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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In the first part of this series, I outlined the general characteristics of an ‘investment grade’ opportunity. I also described how the process can so easily end up being a waste of time for both investors and entrepreneurs.

Entrepreneurs frequently enter the money chase much too early in the game. They often start as soon as they have a business plan finished; if not before. Most presentations that investors see fall into this category. The results are beneficial to the investors because they get regular insights into developments within a space they find interesting. But the story is far different for founders. They end up making presentation after presentation without any progress towards funding. For many start-ups, this series becomes a death spiral. Founders end up spending more and more of their time chasing then having meetings which result in little but a polite “don’t call us, we’ll call you”. They get increasingly desperate as reserves dwindle and finally disappear. Finally run out of money, options and energy. Exhausted emotionally and financially, they frequently decide that it is time to ‘get a real job’.

I then discussed the very first focus of most investors; the implementation of the business plan. Investors are very leery of teams that write plans and then come to a full stop; hinging future actions on some event such as funding. Next I would like to discuss what it usually the second focus of most investor’s diligence efforts.

The Value Proposition

Most investors will next focus on the value proposition. Here ‘investment grade’ involves questions of scalability and sustainable margins. This is how business generates revenues and profits. In general terms it goes something like this; we will offer X at a price of Y to a defined customer base. X is important because it solves the following problems that those customers face. The value of the solution we provide exceeds Y. We have demonstrated that this is the case by already developing a list of paying clients. It costs us Z to offer the service. The difference (Y-Z) is our gross margin. Investors want to see such a formulation demonstrated by the team. Fictionalized descriptions of how good it is going to be post-funding are not going to impress them much.

• Established Markets and Customer Bases: The fascination with cutting and bleeding edge technologies that so dominated the buildup to the bubble bursting in the late 90’s is a thing of the past. Investors know that early adopters generally do not fair very well in the long term. They prefer investment opportunities that involve established markets and well established customer bases.
• Thoroughgoing Knowledge of the Competition: One of the common failures of entrepreneurs is that they do not develop a thoroughgoing understanding of their competition. With the advent of search engines like Google and Yahoo, it is very easy to establish a working knowledge of the competition. Most investors reflexively conduct such searches. The tragedy is that so many entrepreneurs do not. During many a presentation, it quickly became evident that the investors knew much more about the competition than the founders. They had two advantages. First, because of their interest and experience in the space, they regularly saw similar presentations. Second, they did the searches and analyzed the competition. An entrepreneur who presents in such an environment is almost certain to be shown the door; after the investors have added to their own knowledge of the space.
• Competitive Edges: Knowledge of the competition is only a first step. Once gathered, the information needs to be used to define the extent and durability of any competitive edge that a company might have. Successful entrepreneurs are very good at this process. The know how to dispassionately view their value proposition from the perspective of a potential customer. In the end, that is the telling challenge to any value proposition; will the customer choose it over the competing ones? The best way to accomplish such an analysis is to subject it to a SWOT analysis (strengths, weaknesses, threats and opportunities). A professionally drawn business plan will focus heavily on such an analysis. It will also document the systematic testing that went into validating the value proposition. Founders who have not done this will be considered not to understand the competitive environment that their company intends to operate in.
• Disruptive Technologies: One way to point out the potential costs of disruptive technologies is to generate a list of products and services which were at one time the basis of an industry but have now been overtaken by alternatives. For example, the vinyl LP was superseded by the eight track tape; only to be replaced by the cassette. The cassette fell to the compact disk which is now giving way to electronically transmitted music and information. The fax and copy machines are also examples of technologies that are giving way to a convergence of technologies. And how many remember the rolodex? Investors are looking for value propositions which will maintain competitive edges well beyond their participation in the company. Discovery of a potentially disruptive technology will be enough to turn them away; particularly if the entrepreneurs are not aware of it.
• Customer Validation: The most potent validation of any value proposition is customer acceptance. Most experienced investors will not substitute their judgment for the customers’. Until customer acceptance is a proven fact, presenter will be asking investors to do exactly that. Founders need to realize that such a request is likely to be declined. Investors who find a value proposition attractive may simply wait until they see a presentation by a team that has obtained customer validation. In the meantime they have received a free education on developments within the space.
• Margins and Overhead: Investors are very sensitive to how value propositions that might be commoditized. Commoditization means shrinking margins. Too many investors have had the experience of providing funds for a company that assumed their margins will either stay the same or increase only to find that commoditization has sharply reduced them. It is not sufficient to demonstrate that early margins will be substantial. If a company is going to thrive, it needs a value propositions which maintains margins and allows for controlled overhead. If, for example, a company will have to make substantial investment in ongoing research and development in order to remain competitive, investors will assess the team and its potential to stay ahead of the game. Technological advantages are very hard to maintain and easily lost. When lost, margins either shrink or disappear.

As you will no doubt gather from the above, the issues surrounding the value proposition are much more complex than a simple analysis of the product or service being offered against the possible pricing structure. Investors are very sensitive to the ability of the team to monetize any value proposition. The more progress a team has made in that direction, the better its chances of being funded.

© Dr. Earl R. Smith II

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Related Articles:

• The Money Chase: What Does Investment Grade Mean? Part 1

• The Money Chase: Breaking the Truce

• The Money Chase: Oil and Water

• The Money Chase: Should You

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

• The Money Chase: Who They Do Not Invest In

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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 Monday, January 25th, 2010 at 9:58 AM and is filed under Venture Capital. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.