Jan 252010

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Dr. Earl R. Smith II


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.

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