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kill your deal! Although competitive analysis is far from an exact science, en-
trepreneurs must demonstrate a deep appreciation for present competitors
and future barriers to inspire investor confidence that they have a plan to re-
spond to inevitable challenges.
Typically, investors are interested in reducing the risk associated with the
investment by identifying investments involved in established or emerging in-
dustries. The ability to analyze financial projections is much easier for an ex-
isting industry because data are readily available in order to test the
hypotheses and other assumptions associated with the pro forma. However,
investors “swinging for the fence” are inclined toward growing markets or
markets that are growing at high rates. For early-stage deals, a fast-growing
market can be more forgiving if not more fruitful. The high profit margin po-
tential even if described in pro forma financials can be very compelling to the
angel investor looking for high returns.
Proprietary technology is important in reducing the investor™s perceived
risk in a venture. If you have developed a technology advantage, investors
will want assurance that you have protected it. From the investor™s point of
view, properly protected technology reduces risk in the venture. Intellectual
property protection in the form of patents, copyrights, or trade secrets do
represent legal advantages. However, because the deepest pocket often wins
25
The Solution: The Private Placement


in legal proceedings, most investors are aware of the shortcomings in patent
protection; of course, the investor™s appraisal can be influenced by advan-
tages in access to resources or customers, or from being able to exploit a
“first-in-the-market” positioning, or being first to enter the targeted market.
Does the product or service work? Has the designed service or product
demonstrated its function? Is there a working prototype, or are you still op-
erating at the conceptual stage of development? Obviously, the more useful a
service or product is, the more financeable it becomes. Also, is the venture
just a one-product company, or has management developed a plan to ex-
pand, and offer follow-on products to customers?
Another consideration regarding the financeability of your deal is
whether production can currently be performed. In other words, will it be
necessary to create not only a prototype and a product, but also the machin-
ery necessary to construct a prototype or product? Risk is significantly in-
creased”as are capital requirements”when the production facilities do not
exist to manufacture the product.
Channel economics demonstrates that the entrepreneur possesses an un-
derstanding of the cost of bringing a product or service to market. The key
word here is demonstrates. How will management distribute the product or
service? In detail, how will the company connect the product or service it of-
fers with the customers it is targeting? This question goes to the heart of how
management plans to sell and devise a detailed strategy and cost structure for
accomplishing its goals. The question asked by investors is how will distri-
bution be managed. Early-stage company entrepreneurs with their minimal
financial resources sometimes can lose sight of how important it is to clarify
distribution and cost of distribution to achieve the “hockey stick” projec-
tions in their financial forecasts!
High margins are always desirable to investors. They understand that it
will take longer than anticipated to bring a product or service to market, that
it will take more money, and that it will take longer to realize revenues.
Higher margins offset such adversity, offering a sorely needed cushion. We
estimate that 90 percent of all the ventures we review in our practice will end
up needing more money than has been presumed by entrepreneurs in their
business plans. This is precisely why sophisticated investors always discount
projections, or give “haircuts” to forecasts from entrepreneurs. Without an
understanding of the role that Murphy™s law plays in the development and
growth of a company, entrepreneurs are doomed by presenting unrealistic
milestones to skeptical investors, subjecting themselves to negative conse-
quences of missed deadlines, loss of investor confidence, even the role in and
share of ownership in the enterprise.
Post-Bubble risk profiles associated with financial attributes of the
venture must possess reasonable targets. Concerning above-average profit
26 THE CHALLENGE AND THE SOLTUIONS


potential, within 18 to 24 months, the company in its pro formas must
demonstrate with confidence the ability to generate revenue streams, if not
profits, that will position the investors to get not only a return of their in-
vestment but a return on their investment. There is a wide range of accept-
able levels of profit potential in deals that have been completed in the angel
market. But typically investors are looking for a real opportunity to realize a
20 to 50 percent ROI per year compounded annually over the term of the
hold of the investment. In our experience 15 percent of an investor™s private
portfolio accounts for 85 percent of returns, a slight variation on the Pareto
Principle, but noteworthy regardless. On an eight-year hold, investors aim
higher, but will be attracted by 35 percent per year returns, even when swing-
ing for the fence. The central point for entrepreneurs to understand is that
they must make clear, compelling cases that their venture will make money.
Investors must understand that your early-stage venture is not making
money now, but it is your job to convince them that you will make money
and be profitable within a reasonable time. This requires clarifying what will
drive revenues and costs, and thus margins. It is precisely the size of these
margins that create insurance for the venture to absorb unforeseen problems,
mistakes, and unexpected costs or slow-downs in revenue generation.
Capital intensity reflects the investment needed to prove to investors that
a product or service will work. In biotechnology, for example, companies
may spend years and invest millions of dollars before receiving Food and
Drug Administration (FDA) approval to market a product. Significant fi-
nancial risk before proof of concept is available reflects high levels of capital
intensity less attractive to angel investors. Research, development, and good
manufacturing process (GMP) of a growth hormone, for example, can take
up to seven years before permission is granted to test in humans”seven
years of preclinical testing to figure out if it works, if it is toxic, and if the
correct dose is being administered. Add a few more years of separate phases
of clinical trials to determine safety and efficacy. Then file a product license
application (PLA) and wait a couple of years for the FDA™s approval. Finally,
the company arrives 12 years later, having spent $200 million”the estimated
average cost of bringing one protein to market. Such is the burden and risk
that create capital intensity, and this example goes a long way toward ex-
plaining why highly capital intensive biotechnology ventures are less often
funded in the current angel market.
On the other hand, being able to develop and bring a product or service
to market quickly reflects a less capital-intensive circumstance. Investment
will come more easily once the concept has been proven, permitting money
to be used to move the product or service into the marketplace. Quick move-
ment to the marketplace spawns a less capital-intensive situation.
Valuation is necessary to assess the financeability of your venture. Based
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The Solution: The Private Placement


on the most current compilation of data available at the time of writing, me-
dian premoney valuations of seed rounds of completed venture deals have di-
minished to a range of $3 to $6 billion. First Round Series A median
premoney valuations are also down to a range of $9 million to $14 million.
Read any overview of market trends, and the entrepreneur will discover that
the aggregate dollar amount of investments has declined and the number of
“down rounds” is increasing. Entrepreneurs need to have reasonable expec-
tations when it comes to valuations from investors, and to avoid overshop-
ping their deal to attain unreasonably high valuation expectations. As you
consider your valuation, compare it with these statistics and others that you
can locate that are consistent and comparable with your venture.
As ventures progress in the evolutionary life cycle to later stages of de-
velopment, obviously the valuation will increase significantly. To raise
money during the early stages of a company, when its valuation is lowest,
more will have to be ceded to investors. This circumstance illuminates two
things that influence the financeability of a deal: The investor must feel that
the valuation is credible (in other words, it has to fall in line with valuations
occurring elsewhere in the market); and from the entrepreneur™s point of
view, valuation should be based on achieving milestones so that more money
than is presently needed is not being raised. This prevents giving away more
of the company than is necessary when it is at a low valuation.
A clear and believable exit plan must be part of the picture. Investors
who invest in companies directly, in most cases, will not be able to harvest
their investment (especially in equity investments) until those equity invest-
ments are liquidated. And although a number of workable liquidation op-
tions exist, the plan for liquidation must be explicit. The investor must know
whether liquidation will occur through a “claw back””a sale back to the
entrepreneur”or through the merger or acquisition by a public company
and the trading of that illiquid stock for publicly traded securities.
Liquidation may also occur through the sale of the company to other entre-
preneurs, or through an IPO.
Simply declaring that one of these days the company will go public falls
well short of an investor™s expectation because most investors realize that
few companies go public. You need a realistic plan for liquidating the invest-
ment, paying it off, and/or providing for ROI to the investor. In the venture
capital industry™s portfolios, more than 6,000 companies owned by venture
capital funds await IPO™s, merger, acquisition, or sale. Imagine how long this
“overhang” will take to liquidate if it is not written off. The downdraft on
exit in the venture capital industry is estimated to last a minimum of five
years! The IPO market remains moribund, with the lightest new offering
market in 10 years. According to Thompson Financial, there were 510 IPOs
in 1999, 373 in 2000, 108 in 2001, 97 in 2002, and 88 in 2003. If you com-
28 THE CHALLENGE AND THE SOLTUIONS


pare these statistics to the more than 5,000 IPOs in the 1990s, you will ap-
preciate why investors roll their eyes when the entrepreneur says he will re-
turn their investment with an IPO.
The second exit factor to consider is the implication of the amount at
which companies go public or are purchased or sold, and the implications
such amounts have for investors™ targeted multiples of return at liquidation.
For example, although the number of IPOs may be larger, only 264 compa-
nies went public with a deal size close to $300 million. Remember that in-
vestors make big profits and achieve high-level interest rates of return for
their portfolios only when a company they have invested in goes public or is
purchased by a public company at a significant premium. Ask yourself about
the implications for premoney valuations and investor requirements for
shares of stock of the company in exchange for their capital when most com-
panies that do sell are selling for only $100 million to $300 million in the
current merger-and-acquisition market. How much of the stock in your com-
pany will the investor require to achieve targeted multiples over the term of
the hold to compensate the investor for loss of use of capital?
The astute entrepreneur needs to think about all these things in deter-
mining whether your deal is financeable and whether”given its time-inten-
sive and resource-intensive nature”the Sturm und Drang of raising private
capital is merited.
From our experience in working with more than 4,000 companies since
1987, we know that added points need to be raised. Do not risk over-
shopping your deal by introducing your venture to investors before it is
ready. Most companies, before meeting with investors or retaining place-
ment counsel, determine that their product or service solves a problem
for their customers. Some obtain orders or at least conduct research
with customers or potential customers. Many develop a backlog of orders.
Also, packaging, or the packaging idea, is developed, a prototype com-
pleted, and data from test runs are ready. Finally, progress has been made
in developing pro forma financial statements that meet reasonable eco-
nomic preconditions.
We have already discussed the need for the presence of a growth indus-
try and the need for strong management in crafting a deal attractive to in-
vestors. With management, however, we need to address some less obvious
features. Investors need to know that management has made a capital com-
mitment to the venture. This is not to suggest that a reasonable investor
would require someone to put up a house as security; even so, the members
of the management team should be willing to pledge a substantial portion of
their net worth to the venture. In addition, the team must also acknowledge
its responsibility in raising the necessary funds for the venture. Although this
feat often takes months to accomplish, the task belongs to the team, not to
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The Solution: The Private Placement


others. Also, team members must be willing to travel to meet with investors.
Our experience has taught us that money cannot be raised by proxy or
through impersonal contact or through presentations on the Internet.
Raising money is accomplished only by meeting face to face with potential
investors.
You must be realistic about raising capital. Give yourself reasonable time
to complete the financing; do not allow desperation to hover over a deal.
Remember this well: In the eyes of an investor, desperation is a deal killer.
Finally, determining the financeability of your deal should form the basis
of your situational awareness, a term that jet fighter pilots use to establish
the position of their aircraft, especially in relation to the ground. At such siz-
zling speed, their lives depend on knowing precisely where they are, even
when flying upside-down. Although not as breath-taking or life-threatening,
your situational awareness”the management team, market, competition, in-
dustry, proprietary technology, production, channel economics, high mar-
gins, profit potential, capital intensity, projections, valuation, and exit
plan”depends on sensing where you are in relation to your “ground.”


ARE YOU FINANCEABLE?
It is one thing to think about whether your deal is financeable, quite another
to ponder whether you yourself are capable of being funded. One of the
facts of life in private placement investment is that plans do not get funded,
people get funded. Yes, it is important that your deal is financeable, but
more important is whether you can inspire the confidence in an investor to
write a check.
Do you have the traits that will assure an investor that you can accom-
plish your goal and make good on the proposed ROI? What it takes is out-
lined in Exhibit 2.3.
One of the most important traits of a successful fund-raiser is having the
vision to create, conceptualize, and communicate a workable solution to a
problem. Sometimes the visionary starts with a blank sheet of paper and de-
velops something new because he or she understands the market or the tech-
nology. Other times, he or she diagnoses a unique combination of existing
technologies. For example, a recent client has effectively combined CD-
ROM technology with developments in biochip technology, creating a capa-
bility for conducting basic laboratory testing with the same elements in
CD-ROMs that are used in personal computers. And on other occasions the
creative visionary anticipates what customers want in the future. But as we
have mentioned, it is not the vision, but the skill to communicate and act suc-
cessfully on that vision which also matters.
30 THE CHALLENGE AND THE SOLTUIONS



VISION


ENTHUSIASM, PASSION


COURAGE


PATIENCE


PERSUASIVENESS


TENACITY, DETERMINATION


"NO-IS-FOR-NOW" ATTITUDE

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