Dr. Earl R. Smith II

Dr. Earl R. Smith II
Managing Partner, The Federal Circle
DrSmith@Dr-Smith.com
Dr-Smith.com

The most the important difference is that early stage investors have to deal with a class of uncertainties that are much the better quantified in the later stages of a company’s growth. Their attitude towards risk aversion and the focus of their diligence can be quite different. Additionally, because there are no significant ‘corporate tracks in the snow’, these investors very often have to make ‘leaps of faith’ based on their gut feel.

In this article, I want to focus on some of the threshold questions that are almost always on the checklist of every early stage investor. Many of these issues will seem logical to founders but often the logic they see in them is not the logic that the investor applies.

Investment Focus: Most early stage investors specialize in a relatively narrow range of areas. They rely on their experience and expertise in these spaces to help them avoid major missteps and to identify those opportunities for major gains. For instance, I know of one very substantial group of angel investors that strongly prefers information sciences and the life sciences. Given this focus it makes little sense to present a consumer goods company to them. But as any early stage investor will tell you this ‘myth of fingerprints’ happens all the time

Often the investor’s web site will help identify investment preferences. But sometimes even the portfolios which are listed can mask decisions which the group has made. For instance, they may have historically had a preference for investment in a particular space but now, with a significant portion of their total deployed capital involved in that space, may have decided that enough is enough – that they need to diversify. Considerably more current intelligence is required to make sure that a team is presenting appropriately.

Let’s assume that the founders had done their homework or employed an experienced and well connected professional to help them target the right investment groups. Now they have a list of potential investors who are likely to listen with interest. But with that, the challenge has only begun. You may be talking to the right people but you may be saying the wrong things to them. So in that spirit, here are a few areas that are going to be of particular interest to the early stage investor.

The Founding Team: The days when the technology alone was enough to guarantee funding are long gone. In fact most early stage investors will focus on the founding team before they focus on the technology. This tends to be true for two reasons. The first is that recent experience has led them to realize that an early stage investment is first and foremost an investment in people. From their point of view, the management team needs to consist of very experienced individuals who can credibly execute the business plan being presented. Team members need to be able to modify the plan on the run and be battle tested in the chaos that always accompanies a start-up. They need to be the kinds of people who see their company’s growth in terms of critical yet achievable milestones to the next stage of funding.

This last point needs to be clearly understood by the founders. An early stage investor’s horizon extends to the next stage of funding. This event constitutes their first opportunity to either cash out or establish an increased evaluation for their investment.

Certainly investors will want to make sure that the team has a CEO that can lead the company through its early stages. They will also want to see significant experience in important skill areas. All of this can lead the founders to think that their horizons and those of the investors are coterminous. This is a serious mistake. Investors want to see a team which is passionately committed to building the company into a dominating player in its space. But they see themselves as only being a long for part of that ride. Their threshold question is “Are these guys going to make a good, relatively short-term and highly profitable investment for me?”

The Market: I recently heard an early stage investors say that the best decision making process for their group was anti-democratic. By that, she meant that when everybody in the group was ready to vote ‘yes’ on a particular investment opportunity it was probably not a good idea to make the investment. The most successful investments that her group had made were advanced and defended by one or two of her partners with the investment being made over the reservations of the rest.

Early stage investors by their nature prefer opportunities which are disruptive to existing technologies. They look for a ‘big idea’ in a relatively small but rapidly expanding market. They don’t tend to be attracted to marginal improvements which yield marginal returns. They’re in the business of betting on the nature of the next new world.

These investors tend to react negatively to certain mistakes by founders. Here is one quick example that might help illuminate this point. Although it happens less frequently these days many teams approach the question of the market for their product or services by estimating the demand on a global or national basis and then projecting a market penetration of 1% or 2%. The relevant section of the business plan would end with a statement something like if ‘we only get X-percent of the total market, we will have a billion dollar company’. But these days investors tend not to buy that logic. In fact they often see it as an indication of a lack of professionalism within the venture team. As one friend and experienced investor is fond of saying “amateurs have markets while professionals have customers”.

So, for these investors, the relative attractiveness of an investment opportunity turns on the attractiveness of the market combined with the ability of the team to implement. The size and growth rates within the market are important metrics. Investors also tend to focus on the industry structure, barriers to entry, customer switching costs, competitive landscape, behavior of incumbents, etc. Small markets seldom deliver the opportunity to build big companies. But neither do big, well established markets heavily populated by close-variation competition.

Remember when it comes to early stage investors ‘disruptive’ is an important word. Ideally the product or service being offered should be disruptive and unique. It should address a problem or meet a need in a truly innovative way and which establishes a clear and sustainable competitive advantage over presently existing solutions.

The Business Model: The model is the means by which the team explains how it intends to develop profitable, sustainable business. But there are a few more characteristics of the model which will draw the attention of early stage investors.

Most angel investors are going to want to see major impacts from the capitol they provide. They tend to prefer businesses and business models that are not capital intensive. They’re also attracted to businesses with high and sustainable gross margins. The combination of these two factors within a high growth market that can support a high, internally sustainable growth rate is the holy grail of early stage investors.

Entrepreneurs need to be incredibly parsimonious – conserving scarce resources while generating huge effects when they are deployed. It is important to remember that most early stage investors will have seen many attempts to implement similar business models. They will have seen teams fritter away resources ineffectively. They will not want to see their invested capital suffer the same fate.

Most of these investors see a business plan as a dynamic undertaking. The pristine logic of it is not nearly as important to them as the plans for implementation. Start-ups will go through very chaotic stages on their way to stability. Success in navigating these challenges will require a team which is agile and willing to completely a remake the business plan if circumstances conspire against the original approach. Investors become very leery if they suspect that a team is adopting an “our way or the highway” approach. In all early stage ventures, all business planning is provisional.

The Competition: This is one of those areas where many teams really drop the ball. If they are presenting to investors who have historically indicated a preference for investing in their space, they’re going to find themselves in front of professionals who may have a far more thorough going understanding of the competitive landscape. These investors may have seen many variations on the theme that the team is presenting. They may be familiar with alternative approaches to structuring and delivering a value proposition. They may even have seen similar proposals get funded and fail. Presenting teams would do well to keep this in mind and avoid either being dismissive of the competition or understating its potency.

The management team needs to display a mastery of the competitive landscape and understand both its present and future direct and indirect competitors. Their understanding should be based on extensive research and extended personal experience in the space. The team needs to establish a value proposition that gives it an advantage over the competition. But they also need to have a firm grasp on how that advantage is going to be sustainable.

The Exit Strategy: This is another one of those areas where teams need to operate on assumptions which clash with the objectives of the early stage investor. The liquidity event for the angel investor is almost never a liquidity event for the founders. The investors are interested in teams that can credibly build a company that will thrive and attract additional investment. Most of them will want to exit before the company’s liquidity event.

Early stage investors are in the business of deploying capital for a relatively short period of time and realizing significant gains through a near-term liquidity event which returns all or most of their capital. They will be happy to hear that the team has successfully built annual revenues of $200,000,000.00 and that the company has been acquired by a major public company – or that it has successfully arranged an IPO. In fact most will tell you that they favor management teams that have the ‘company building’ mindset versus the ‘build-it to flip it’ approach. But they expect to cash out early on and well before the company’s liquidity event. They have other early stage investments to make.

How to Get Ready to Present: Founders need to realize that investors think about their company in a completely different way than they do. Their request for funding needs to be presented within the investors’ frame of reference. Arranging the first round of investment is difficult enough without having it made more difficult by overlooking this fundamental fact of life.

Elsewhere I have written about the wisdom of arranging a professionally supervised red-teaming of a request for funding. I’d like to reinforce that suggestion here. Success in arranging funding is mostly about getting ready and only to a lesser extent about making presentations. It is 80% preparation and 20% execution. The risks of being unprepared are substantial and often can prove lethal to a company’s future.

The venture capital community is itself a tightly knit and interconnected group of professionals who regularly communicate with each other. They are dedicated to improving their results through professionalizing their decision-making process. The early stage investor community is a small part of the total venture capital community and even more tightly connected. Increasingly angel investor groups are behaving like the bigger venture fund managers. Their criteria for investment are tightening. Their expectations from founding teams are for more professional presentations as well as a more thorough going understanding of the company from the investor’s perspective.

Navigating these dangerous waters without an experienced guide is like running through a darkened room full of furniture. Do yourself a favor. If you are going to start looking for early stage investment, get a guide – listen, learn and improve your chances for success. Give me a call or send an e-mail and I will be glad to organize a time to discuss how you can significantly improve your chances of being funded.

© Dr. Earl R. Smith II

Related Articles:

• Lack of Accountability – The Core of Failure
• Angel Investing – Governance
• Financial Strategies – Some Basic Rules
• Red-Teaming: Improve Your Chances of Getting Funded
• Venture Capital – The First Meeting
• Gap Analysis

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 Tuesday, August 12th, 2008 at 8:30 PM 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.