In the course of our work with investors and entrepreneurs over the years, a number of lessons about the investing process have become apparent that can be helpful in various kind of industries and locations. Among them are the following:
From the entrepreneur’s point of view
✔ Seek investors for the long term. Seek investors who bring more than money. Seek investors who will be able to bring in other investors at a later date if that will be necessary. Be specific about what talents and qualities they bring before entering the deal.
✔ Be very careful about the valuation of the firm. A valuation that is too high may make raising money difficult. A valuation that is too low effectively reduces the amount that can be raised.
✔ The investors will perform due diligence prior to an investment in the company. Perform due diligence on the investors. Ask to talk with their current portfolio companies.
✔ Capital-raising will be an ongoing process, even if it’s only dealing with the investors that have been brought in. Plan on it.
✔ If possible, generate increasing sales and profits before seeking outside investors. It will make the negotiation process much easier.
✔ Assemble a competent and complete management team. Management is the single attribute of the company that is most important to investors. If that is not possible, be prepared to acknowledge its weaknesses and develop a plan or schedule for resolving them.
✔ Many successful entrepreneurial firms develop strategic alliances with major players in the industry for the purpose of marketing its products. The name recognition and experience of the larger partner will help in getting the product to market when the company is so young that it’s name is not likely to be well known and its industry contacts are few. Investors are often impressed by strategic alliances.
✔ Try to avoid a concentration of sales with a single customer if possible. Be prepared for contingency plans if that customer’s business fails or is given to a competing firm.
✔ Develop a business plan with the idea that it is a constantly evolving document. It will always need to be updated in some way. Do not prepare it solely to satisfy investors.
✔ Maintain quality business and financial records. Investors may avoid considering companies which cannot demonstrate clear and reasonable record-keeping as well as compliance with government authorities.
✔ The entrepreneur needs to be somewhat competent in all aspects of the business. Investors are likely to be impressed by entrepreneurs who are particularly knowledgeable about their customers.
✔ Demonstrate integrity in all of your affairs, both personally and professionally.
From the investor’s point of view
✔ The quality of management is the single most important ingredient in the investment decision.
✔ A venture capital investment is a partnership between the investors and the management. It is therefore important that management wants the involvement of the investors, not simply their capital.
✔ The goals of the investor and the entrepreneur need to be aligned — although not necessarily the same. They should discuss these early in the negotiation process to determine if their interests are compatible. Agreement on the need for and the timing of an exit is key.
✔ Quality deal flow is essential to having enough investment choices to make good decisions and create a viable fund.
✔ Due diligence requires an extensive knowledge of the business, its customers and its suppliers.
✔ The ability of the entrepreneur to penetrate the market (through distribution, direct sales or strategic alliances) is key.
✔ A minority stake in the firm may be preferred. It gives the entrepreneur the incentive to work hard and make the right decisions. If the entrepreneur is not qualified, even owning a large stake in the firm may not be enough to make it a profitable deal.
✔ Exit opportunities are difficult in both developing countries and the US.
✔ The most likely exit opportunity may be a strategic sale. The investor needs to be prepared to “open doors” to make that happen.
✔ A minority investor may need protection against sale of assets, excessive compensation of executives, payment of dividends, etc.
✔ The valuation should be discounted if the investment is perceived to be particularly illiquid.
✔ Even if it’s necessary to help in preparing the business plan, make sure that the entrepreneur is deeply involved in the plan, rather than outside consultants.
✔ Problems with valuation may be remedied with earn-out provisions. The investor agrees to give back shares (i.e., accept a higher valuation for the company) if the entrepreneur is successful in meeting milestones related to sales, profits, etc. after the deal is completed.
✔ The IRR of some investee companies is likely to erode over time. Seek portfolio companies that can provide a 30% IRR in order to achieve 20% for the fund.
✔ Seek gross margins of 50% or more wherever possible.
✔ The most difficult investment decision is the second investment in a company that has not performed up to expectations. “Good money after bad.”
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