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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Very few entrepreneurs take the time to really study their company from the perspective of an investor. Those that do are often initially frustrated by what they see as a heartless and antiseptic assessment of the object of their passion and dedication. But, if they fight through those self-justifying tendencies and come to understand the investors perspective, they can substantially improve their chances of fathoming the process and, perhaps, of getting funded. The investor’s world is quite different from the entrepreneurs in many ways. But there are also similarities.

Similarities

The most notable of these similarities is the fact that investors, much like entrepreneurs, make decisions in anticipation of a future which may or may not actually come to pass. Investors know that projections of future results are not the same as future results. They know that estimates are just that. The best investors use all their skill and judgment to make investments that will have a high probability of generating a very significant return. But, no matter how good they are, none can truly see the future.

Investors, like entrepreneurs, plant a flag every time they commit resources. They decide to put down a marker on this technology, with this team and on these terms. Once they have committed, they do everything within their power to help their investment pay off. In doing so, they are taking significant risks. They expect very significant profits in the form of a high return on investment (ROI). Like entrepreneurs, they are in it for the payoff.

Venture capitalists tend to be industry specific. Much like entrepreneurs, they focus on industries that they know. Many investors pick an industry focus because of personal experience, education or the anticipation that it will provide good opportunities for profit. Most entrepreneurs to do the same.

Both investors and entrepreneurs are focused on building a reputation for success. Investors realize that their ability to raise subsequent funds will depend of the success of their current portfolio companies. The most successful venture capitalists have built a reputation for picking winners. As a result, they have raised a series of funds involving increasingly larger amounts of investment capital. Many entrepreneurs also look beyond their current company. They realize that a reputation for success will make it easier to fund a second or third company. These recidivist or serial entrepreneurs see their career over decades and as involving multiple companies.

Differences

The similarities pale in comparison to the differences. Bringing entrepreneurs and investors together is a lot like mixing oil and water. No matter how vigorously you shake the bottle, the mixture will, in time, separate out. But the fact that mixing these two perspectives is difficult does not mean that it should not be attempted or cannot be done. Both sides make efforts, some successful and others not, to understand where the other is coming from. Investors tend to see a lot more entrepreneurs than entrepreneurs see investors.

From my experience, the short-comings that often make the meeting of minds so difficult come from the founders. They simply do not put in the time and energy to understanding how investors think and what they consider a quality opportunity. The worst offenders are ones who rail against investors as stupid, lacking creativity, manipulative or arrogant. It is not just that this attitude, which you can track with a simple Google search, is insulting. For most investors, it reduces their interest in backing a venture involving such people and attitudes to zero.

My goal is to outline some of the differences between investors and entrepreneurs. My hope is that, by laying out some of these differences, I can help entrepreneurs better understand the vision and objectives of investors. Here are just a few of those differences:

Investors tend to spread their risks over a portfolio of companies. Even though they might group them within a particular industry, their approach to risk management leads them to invest a percentage of their funds in a number of companies. Unlike entrepreneurs, who have bet on a particular value proposition, in a defined market and with a specific team, investors diversify as a strategy. They protect themselves from losing all their funds because of one wrong decision by making a number of bets.

Here is how the average investor looks at the issue of risk management. Say they make ten investments over a period of two or three years. Their expectations are that at least two or three of them will prove very successful. The rest will fall into one of two categories. Either they will prove to be a total bust (and therefore written off) or limp along without managing the growth that was initially projected. The latter category is the most expensive for investors. They will need to become more involved in oversight and finding a way out of the investment. This approach to risk management is in sharp contrast to the entrepreneur who makes his bet on a specific technology, value proposition and team. Investors are more risk averse than founders.

When they look at a company, investors see opportunities for putting capital to work. They are far less focused on the inter-personal issues that take up so much of a founder’s time and energy. For investors, the company is primarily a set of spreadsheet projections, performance metrics and agreements which specify their rights and the returns they will receive under various possible outcomes. They will tend to tie the founder’s interest in the company to their ability to meet the projections. This can be a real shock to founders who, prior to funding, consider that they own the company and are offering a piece of it to the investors in return for equity. Most professional investors consider a fair first-round, pre-revenue valuation as the sum of the funds provided plus a small margin for the founders. Performance metrics may allow the team to earn-in to a very large percentage ownership, but it is performance (successful and profitable implementation) that determines that ownership.

Most investors do not want to actively participate in the management of their portfolio companies. In fact, there are real liabilities if they act is such a way so as to be considered part of the management team. Their job is to make investments and monitor the results. This is true for angel investors as well as venture capitalists. The best investors have not been drawn from the ranks of successful CEOs or founders. In fact, these types have not historically done very well. They tend to be much more intrusive when it comes to managing the company and much less professional when it comes to evaluating investment opportunities. A friend of mine refers to them as the ‘meddlers’.

Investors tend to have a much shorter time horizon. They are making the investment with the expectation of receiving a big payoff in the near to medium term. That means somewhere between two and five years. Their best results come through one or another type of liquidity event; a follow-on financing, sale, merger or public offering. In the best of all worlds, this event will ‘cash them out’ of the company. At minimum it will establish a higher valuation for their interest. Entrepreneurs are normally in it for the longer term. They maintain their interest in the company long after the initial investors have cashed out.

The core of an entrepreneur’s world is a value proposition that is focused on delivering a product or service to customers at a price that will cover expenses and generate a healthy profit margin. The companies that they invest in are in the business of monetizing that value proposition. Investors have a value proposition as well. In it, the entrepreneurs are the customers. Their value proposition is focused on providing investment capital prudently and under terms and conditions which will generate acceptable levels of profit. Although this might seem like a similarity, it is one of the defining distinctions between investors and entrepreneurs. Investors have one client per investment. The founders and team are responsible for delivering the results which will give the investors a healthy ROI. The investors’ focus is on making the investment under prudent terms and then insisting on the oversight and monitoring which will allow them to monitor progress towards the desired liquidity event. Companies have many clients. In fact, they need a growing customer base to be successful.

Investors, particularly venture capitalists, are normally managing funds supplied from a range of institutional investors. That means that they are managers of assets provided by investors who have decided to invest in their judgment and prudence. The source of their ability to make investments comes from others. Entrepreneurs are focused on creating value where none existed; using their own initiative, energy and skill.

Because investment funds are investing other people’s money, they are bound by fiduciary obligations to carefully scrutinize potential investments. They are incentivized to pick winners. Given the rain of applications received, they tend to subject each to a superficial screen. That first pass is designed to eliminate the requests that suffer from superficial faults. Only requests which are well presented and include a credible business plan with a detailed revenue and expense projection, use of proceeds schedule, detailed analysis of competitors and comparison of value propositions are considered. Of these, only the ones that have already successfully monetized the value proposition are likely to be considered seriously.

Investors are constantly bombarded with requests for funding. As a result, they tend to be in a defensive or highly selective posture most of the time. Their review process amounts to whittling down a range of potential clients. Many are eager to receive financing but few will qualify and meet the investor’s criteria. This process is generally time-extended. Investors are not normally in a hurry to make decisions. They prefer an orderly and extensive diligence process and negotiation. Entrepreneurs tend to want important issues resolved favorably so that they can move on to other things.

This brings me to the last difference I want to discuss in this article. Investors have standards which define an ‘investment grade’ opportunity. There are generally some very specific conditions which are essential before they will even consider committing funds. Here are just a few to consider:

The first of these is the demonstration that the team can successfully monetize the value proposition. To investors, that means delivering a product or service that clients have proved willing to pay for. Further, it means that the pricing structure leaves sufficient room to provide for overhead and a profit margin. Without this demonstration, most investors will not show much interest. They will gravitate towards those situations where the team has generated revenues and show that they understand the need to prove market acceptance.

Secondly, investors look to the composition of the team. They will be more favorable to a well-balanced, experienced team that has already demonstrated the ability to work together. Each team member will be scrutinized. Weak links will be taken as a sign that the CEO had poor judgment and weak team-building skills.

Thirdly, investors will look for assets that can serve as collateral in the event that the company is not successful. This may include founders’ guarantees, personal assets, intellectual property and assignment of ownership rights. This protection is their insurance policy against catastrophic loss.

Finally, investors will look to the structure of the investment agreements and the performance metrics that guide the allocation of ownership. Their objective is to protect themselves offer a wide range of possible outcomes. If the company is very successful, they will be happy to own a relatively smaller percentage of the equity. If it barely manages to stay afloat, they will want to own most of it. In situations that require follow-on funding, they will most often require close to 100% ownership.

Oil and Water

Mixing investors and entrepreneurs is truly akin to mixing oil and water. But, the challenge is greater for the entrepreneur who wants the funding than for the investor who already had the funds. If you are going to successfully arrange the financial resources that your company needs, you have to understand how investors think and what they are looking for in an investment.

© Dr. Earl R. Smith II

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Related Articles:

• The Money Chase: Should You

• The Money Chase: One Way to Avoid Being ‘Avoided’

• The Money Chase: Who They Do Not Invest In

• Funding Strategies for New Businesses

• Angel Investors to Avoid

• Angel Investors – The Good, Bad and Very Ugly

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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.

This entry was posted on Saturday, December 26th, 2009 at 12:11 PM and is filed under Advisory, Turnaround Management, Venture Capital. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.