Nov 112014
 

Page 1 Page 2

Dr. Earl R. Smith II
DrSmith@Dr-Smith.com
Dr-Smith.com

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

In the first three parts of this series I discussed major areas of focus for investors considering funding a company. Briefly, they were:

  • Implementation – Are the founders implementing or just talking about implementing once they get the funding?
  • The Value Proposition – How scalable is the business model, what are the margins and are they sustainable? Have the founders proven that they can monetize the value proposition?
  • The Team – Is the team balanced, experienced and operating as a team? Are there weak members? Are they a team or a gaggle? What are the tracks in the snow that show that they can build and manage a company?

Generally these and many more questions have to be answered satisfactorily before a professional investor turns to the financial projections provided by the founders. Amateurs will start with them, but this is more an indication that they are amateurs than anything else. Financial projections need to be analyzed within the context of well developed and tested knowledge of the team that is providing them. Otherwise, you are looking at a series of spreadsheets that may or may not be realistic or reliable projections of an achievable future.

Projections

One of the two most dangerous pieces of software is Excel (the other is PowerPoint). They support a shallowness of analysis and a facility with manufactured fantasies that result in presentations that seem sensible on the surface but have no direct relationship with reality. ‘Investment grade’ projections are well based in direct experience and connected directly to the monetization of the value proposition. When reviewing a presentation, investors pay attention to these issues to a greater extent than to the actual numbers on the spreadsheet. Consequently, the projections that come with requests for funding tell investors a lot about the founders and their team. Most investors pay a lot more attention to the structure and attention that has gone into producing them than the actual numbers themselves.

  • The Hockey Stick: There is something about this fiction that almost every entrepreneur feels a need to salute. It is a central part almost every business plan. Year one revenues are zero, year two a bit better and then, in year three, the hockey stick starts to kick in. To be fair, investors have done as much to perpetuate this fiction as entrepreneurs. It is almost considered required by both sides. Entrepreneurs are trying to establish a valuation that will cost them as little as possible for the funding. A valuation of a million dollars will yield a forty percent equity exchange for four hundred thousand. One of four million dollars will reduce that share to ten percent. But, of course, the valuations are completely fictional. There is a better way. The correct valuation for early-stage funding is the sum of the investment plus a small amount for the founders. Such an approach shuts down the con game. The founders are compensated according to their ability to deliver. Such an arrangement will contain an earn-in program that allows the senior team to accumulate equity based on performance against pre-agreed to metrics. These programs can allow the team to achieve controlling interest in the company. This approach has several advantages. First, it virtually assures that projections are achievable in the eyes of management. The days of ‘promoting’ investors into a deal using hockey stick projections quickly fades away. Second, the plan allows investors to maintain a steadily increasing value while splitting the value created by the founders and management between the two interests. Third, it establishes clear performance metrics from the very beginning; before any investment has been made. Fourth, such a plan will only be attractive to teams confident of their ability to deliver; paid consultants will wilt under the bright light. Finally, this approach melds the perspectives of both sides into a solid, working framework.
  • Use of Funds: Investors generally divide the use of proceeds schedule into two broad categories. The first includes expenditures which are directly connected with the development of a going business while the second lists overhead and related expenses. The latter category includes the salaries and benefits paid, expenditures for equipment and supplies not directly related to delivery on the value proposition and other ‘perks’ that the team includes. Most investors are very leery of presentations that show a very high percentage allocated to this second category. One extreme example was a ‘Use of Proceeds’ schedule that provided for full salary payments to a fully expanded team from day one. In this case the company was pre-revenue and not expected to generate revenue for the first full year. The investors regarded this team as ‘paid consultants’ and quickly came to the conclusion that the company could not afford them. Another example was a schedule that provided for purchase of sophisticated laptops and cell phones for the entire senior team. When asked why this expenditure was necessary, the response was ‘we need to establish a successful image’. The investor, to his credit, patiently explained that such an image was established by successfully generating revenue; then showed them the door. Good entrepreneurs understand that scarce financial resources should be used in ways that generate customers and revenues. Overhead is corrosive of that objective. Investors know this and look for teams that act on this wisdom.

    Page 1 Page 2

Sorry, the comment form is closed at this time.

Show Buttons
Hide Buttons