The Money Chase: Oil and Water

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When they look at a company, investors see opportunities for putting capital to work. They are far less focused on the inter-personal issues that take up so much of a founder’s time and energy. For investors, the company is primarily a set of spreadsheet projections, performance metrics and agreements which specify their rights and the returns they will receive under various possible outcomes. They will tend to tie the founder’s interest in the company to their ability to meet the projections. This can be a real shock to founders who, prior to funding, consider that they own the company and are offering a piece of it to the investors in return for equity. Most professional investors consider a fair first-round, pre-revenue valuation as the sum of the funds provided plus a small margin for the founders. Performance metrics may allow the team to earn-in to a very large percentage ownership, but it is performance (successful and profitable implementation) that determines that ownership.

Most investors do not want to actively participate in the management of their portfolio companies. In fact, there are real liabilities if they act is such a way so as to be considered part of the management team. Their job is to make investments and monitor the results. This is true for angel investors as well as venture capitalists. The best investors have not been drawn from the ranks of successful CEOs or founders. In fact, these types have not historically done very well. They tend to be much more intrusive when it comes to managing the company and much less professional when it comes to evaluating investment opportunities. A friend of mine refers to them as the ‘meddlers’.

Investors tend to have a much shorter time horizon. They are making the investment with the expectation of receiving a big payoff in the near to medium term. That means somewhere between two and five years. Their best results come through one or another type of liquidity event; a follow-on financing, sale, merger or public offering. In the best of all worlds, this event will ‘cash them out’ of the company. At minimum it will establish a higher valuation for their interest. Entrepreneurs are normally in it for the longer term. They maintain their interest in the company long after the initial investors have cashed out.

The core of an entrepreneur’s world is a value proposition that is focused on delivering a product or service to customers at a price that will cover expenses and generate a healthy profit margin. The companies that they invest in are in the business of monetizing that value proposition. Investors have a value proposition as well. In it, the entrepreneurs are the customers. Their value proposition is focused on providing investment capital prudently and under terms and conditions which will generate acceptable levels of profit. Although this might seem like a similarity, it is one of the defining distinctions between investors and entrepreneurs. Investors have one client per investment. The founders and team are responsible for delivering the results which will give the investors a healthy ROI. The investors’ focus is on making the investment under prudent terms and then insisting on the oversight and monitoring which will allow them to monitor progress towards the desired liquidity event. Companies have many clients. In fact, they need a growing customer base to be successful.

Investors, particularly venture capitalists, are normally managing funds supplied from a range of institutional investors. That means that they are managers of assets provided by investors who have decided to invest in their judgment and prudence. The source of their ability to make investments comes from others. Entrepreneurs are focused on creating value where none existed; using their own initiative, energy and skill.

Because investment funds are investing other people’s money, they are bound by fiduciary obligations to carefully scrutinize potential investments. They are incentivized to pick winners. Given the rain of applications received, they tend to subject each to a superficial screen. That first pass is designed to eliminate the requests that suffer from superficial faults. Only requests which are well presented and include a credible business plan with a detailed revenue and expense projection, use of proceeds schedule, detailed analysis of competitors and comparison of value propositions are considered. Of these, only the ones that have already successfully monetized the value proposition are likely to be considered seriously.

Investors are constantly bombarded with requests for funding. As a result, they tend to be in a defensive or highly selective posture most of the time. Their review process amounts to whittling down a range of potential clients. Many are eager to receive financing but few will qualify and meet the investor’s criteria. This process is generally time-extended. Investors are not normally in a hurry to make decisions. They prefer an orderly and extensive diligence process and negotiation. Entrepreneurs tend to want important issues resolved favorably so that they can move on to other things.

This brings me to the last difference I want to discuss in this article. Investors have standards which define an ‘investment grade’ opportunity. There are generally some very specific conditions which are essential before they will even consider committing funds. Here are just a few to consider:

The first of these is the demonstration that the team can successfully monetize the value proposition. To investors, that means delivering a product or service that clients have proved willing to pay for. Further, it means that the pricing structure leaves sufficient room to provide for overhead and a profit margin. Without this demonstration, most investors will not show much interest. They will gravitate towards those situations where the team has generated revenues and show that they understand the need to prove market acceptance.

Secondly, investors look to the composition of the team. They will be more favorable to a well-balanced, experienced team that has already demonstrated the ability to work together. Each team member will be scrutinized. Weak links will be taken as a sign that the CEO had poor judgment and weak team-building skills.

Thirdly, investors will look for assets that can serve as collateral in the event that the company is not successful. This may include founders’ guarantees, personal assets, intellectual property and assignment of ownership rights. This protection is their insurance policy against catastrophic loss.

Finally, investors will look to the structure of the investment agreements and the performance metrics that guide the allocation of ownership. Their objective is to protect themselves offer a wide range of possible outcomes. If the company is very successful, they will be happy to own a relatively smaller percentage of the equity. If it barely manages to stay afloat, they will want to own most of it. In situations that require follow-on funding, they will most often require close to 100% ownership.

Oil and Water

Mixing investors and entrepreneurs is truly akin to mixing oil and water. But, the challenge is greater for the entrepreneur who wants the funding than for the investor who already had the funds. If you are going to successfully arrange the financial resources that your company needs, you have to understand how investors think and what they are looking for in an investment.

© Dr. Earl R. Smith II

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Related Articles:

• The Money Chase: Should You

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

• The Money Chase: Who They Do Not Invest In

• Funding Strategies for New Businesses

• Angel Investors to Avoid

• Angel Investors – The Good, Bad and Very Ugly

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Contact Dr. Smith

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The Federal Circle provides advisory services to companies working in the federal contracting space. Its core team and network of advisers has a deep understanding of the government contracting space. Together they represent a rich resource for companies trying to generate traction in these very competitive markets. Contact us for a free initial consultation.

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