on board A-level talent. It is important to remember that the team is one of the first assessments that any investor makes.
- Resourcefulness: This is such a key part of any successful start-up that it is hard to understand why so many founders do not focus on it. Resourcefulness means getting every advantage out of the resources at hand and exceeding expectations through that effort. It involves a focused and disciplined use of the sweat equity that is so central to any new company. It also means creatively tapping into pools of resources, financial and human, that can move the company forward.
- Uniform Strength: Investors look for ‘holes in the team’. They are particularly sensitive to a lack of business experience. One of their nightmares is investing in a research project that never even begins to monetize the value proposition. Early indications that this might be the case are often discovered by reviewing the background and experience of team members who are not directly associated with the underlying technology. Sometimes these functions are not covered. One presentation by a group of programmers comes to mind. The team was completely made up of programmers. When asked about the business model or projections, they responded dismissively. The investors responded in kind. A well balanced team will have high quality members who bring experience in the business of business. Any company is, after all, first and foremost a business.
- Experience: Investors have a number of types that they are always on the lookout for. One is the serial failure entrepreneur. If a founder has had a series of failed attempts to start a business, investors are not likely to provide funding for the latest. They take it as a weakness that the prior attempts have resulted in lost resources and funding. A second type is the ‘entrepreneur’ who thinks that going into business is a way to get rich. This may sound counter-intuitive but it is, in fact, a good indicator of impending failure. Investors want to provide funding for founders who have a passion for the value proposition that their company stands for. For the most part, entrepreneurs do not get rich; at least not quickly. A third type that investors avoid is the ‘I was a consultant for years and now have decided to get into business’ person. Good investors take a long, hard look at the resumes of key team members. For them, the past is prologue. Successful entrepreneurial activities will give them some confidence that the founder and team have a good chance to build a profitable business.
- Skin in the Game: When investors evaluate the team, they put heavy weight on evidence that they have real skin in the game. That means more than their time and future prospects. Investors frequently hear the following, ‘we are committed to this company and will dedicate our careers to making it a success’. Of course, the fine print reveals that they expect to draw a salary and have their expenses covered. Investors see such proposal as really being, ‘hire me as a consultant with equity, and I will work as long as you pay me’. The root of failure for most funded start-ups is that investors have settled for exactly that; companies run by well-paid consultants. Teams that can demonstrate that they have significant skin in the game and are willing to have scarce financial resources used for other purposes than paying their salaries are prized by investors.
- Focus on Winning: There is a difference between winning and talking about winning. All entrepreneurs do the latter; most of them do it very well. Investors immediately set about sorting out the talkers from the doers. Talkers tend to become paid consultants and poor investments. Most experienced investors have had the experience of providing funds in the hope that talkers will turn into doers; in other words, they have lost money. So, how do investors identify the doers? They look for tracks in the snow. Doers are always doing and that is the difference.
- Board of Directors: Investors take the presence of a casually formed or non-existent board of directors as a sure sign that the founders are not willing to subject themselves to effective oversight. Most investors avoid entrepreneurs who see themselves as cowboys or ‘lone rangers’; in other words, ungovernable. They also avoid the self-righteous, self-certifying types who either cannot or will not learn and grow. A well structured and operating board provides a range of important services in addition to their fiduciary responsibility for protecting and extending shareholder value. Three of these are succession planning, compensation alignment and audit review. It is a mistake to assume that, simply because a company is early-stage, these services are not important. It may take a creative approach to involve outside directors; but oversight is essential to success. There is one formulation that investors are particularly averse to; the CEO who also wants to be Chairman. The combination of these roles is normally a bad idea, but, when the CEO is a relatively inexperienced entrepreneur, it can be a recipe for disaster.
- Board of Advisers: There are two kinds of advisory boards. One is focused on the technology of the company and serves as a strategic adviser to senior management and the board of directors. The second is focused on generating revenue and is populated with high-profile and well connected individuals who can reach and influence decision makers. Most investors see the first type as evidence that the founders do not have the depth and breadth of knowledge necessary to run their company. Some have seen trade secrets and competitive advantages leak out through such boards. It is the second type that really attracts investors’ attention. An advisory board made up of four to six very well connected, committed and experienced people, who are committed to pro-actively representing the company to key decision makers, is seen as an asset and indication that the founders know how to put together an aggressive business development team.
It is rare that investors will come to the conclusion that the team is exactly right; that it needs no ‘tweaking’. They will often suggest additions to or replacements for the team. Most investors also realize that a team needs to evolve over time; that the people who help get the company off the ground will probably not be the ones that take it to its first ten million dollar year. Teams are, by their very nature, dynamic organizations. Investors do well to make sure that the CEO understands this and can manage the very difficult balance between loyalty to those who have rendered service and loyalty to the needs of a growing company.
The Money Chase: What Does Investment Grade Mean? Part 4 – Projections
© Dr. Earl R. Smith II