Dr. Earl R. Smith II

Dr. Earl R. Smith II
Managing Partner, The Federal Circle
DrSmith@Dr-Smith.com
Dr-Smith.com

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I am sometimes asked by investors to ‘parachute’ into a company and give them a quick assessment of conditions and possibilities. Most of the time, the company has been under-performing. Frequently the money that the investors provided has been spent and they are facing the need for follow-on funding. The investors want to know if additional investment is prudent. Generally I am asked to opine on four options: 1) shut it down, 2) sell or merge the company, 3) overhaul the team and value proposition and re-launch, or 4) make an additional investment and stay the course. My first steps are to prioritize those options and present a quick summary of the strengths and weaknesses of each. I also focus on the threats and opportunities that will most likely present themselves.

I divide the assessment process into phases. The first phase is designed to surface early indicators that might either eliminate the need for further investigation or focus the effort along one or two of the options. Many times, the first phase can be completed within two to four weeks. A presentation of findings and recommendations can then be used by the investors to decide whether there is anything worth saving and to chart, at a high level, a strategy for moving forward. Occasionally the decision is to shut down the company. At others times it is to find another company to buy it. Less frequently, the way forward is to invest further funds. Most often the decision is made to sketch out an overhaul of the value proposition and management team in preparation for a re-launch. This latter option can require a short-term investment of cash to keep the doors open during the strategic review phase but may be the best way forward.

The approach is hierarchical. It seeks to eliminate options one at a time; starting with the first one. Sometimes things have gone so far down that the only option is to shut it down. If there is nothing worth saving or the cost of saving the company would be much higher than any expected return, there are few options. If the decision is made to close the doors, the assessment is over and the clean up begins.

Most assessments reveal value that is worth protecting. As a result, the work continues. During this second phase, I use a seven-item screen to search for ‘indicators’. These are conditions that, should they exist, generally mean that one or the other of the options is indicated.

Unwarranted Hubris: I know this might seem like a redundant title. Generally all hubris is seen as unwarranted. In fact, it is generally seen as a highly unattractive tendency in both individuals and companies. But there is some hubris that is worse than others; and that is a hubris that rests on having accomplished nothing at all. It is entirely pretense.

I remember a recent presentation at an angel investor conference. The presenting team was completely unaware that they were making fools of themselves. Investors would ask basic questions. The responses were always inadequate and poorly thought out. But the team soldiered on. Their mantra was “we are a bunch of smart guys and will figure that out when the need arises”. Of course, most of the audience was thinking “if you are so damn smart, why didn’t you realize that you would need to have effective answers to these basic questions ready?”

Another company was full of this ‘change the world as we know it’ crap. They saw themselves as missionaries converting the ignorant. I remember a presentation that they gave to potential follow-on investors. Their basic message was that their likely clients were behind the curve. (The company was still pre-revenue) They, the super-team, were on a mission to educate the masses and convert them to the new technology. When one of the potential investors pointed out that their ‘ignorant likely clients’ were running successful businesses that made profits and had solid balance sheets, the team responded that ‘such success is no indication of anything’. The same realization was reached by every member of the audience at that very moment. The presentation was over even if the presenters did not realize it.

Sometimes this form of hubris is fueled by initial success or apparent success. A good example was one company that that developed a very innovative solution to a hard problem. That success generated a hubris that was magnificent to behold; if your stomach was strong enough. The problem came, of course, when the founders felt that monetization of their ‘gift to the world’ was far beneath them. Having spent the investors’ money, they had proven how smart they were. They did manage to forget that the investors were in it for a return on their money. But then, as the CEO said, “investors are just money grubbers”.

Hubris is a company killer. Once it sets in, it is very hard to eradicate. No logical conversation will help to mitigate the tendency. The habits of the management team will continue to destroy opportunities and increase costs. The behavior goes to branding and establishes the reputation of the company in the minds of potential customers. Arrogance is insulting and hubris is the worst kind of arrogance.

Too Much Talk and Not Enough Action: Business is all about monetizing the value proposition by getting customers to pay for the product or service. That is what investors really invest in. They want the team to turn concepts into revenue streams and manage expenses in such a way that profits are generated.

I am amazed at how many management teams fail to understand that seminal concept. Without customers, you do not have a company – you have a class project. I recently was asked to look at a company that had received and spent over ten million dollars from investors and were still pre-revenue. My initial interviews not only highlighted that fact but the underlying cause. Management understood that monetizing the value proposition was hard, would take a lot of work and would involve bringing all sorts of new skill sets onto the team. These were people that the management team referred to as foreigners. This meant dilution of their position and a short-term increase in the ‘burn rate’. They preferred to collect their salaries, spend the investors’ money and take the easy road. The problem came when the money ran out. The founders were convinced that the investors would put good money after bad to keep the doors open. They got two big shocks. First, doors closed and you’re fired. Second, here’s a lawsuit for negligence, fraud, misuse of funds and a bit more. The results, two personal bankruptcies with both founders now working as ‘consultants’.

In a second company, the CEO was always going on about how he had learned ‘hard lessons’ and how valuable that had been. His education had come at a very high cost. The investors’ money had been spent and his company was on life support. Several people who had tried to help him were now creditors with little chance of getting paid. Employees were receiving subsistence-level, partial salary checks. All the talk about ‘learning lessons’ masked the fact that the team had not been able to effectively monetize the value propositions.

A team that is not spending ninety percent of its time implementing, monetizing the value proposition and generating revenue does not understand what being in business is all about. Without that clear understanding, the team is not worth investing in. Too much talk and not enough action is a recipe for loss of investment. The bare fact is that this lack is easy to diagnose.

Once a team has settled into an implementation avoidance pattern, it is very hard to change their behavior. Most of the time major surgery is required. In a number of cases, wholesale replacement of the senior team was the only viable solution. The central issue is the preservation and enhancement of shareholder value. When that is threatened, there is nothing to do but make the substantial changes or liquidate the company.

The Blind Leading the Blind: Knowing your competition is one of the core requirements of any successful business. It’s not just about identifying potentially disruptive competition, (although that is very important) it means understanding what your competition is offering and how your company stacks up against those offerings. I am astounded at the levels of ignorance in some teams. The most extreme is the statement ‘we don’t really have any competition’. That is generally enough for me to shut down the assessment process and tell the investors that it is time to flush the toilet. Every company has competition and every value proposition does as well. Every company is competing for scarce resources, namely the customers’ money, and that always has a variety of places to end up.

A variation of this ignorance is ‘our competition is not nearly as good as we are’. I generally hear this from a CEO whose company is pre-revenue. He is almost always talking about a competing company that is turning a profit and has a history of success. His team is almost always pro-strategy and anti-implementation. And he is generally soon to be out of business and applying for a job at one of this ‘inept competitors’. The measure of how good you and your team are is to be found in your customer base. The one definitive indicator that a company is offering a value proposition that has merit is that they have found a steadily growing group of customers who are willing to pay for it. You build that customer base by outperforming your competition. The company that consistently wins new customers is better than the one that does not.

A good example of the importance of this knowledge is to be found in the federal government contracting space. Government agencies and the major prime contractors are under a great deal of pressure – both budgetary and otherwise. The sales process is highly ritualized and heavily monitored. Priorities are shifting; partially because there is a new administration and also because of major trends in the economy. Subcontractors who make their living supporting primes need to be aware of these pressures and trends. As conditions change, the requirements of the agencies and prime contractors evolve. Failure to adjust understandings can make a company seem out of touch. As an old friend sued to say, “Do not attempt tomorrow’s journeys using yesterday’s maps”.

The cost of not understanding your competition is very high. Management and the board need a thoroughgoing knowledge of the competitive space. They also need to understand the situations that their likely clients are facing. There is no substitute for that knowledge. Without it, it is literally the blind leading the blind.

A Culture of Entitlement: “We will get additional funding because we deserve it”. I call this the ‘little lord Fauntleroy’ or ‘little prince’ syndrome. We all grow through phases and one of them has us feeling that our parents are going to take care of us and that, as their child, we are entitled to that care. Part of the journey to adulthood is the realization that relationships between adults are based on recognition of individual preferences and needs and a negotiated settlement that recognizes both. An attitude of entitlement is essentially a return to childhood and an ego-centric focus on one person’s needs. In this case, it is the management team’s focus on its own needs at the expense of the needs of the investors.

The most insidious implication of a culture of entitlement is that the investors’ objectives are denigrated or ignored. Team members may give lip service but their actions consistently demonstrate that they have other, personal objectives that are higher priorities. The corrosive implication of such a culture is that the investors’ interests will always be severely subordinated to the ego-driven interests of the management team. Once a culture of entitlement settles in, it is almost impossible to change without wholesale replacements within the senior team.

Waste a Lot Have Not: Initially I comb through the income statements of a company. It is amazing how much you can learn by studying patterns of expenditures. The casual assumptions of what is appropriate or necessary to maintain the ‘image of the company’ gives you insight into how the senior team is viewing the question of conservation of resources. Some of these priorities are easily observed. In one case, the team bought each member a new laptop even though they were replacing serviceable ones. The same team purchased top-of-the-line cell phones with the most expensive service plans. When asked whether these expenditures would deliver a good return on the investment, the CEO responded as if the question was pure gibberish.

There is a lot of debate over what makes a successful entrepreneur but I suspect that there is one characteristic on which there is almost unanimous agreement. Good entrepreneurs make a dollar go farther and get more value out of it. They don’t turn one loose unless they have to and they don’t fritter away funds. I like to work with CEOs who are justifiably proud of how far they can stretch investors’ funds. Maybe it is the Scot in me, but I feel that such an attitude is one of the seminal indicators of pending success.

Good entrepreneurs hate the very idea of ‘burn rate’ while poor ones take pride in high burn rates. The attitude towards this concept is a handy indicator when you are trying to separate out the business builders from the venture-backed consultants. The most effective way to attack a burn rate is to generate revenues. Lack of revenues is generally a sign of a very dangerous dynamic; a management team that has neither the drive nor the ability to monetize the value proposition.

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The last two areas in my initial screen touch on the relationship between management and the investors. They are ticklish topics because they open the possibility that the behavior of the investors has been contributing to, and even supporting, the failure of the management team. Needless to say, I approach both of them very gingerly.

Performance Metrics: I begin looking for performance metrics from the start and always take their absence as a big red flag. The investors have provided funds to the company and metrics are the codification of their expectations. The initial charge may vary from ‘go forth and do great things’ to ‘here is the basis that you will earn-in to the company’. The first is an indication that investors have made a grant to the company. The second shows that the investors see the company as worth the total of funds invested until the management team adds value. There are, of course, lots of variations within these two extremes. But my initial screen is designed to determine whether there are any effective performance metrics in play.

To be very clear on this, the lack of effective performance metrics is an indictment of the investors’ approach to investing. Most management teams will prefer to operate without them if that is an option. Most would prefer to get their carried interest in the company with having to earn-in. I say most because the very best entrepreneurs insist on performance metrics and they are willing to tie their interest in the company to how well they perform.

When asked what the proper valuation of a start-up company, I always respond ‘the total investment in the company plus a small percentage for the management team’. This formulation is often a conversation stopper with both entrepreneurs and investors. I go one to explain that the best way to approach an investment in start-up and middle market companies is to deploy and enforce performance metrics that allow the team to earn-in. The formulas used should allow them to accumulate a very large percentage ownership in the company. Indeed, there are levels of performance that would make the investors very happy to end up with a minority interest. The question is how closely performance is tied to attainment of these results.

Performance metrics define the relationship and understanding between investors and the management team. The lack of metrics means there is no understanding; no matter what any other agreements say. Thoroughgoing metrics indicate a clear and well-defined understanding.

Governance, Oversight and Reporting: One of the most ignored corporate functions, particularly in start-ups, is governance. Oversight is the mechanism that investors use to keep track of the company’s performance and challenges. The lack of an effective board of directors and oversight is a condition that I frequently encounter. Investors attempt to engage in oversight through a range of alternative strategies, but none are as effective as a well run and populated board of directors.

Governance and oversight are actually a far more complex and subtle issues than it might initially seem. All investors rightfully insist on being involved in their portfolio companies. The real question is how and how much involvement. There are a number of approaches that I look for. All of them can have negative impacts on the company.

The Shadow CEO: This situation occurs mostly in start-up and middle-market, privately held companies and with investors who have had some success in their own right. An angel investor might insist on micro-managing the CEO of the company. The result is a form of castration. The CEO does not have the ability or authority to fill the leadership role. The team quickly realizes that the real power behind the throne is the investor. As a result, the team is dysfunctional and results suffer. Companies run in this way seldom prosper.

My Way or the Highway: I know one investor who reduces all of his investments to spreadsheets. He insists on detailed analysis and grumbles when the CEO or CFO does not know how to create complex spreadsheets. As a result, all of his portfolio companies suffer. There is little recognition that business is, first and foremost, about the team and teams are all about team members. The investor has a strong anti-humanist personality. Interpersonal issues are ignored and the teams tend to disintegrate. Another investor has a strong focus on product development but little patience for marketing and sales. This is mostly because her background is in the technology that allowed her to build a company and sell it out for a fat profit. But, as an investor, she confronts every challenge as if it was twenty years ago when conditions allowed such blind spots.

The Crazy, Rich Uncle: Another investor takes a ‘kindly uncle’ approach to ‘helping the kid get started in business’. Oversight tends to be a series of ‘firm conversations’ followed by another check. The investor, who built a couple of businesses and sold them, talks in terms of those businesses in their mature state. The lessons he delivers do not relate to the challenges that the CEO is facing. Lacking professional oversight, the CEO tends to tolerate the crazy uncle’s tendency to tell irrelevant stories as long as the checks keep coming.

When asked by investors about the best way to build a board for their companies, I always deliver the same message. “You stay off the board. Let’s find three potential board members who understand the space the company is operating in and let them provide oversight. They will report to you as shareholders”.

Protecting Investor Interests: Good governance is the key to enforcing performance metrics. Enforced performance metrics are the best way to avoid the problems discussed above. Protecting investors’ interest involves putting both in place.

From my experience, there is value worth saving in most portfolio companies. Some will not survive as a free-standing company. They will need to be merged into another, larger and more professionally run operation. Others will need major surgery. This is particularly true in cases where the core of the value proposition is very good but the management team is not the one to monetize it. I find this regularly in companies that have made strides in the past but are now stuck on a revenue plateau. The old saying ‘the people who got you here are not the ones who will take you to the next level’ is often relevant. It is rare that I recommend follow-on investment without alteration of the performance metrics and governance approach. Additional investment is a serious step and should be approached as an opportunity to ‘tighten up’ the understanding between investors and the management team.

In the advisory business there are lots of consultants who work with management teams. Their advocacy supports the team’s agenda. But there are few who operate as I do. I stand to protect the interests of the investors.

© Dr. Earl R. Smith II

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Related Articles:

• Moving the Ball

• The Cost of No Cost

• Lack of Accountability – The Core of Failure

• Death of the Hockey Stick

• Angel Investing – Hard Choices or Hard Times

• Angel’s Sins

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Dr. Smith is Managing Partner of The Federal Circle. The Federal Circle partners with teams and existing companies. We help them up their game and win big in the Federal space. We also arrange funding for acquisitions and expansion by acquisition. Our model is based on the belief that, if you select the very best and work with them in a highly professional and focused manner, the results will be truly amazing. He is the author of Amazing Pace: Turbo-charged Business Development – a book that shows how Advisory Boards can dramatically increase revenue. Dr. Smith is also the author of Dream Walk: Parables for the Living – a book of Raven Tales and exploration.

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