Dr. Earl R. Smith II

By Dr. Earl R. Smith II & Marty Secada

Between us we have close to sixty years of working with start-ups seeking venture funding. Over that time we have noticed patterns – most of which lead to failure – in how founders approach the process of presenting to venture capitalists and attempting to arrange venture funding. In this column we will describe Gap Analysis - an approach developed to help focus presentations and significantly improve their chances of success. We will also briefly describe programs designed to significantly improve the chances of successfully arranging funding by combining this important tool with red teaming venture presentations.

The New Terrain

The investing terrain has changed markedly since the 1990s. Most literature available is out of date and does not tell the current insider’s story. Many of the changes have occurred due to the internet, others due to more options available to the average investor. Some of the major changes are:

1) There are more communications between potential investors. When a deal is presented a VC or other investor will ask who has seen it. If they know that person, they will send a quick e-mail to find out what they thought of it and why they did or did not invest. Angel groups and early stage VCs are heavily networked. There are many early stage angel networks. What you say to one gets relayed to the other.

2) There are fewer funds willing to do small deals. Though there is more money than ever, funds are doing fewer but larger deals. This does not mean that valuations have increased. A company that would support a $3 million valuation last year or 3 years ago will still get the same valuation today. But a three million dollar investment is less interesting to most VCs. Instead they are doing later stage, lower risk investing.

3) The money is smarter. Organized private equity groups, at the earliest seed stage - angel investors - are sophisticated. They perform due diligence and offer terms similar to VCs for smaller deals. In many ways they have become mini-VCs. And they communicate with each other as well. As founder of the Wharton Angel Network, Marty has several angel groups on his rolodex and direct access to the Kaufman Foundation which runs the Angel Capital Association. The best of our peers operate similarly.

4) VCs are only one of many ‘alternative investments’ available to the investing public. In 1999, VC capital represented half of all private equity investment in the U.S. and was about 25% the size of the hedge fund marketplace. Venture capital currently represents less than 15% of all private equity funds and is dwarfed by the $3 trillion hedge fund industry, which is an industry based on making less risky bets on investments.

5) Today the overwhelming majority of early stage investing is done by angel investors. This group covers a broad range. Some are organized into groups which are topically focused. Others are free standing investors. As the University of New Hampshire’s Center for Venture Research reports, angels invest primarily and heavily in early stage companies. The total number of VC investments is less than 3000 annually with an average investment in excess of $7 million. In 2004, VCs invested in less than 175 deals seeking less than $2 million. There are more than 50,000 angel investments annually totaling more than $25 billion.

The business of arranging venture funding has radically professionalized over the last decade. In the pre-bust days it was often enough to have a sexy idea. Increasingly venture capitalists require that presenters not only understand their own business model but the business model of the investor as well.

We regularly hear stories from angels about the inability, or the unwillingness, of founders to view their company through the eyes of an investor. Whereas before a measure of the professionalism of a group of founders might be limited to their knowledge of their product, business model, value proposition and exit strategy, today’s founders have to adopt a much more sophisticated view. Increasingly there is recognition that the interests of the investors do not map exactly to the long term agenda of the founders. As a result, founders must understand their business from multiple points of view.

Shortcomings in this area often, and tragically, show up during an initial presentation to potential investors. Monocular understanding of the process almost always results in presentations which do not adequately address the investor’s concerns. We have found that a gap analysis and red teaming review prior to these presentations can have a significant impact on a company’s chances of successfully arranging funding.

Gap Analysis

As Earl mentioned in his recent article, Red-Teaming: Improve Your Chances of Getting Funded, the Venture Capitalist environment is a tight knit community. Of all the small worlds this is one of the smallest. Most of the major players know each other and many exchange impressions frequently.

In response to recent history, VCs have become even more specialized and risk averse. The total field of investors who would be interested in your presentation may actually be quite small. Early stage investors often invest on an infrequent basis. If you miss their investment cycle it could be some time before they are ready to invest again. So when you go to pitch, it is best to be as well-prepared as possible. You may not get another chance.

Since the 1990s venture investors have become more focused on professionalizing their decision making process. As a result, there are far fewer ‘off-the-cuff’ decisions being made. The standards for analysis and decision making have become much more finely developed. The decision-making cycle has lengthened and become far more detail oriented.

The good news in all of this is that the rules are much better defined. The bad news is that presenters who aren’t aware of or do not follow the rules are likely to fail no matter how good their value proposition is.

Gap Analysis is used in this article has several facets.

• How do you find an interested investor?
• Where can you find information about that investor?
• How do you qualify the investor for your needs?
• Once you have qualified them, what information do you need to give them to win a face to face meeting?
• What do you present to them during your meeting?
• How do you manage the Q&A with the investor?
• Once the investor has decided to perform due diligence, what information must you provide to them?

If the investor is interested in investing in your venture, how do you negotiate the terms?

Finally, Gap Analysis refers to the growing gap in knowledge, specialization and opportunity between investors and entrepreneurs, in particular those entrepreneurs seeking funding for the first time or who have not sought funding for more than five years. If the entrepreneur’s presentation misfires, the venture may never get funded. It is a new world and current knowledge is critical to success.

A key consideration in Gap Analysis is the role of time to market. Most gaps can be filled over time, but if the team’s time to market is longer than the entrepreneurial window, the opportunity will disappear and the investors and entrepreneur will lose their money.

Although the investor will lose some of their funds, it is highly likely the entrepreneur will lose far more since the venture not only represents their assets but also their livelihood. It is essential that a gap analysis be done early on and that the surfaced issues are resolved expediently.

Gap Analysis is a review of a proposed presentation from the perspective of the potential investor. It

* Identifies those areas which are not well-conceived by the entrepreneur.
* Analyzes the proposed responses to well known threshold questions.

The analysis is done from the perspective of the investor by people who have extensive experience in the venture investment space.

Some Classic Mistakes

In order to have a funded venture, the founders must establish credibility and integrity with potential investors. In presenting to investors each statement the founder makes, including their marketing and financial figures are looked upon as a promise by the entrepreneur of what they will deliver to the investor. The investor will then perform due diligence using a host of topic experts and web based or other business databases to validate those statements. Investors seldom reject a deal outright, they just stop returning phone calls or ignore the entrepreneur. The more invalid statements made by the entrepreneur, the further to the back of the queue they are placed by the investor.

The best VCs are pros at sniffing this kind of thing out and avoiding founders who try to substitute BS for substance and experience. They are ever on the alert and take such statements as a red flag. Most of them have a series of threshold questions designed to identify founders who are not able to see the difference. Here are just a few of the most common classic mistakes that presenters make:

* They don’t speak my language: We often encounter situations where the entrepreneur could not, or would not, speak the language the investor understands. One of the most classic shortcomings is that presentations are often couched in the language of the company rather than the language of the investor. That is not to say that investors are completely uninterested in the vision that the founders have for their company. But the angel investors are along for only part of the ride and expect to be cashed out early in the company’s history. That means that the investor’s perspective is inherently short term when compared with that of the founders.

* They don’t understand what is important to me: Presenters often focus the short time they have with investors on trying to convince them of the merits of their product or service rather than how they will make money from the product. For the most part an interested angel investor will have, prior to the presentation, decided that the team’s ideas are worth considering. They want to hear about implementation and how their investment is likely to fare start to finish. Investors think in different terms, operate within different horizons and analyze an opportunity in a language which is different from the one which the founders have used to develop their company. When founders ignore this, the result is most often a meeting of miscommunications and frustration.

* Wrong Focus: A team of founders begins to develop a reputation with the first presentation and that reputation can spread with lightening quickness throughout the venture investment community. Most often negative reputations are earned by failing to adequately understand, and prepare for, the process from the investor’s point of view. Presentations are often incomplete, do not address threshold questions, focus on the product rather than the investment or simply assume that the investor will fall in love with the inevitability of the company and fork over a check.

* They don’t understand that everything is important: A bad presentation or perception may create a negative reputation for the founders. Everything matters for the 30 to 90 minutes the entrepreneur gets with the potential investor - from the tie worn to the graphic used on a slide or a joke made which doesn’t resonate with the investor. This is a serious business and teams which don’t seem to realize this fact do not fare very well.

* Self-delusion: Founders are expected to be experts on their value proposition and market. Teams who look to bully their vision on a potential investor or are perceived as zealous without knowing the breadth and depth of the marketplace frequently do not get funded.

* Knows the product but not the market: Investors are interested in knowing the size of the market and what part the founder will carve out of it and how. There is a science to this that the investor knows well with a network of subject matter experts. The less the founder knows about the market than the investor, the more likely they either will not get funded or will not receive favorable investment terms.

* Weakening your position: Fax or e-mail blasting a deal can often age it before you ever get a chance to present. It is a bad idea to market your presentation to a broad array of uninterested investors. It is best to find the handful of investors that will be interested in your venture and present to them.

* Closing the deal: To negotiate the best terms, it is ideal to have more than one investor engaged. But the etiquette in this area is important and founders often damage their prospects by transgressing. In one case, an angel investor offered an immediate investment only to be stalled by the entrepreneur who told them to come back in 6 months. The next week, the angel invested in another company.

Finding & Closing the Gap

Gap Analysis highlights shortcomings through an organizational, execution and strength and weaknesses analysis. It focuses on the gap between the materials developed and presentation skills of the founders and the expectations and needs of the investors.

Gap analysis considers questions such as:

• What investors are interested in my product?
• What are their expectations when they meet me?
• Does my product fit into their selection criteria?
• What are their deciding factors for investment?
• How well does the entrepreneur present to an investor or a group of investors?
• How well does the entrepreneur prepare for that presentation?
• What are the key points to make to the investor in the allotted time with them?
• Once introduced to an investor, what is the typical time-line for investment?

Fortunately, once gaps have been identified the team can set about closing them. Frequently this process is beyond the skill sets of founders. Because of the high stakes involved, the team should get assistance from professionals before making presentations to VCs – or before the funding opportunity is closed by others.

Gap Analysis Programs

Our gap analysis and red teaming programs involve three phases. In Phase One a group of founders are introduced to the process of gap analysis and schooled in the critical issues affecting their chances for being funded. The purpose of this first phase is to help founders identify and close gaps in their presentations. The program results in a gap analysis of their company and presentation.

In Phase Two we build on the results of Phase One by providing a real world, red teaming experience for selected team. Phase Two simulates an actual presentation to a group of angel investors. Founders present to an experienced panel of investors and advisors. The presentation is followed by a critique and one-on-one coaching for presentation improvement.

Phase Three is offered to teams which graduate from the Phase Two program. We supply customized ongoing support for teams as they identify potential investors, schedule and make presentation and negotiate funding.

© Dr. Earl R. Smith II, Marty Secada

Dr. Smith is a senior advisor to companies and CEOs (http://www.dr-smith.info/) Marty Secada is Managing Director of Broad and Wall Consulting (http://www.broadwall.net/).