Dr. Earl R. Smith II

Dr. Earl R. Smith II says:

Praveen Kumar wrote:

@Dr. Smith…

Glad to know that an example that came to my mind is one given by stalwart like you …

you are right about the baby example as well…..

and I must thank you for the statistics on marriage and investment…. I thought the equation was heavily tilted to the investment side

Dr. Earl R. Smith II says:

Walter Breidenstein wrote:

Praveen, I agree with your example quickly.

This is why I never accept the traditional VC model that gives you 15 minutes on the phone to pitch your investment. This analogy is not the best way to find a wife, nor is it the best way to find an investor. In my view the traditional courtship process is preferred where time and quality are take precedence.

However, I understand the VC is going to enter multiple relationships, and speed is the key. When you see 100 proposals a month to marry, you want to get through them as quick as possible since you know 90% of those marriages will fail, and the top 10% is what you know will make you money in the end.

Your example will not go over well with many who have a different view of how they “choose their mate” but I think yours is correct in my observation over the past 20 years. The only difference now is that they want 3-4 of their friends to join in the relationship so they don’t take all the risk when the marriage falls apart in the end…and the 15 minutes has been reduced to 10.

Dr. Earl R. Smith II says:

Praveen Kumar wrote:

@ Walter

Of what I have read so far in the discussion I would subscribe to your point of view completely… the way i see it is … Investor and enterpreneur relationship is like a girl meeting a boy and falling in love at first sight, dating and getting married.

When an investor is looking around with both hands full of money he has an some set guidelines and criterion accordingly to which he would want to invest. However, in the subconscious he is fond of certain aspects of enterpreneurship (promoters attitude, product or service portfolio etc.) that he has not included in his guidelines or criterion. A first generation enterpreneur is someone who believes in his idea or product and risks not only his little money but more importantly his career and family’s well being. He absolutely loves it when someone listens to his arguments on why the business is going to be successful and endorses it.

So when a investor finds an enterpreneur who does’nt fit in his guideline but appeals to his subconscious he expresses his excitement which in turn excites the enterpreneur. It’s like love at first site .. sparks fly.. heart races and gets filled with emotions.

Then after initial exchange of emotions and liking each other they start dating and finding out more each other in detail. After a while you know if your first impression was right or wrong and whether the things are as rosy in details as they appeared on the first sight. If thats not the case you part your ways. However if it clicks you go ahead and make your pitch and pop the ring.

The whole city comes to your wedding, eats and drinks and goes back to home. You spend some quality time on honeymoon(where you fund based on emotions). However, the dating thing was just an assessment the reality starts off now. You politely tell each other about things you don’t like and see if they can be moderated or changed completely. Again some marriages hold and others don’t. Some hold for few months the others for some years and some last for decades or lifetime.

So the risk is always there and your have to assess it in percentage and see if it is still less that the appeal of the business plan or the operational plan later. You have to have deep understanding of each others perspective and respect for each other’s view and you make small corrections/adjustments here and there when you see your marriage is more important that these small things. However, one sided understanding and adjustments also don’t last long. It has to be both ways.

Dr. Earl R. Smith II says:

Mohammed, Thanks for your comment. By far the easiest way to determine the interests of venture capitalists is to visit their website and review their portfolio companies. That will tell you a great deal about the spaces they are interested in. If you do some additional research, you can find out which funds have resources to deploy and which are fully invested. The more you know about a fund before you approach it, the better your chances will be to get funded. Many funds do use experts to analyze potential investments. for the most part, they do not publicize those relationships. They tend to be with people who they have know for a very long time and who have the experience and track record with the managing partners which would justify such trust. Dr. Smith

Dr. Earl R. Smith II says:

Kishore, My approach to valuation is out of pattern I will admit but it solves many problems that the old way of doing things cannot avoid. It is centered on two principals. The first is that the process should be collaborative and not adversarial. The old way puts the entrepreneurs in the position of pushing projections in order to retain as much equity as possible. That makes the projections overly adventurous and puts them as odd with the interests of the investors. Such an adversarial relationship is seldom therapeutic. The second is that arriving at the earn-in formulation aligns the interests of both sides. In the initial equity distribution, the founders will get a recognition of the value that they bring to the closing table. The key negotiation is the formula for earning additional equity. From an investor’s point of view, a realistic baseline will allow them to feel secure if the team cannot deliver. If the team makes the milestones, they will be happy with the agreed upon equity earn-in. If the team blows away those projections the investors will see a decreasing percentage interest but an increasing value of their investment – a smaller cut of a bigger pie that is more valuable than a bigger cut of a smaller pie. In order to achieve this arrangement, the approach of both sides needs to be collaborative from the beginning. Investors are generally receptive to the proposition on its face. Entrepreneurs need to come to understand the process and have the confidence that they will out-perform expectations. The resulting partnership will better survive the glitches that inevitably show up along the way. Dr. Smith

Dr. Earl R. Smith II says:

Kishore Jethanandani wroe:

I think this makes a lot of sense especially given that the value of an early stage project is hard to determine. That said questions are bound to arise when entrepreneurs are bringing tangible value to the table at the outset such as intellectual property. Granted the IP has not yet proved its worth in the marketplace, I don’t see how an entrepreneur is going to agree to zero share at the outset. Similarly, partners would have invested time to build a team, prepare a business plan and have some work done such as engineering designs. If investors are going to insist on something as tangible as revenues, then I guess we might as well go to banks or hedge funds.

Dr. Earl R. Smith II says:

Posted by Kishore Jethanandani wrote:

“When the focus settles on accumulating ownership based upon meeting or exceeding expectations, the tendency to develop unrealistic financial projections disappears”

I would think that this is the way to go to manage risk. Financial projections are really a shot in the dark. The focus should be really on milestones to be achieved to get there. But this rarely happens.

Dr. Earl R. Smith II says:

Kishore Jethanandani wrote:

Dr. Smith said: “OK, then tell us what you are looking for, how you determine value and what your investment criteria really are.”

I think this is pretty reasonable. There is no reason for entrepreneurs to have a problem with this kind of approach.

I will illustrate my issue with an actual case study.

I introduced one entrepreneur to an angel friend of mine. The entrepreneur had developed a medical device for the detection of breast cancer using optics. The device was tested in Russia and the initial results were encouraging. The angel, a Ph.d in life sciences, liked the product. It was clear that the device could be a game changer. The entrepreneur also introduced the angel to folks in a medical group who put in a good word and said they would be willing to try it in their own clinics.

The hitch was some problems the entrepreneur had with an investor in the past. The first round of funding went fine. Then the company needed more money. The investor then started issuing letters in the name of the entrepreneur’s company, without informing him, to raise money from the wealthy even though he was not a licensed broker. Things went awry and the investor proved to be less than professional and the company was charged for violating security laws. The matter was resolved by going into bankruptcy and taking out the investor.

Now the angel was not willing to have the entrepreneur to be a part of the management team. He wanted him to be a consultant. The entrepreneur was not willing to accept those terms and his point was that he had solved the problem. When he was later introduced to an attorney-cum-investor by the angel, he suggested to him to forget the angel and to do business with him directly. Needless to say, the matter ended there. The angel also bad mouthed the entrepreneur.

My question is: Was the angel being reasonable? This is not an instance where the entrepreneur had just a business plan to show. Could the management have been structured to retain the founder but put in enough checks to safeguard the investment?

The irony of it was the the angel kept saying that he liked the medical device and inquiring about the entrepreneur. Well, if you have burnt bridges, how do you restore them.

Dr. Earl R. Smith II says:

Walter, I think that you might find the approach more useful than initial reactions indicate. It is better to understand first then judge. It is not hard to include ‘intangibles’ in the formulation. I worked a arrangement where the founders ended up owning two-thirds of the company. They monetized, including the intangibles, and blew away the projections. There never was the tension that is so prevalent between investors (who have crafted unrealistic projections in order to retain a large chunk of the company ab initiao) and investors (who normally think they are getting hustled). In that case, the investors actually celebrated the regular reduction of their percentage interest in the company as the value of their holdings went through the roof. The point here is that some approaches to valuation inherently create conflicts between founders and investors while others do not. In the end, the successful entrepreneurs will benefit more from the latter and enjoy a more constructive relationship with investors as a benefit. Dr. Smith

Dr. Earl R. Smith II says:

dr-smith.infodr-smith.info

Walter, Thanks for the comment and for participating in the discussion. Most investors fit the description I gave. I do a lot of work with them and, as a result, have an inside seat. You raised a couple of interesting points. The first, valuation. My position is that the correct valuation for a start-up is the sum of money being invested plus a small amount for the founders. The founders will then have a progressive earn-in ability to accumulate ownership through meeting and exceeding metrics. I wrote about one of the major benefits of this approach in Death of the Hockey Stick: http://www.dr-smith.info/death-of-the-hockey-stick/. When the focus settles on accumulating ownership based upon meeting or exceeding expectations, the tendency to develop unrealistic financial projections disappears. That leads me to the second benefit. Plans based on this formulation are much more likely to anticipate glitches and provide for delays in meeting expectations – therefore the companies are more likely to have the resources to get through the initial years.. Finally, such an approach better serves as a basis for an understanding between investors and founders. Dr. Smith

Dr. Earl R. Smith II says:

Walter and Kishore: Early-stage investor attitudes have changed considerably since the bubble burst in the late 90′s. They are more demanding of demonstrated results as a precursor of investing. For the most part this is because they have had bad experiences with ‘promoters’ parading as entrepreneurs. Kishore wrote, “I really don’t see a point in going to an investor who expects a working product and a revenue earning project before they will invest. They should be able to tell ahead of time whether they have an effective team to deliver a viable business.” Although that attitude may make sense from an entrepreneur’s point of view, it is difficult to maintain if the investor’s response is, “I don’t really see a point in investing in a company that does not have a working product and revenue earning project.” The point of the article series is that successful entrepreneurs achieve funding by recognizing the legitimacy of investor standards and expectations rather than arguing against them. Investors have learned that the only reliable way to “tell ahead of time whether they have an effective team to deliver a viable business” is to look for teams that implement and monetize the value propositions reflexively. They have had too many experiences with teams that said “give us the money and we will begin to act like entrepreneurs” only to find out after the money is gone that they can’t. As a result of these experiences, early-stage investors are acting more like later stage ones. They are demanding that a team actually demonstrate that they can produce results prior to investing. I recently chaired a panel which focused on the expectations of investors and entrepreneurs. The discussion that followed the program provided a good example of how wide this chasm can be and how it might be bridged. The investors had little patience with packages which contained a business plan and a request for funding. One investor called them unprofessional – another lazy – a third referred to them as irrelevant noise. Of course, the entrepreneurs who put forth these packages took offense – but there were a number of other entrepreneurs in the room that seemed to be listening. For them, the question became, “OK, then tell us what you are looking for, how you determine value and what your investment criteria really are.” These were the entrepreneurs that the investors really wanted to talk to – entrepreneurs who recognized that investor criteria were closely related to the chances of their business being a success – not irrelevant chatter but real measures of potential success. The result of that program is a planned series of seminars. I have pulled together a panel to approach the core question – how do you improve the investment grade of your company. Panelists will discuss the business, legal and financial considerations and an investment banker will discuss value creation as he sees it. The goal of the seminar will be to provide audience members – CEOs and CXOs – with valuable insight and specific action steps that can help them improve the investment grade of their company and their chances of getting funded. The point of all of this is that the world has changed considerably since the late 90′s. Entrepreneurs who recognize and accommodate those changes are more likely to get funded. Dr. Smith

Dr. Earl R. Smith II says:

Walter Breidenstein wrote:

Dr. Smith, you wrote:

“I agree totally that entrepreneurs should seek out those sources of funding that are more accommodating but I also have seen that strategy lead to institutional investors who are more litigious and less experienced than some VCs.”

Litigation from institutional investors, or any investors, is the end result of an investment gone bad. As you know, it is very rare that a happy investor is ever going to sue the entrepreneur and the company. I think that litigation most commonly brought by institutions is because they have a business and investment model not to loose money, and be happy. The VC model is not likely to sue the entrepreneur because their mind set is different, and they expect to loose money on a vast majority of investments…hoping to score it big with a couple. Have you ever seen a resume of a VC which highlights all their great successes and brand names? I once asked one if he has a list of the deals he could provide of those investments that tanked with him given away someone else’s money, and the smile and silence said volumes.

Private equity and institutional investors are not out there looking for the big score, but rather using a much more balanced approach to nurturing the entrepreneur and growth if there is an active role, and carefully watching their investments if there is a passive one.

One point on litigation. I would encourage entrepreneurs and investors to use the services of mediation rather than arbitration when things go sour…since managing lawyers for both sides of a dispute can be difficult. Once I was working with a well respected American working in China that had been there most of his life, and he helped develop the mediation rules for the American Chamber of Commerce in Beijing. He told me that most internal disputes (where during his years nobody wanted to go to court in China) could be often easily resolved with third-party, neutral mediation, and not attorney driven arbitration. His examples were very consistent with my own experience working all over the world. The principle of mediation is sound, and I think many times there is no need for litigation except in the very minority of cases. Again, our society has been turned upside down with litigation as well, but that is another topic all together.

Dr. Earl R. Smith II says:

Jesse, Thanks for the comment. Every entrepreneur should learn the lessons you outline before entering the Money Chase. Even the first investors ask the questions you outline – ‘what have you done so far?” To object to them or not have good answers is to misunderstand the process completely. Dr. Smith

Dr. Earl R. Smith II says:

Jose, Some decades back I could say that there were significant and persistent geographical differences in the approaches of investors. But in this globalized world the differences, if they exist at all, are often fleeting. The internet and search engines like Goggle are the great levelers. Professional standards in the more advanced economies quickly spread to emerging markets. This is driven by the fundamental nature of investment. Investors provide funds and expect a significant return for taking the risk. the risks in emerging markets may be significantly higher than in established ones – so investors quickly become more sensitive to risk. Most experienced investors have been through at least one and sometimes many bubble bursts. They know that hype does not make for profit and that over-hype is an invitation to loss. Investors also know the value of government regulations and a reliable legal systems. They feel more exposed when these are not available. This also could push investors to be more cautious. Most emerging markets are fueled initially by the ‘fools that rush in’. Most of them loose all or most of their funds. The second and third waves are more cautious – and more professional. Dr. Smith

Dr. Earl R. Smith II says:

Walter Breidenstein wrote:

Dr. Smith, I agree generally to most of what you said. I’ve been an investor most of my life in many businesses, technologies and real estate. My experience on both sides of the transaction have given me a broader approach to value that is founded in facts about a deal rather than emotion. This does not mean, by any stretch, that I don’t appreciate the value of investor money, but I think the world has sort of been turned upside down in the past generation or three. What at one time was an investment into the company, based upon solid fundamentals, has turned into loading up legal agreements for one side of the table, and making it near impossible for the company to grow.

This is why I have and will continue to refuse any money from VC’s since their model is broken in my view, and when they use other people’s money they will not change until their investors get fed-up with the inferior returns for the risks.

Private equity in the middle market is the obvious smart money, and I see their terms becoming equally complex which will cause growth to be slowed. It is like the company who lives and breaths for quarterly reports and does nothing to offend the “market” with their earnings reports…even to the point of fraud. Which is all too common in the markets today.

Entrepreneurs need to wise up, and stay away from these money sources, and go after either long-term institutional investors (cutting out the VC guys) or look for money from China, MENA or other more reasonable investors who understand the value of long-term relationships, and are not so arrogant. I know it is a bit harsh, but people need to walk away from New York and Silicon Valley money and go outside the country for the smart money if they want reasonable terms, and to get ride of the early investors who make their lives and companies miserable to grow. I might end up deleting this message if I get hammered too hard on the forum!

Dr. Earl R. Smith II says:

Walter, Thanks for the comment. I hear that a lot from my entrepreneur friends and am guilty of the same in earlier times. Waiting for other people to change is like waiting to die – or like the proverbial ‘old man yelling at clouds’. The better way forward is to develop a more sophisticated understanding of how investors think and an ability to ‘walk in their shoes’ when putting together your pitch. That was my purpose in writing the series of articles. The better an entrepreneur’s understanding of the investor perspective, the better the chances that he will get funded. That is because he will understand concepts like ‘investment grade’ as legitimate investor concerns. Too many CEOs only see their company only from the entrepreneurial perspective and most of them fail or under-perform when it comes to funding. Dr. Smith