Deep Pocket Investor

Even if you give up a significant chunk of your company to get the right management in place, you'll be way ahead for having done it.

In my career I've been an accountant, a lawyer, a consultant, a CFO of high-technology start-up companies, and most recently I'm president of a software company. I have been an active individual investor, and over the past 15 years have done 15 investments, roughly one a year, although it's more a matter of accumulating enough money to make the next investment than it is an ability to accommodate them. The rate of investment seems closely related to my earnings from other things. These 15 investments ranged in amount from $10,000 to $90,000. The average is about $50,000 to $100,000 (Exhibit 7.3).

My experience as an entrepreneur puts me squarely in the middle of individual investors. And when you put up private placement out there and you're looking for 10 to 35 people on a regulation D offering, that's the kind of folks you're going to get. Of my 15 investments, five have been winners, four outright losers—"losers" as in all my money is gone— and five have either not had their outcome determined or have more or less broken even. Of the 15, nine have been in start-up or early-stage companies; three have been in venture capital funds—in which my money was pooled with other people's and then professional management hired us out of the funds—and three have been in real estate.

I have divided my primary investment criteria between those that are absolutely essential and those that are merely essential. It's like saying in a business plan that you want to have an analysis of the market and a description of the people and a financial forecast and a description of the assumptions. I want good grammar and correct spelling.

EXHIBIT 7.3 Deep-Pocket Investor

• Built and sold company

• Corporate not technical background

• Emphasis on deal structure to mitigate risk

• Invests only in what he or she knows

• Prefer that investor(s) hold control, e.g., outside board

• People and plan equally important

• Can be lead or independent investor; can search for opportunities, makes independent decision to invest, suggests investments to others, welcomes leads from respected colleagues, but always relies on own judgment, and investigation in deciding to invest

• Geographic preference

• Some involvement to make a contribution

• Open to both debt and equity

• $50,000-$100,000 per investment, 1-3 investments per year

Source: International Capital Resources

If it doesn't have all that stuff, I'm disappointed, though I may still make the investment.

At the top of my list of criteria is a high ROI—at least 50 percent a year—50 percent a year after all of my discounting of time slippage, risk assessment, and everything else. Only in an early-stage deal are those kinds of returns usually offered, which is what drives me to early-stage companies. Sometimes—and I've made this kind of investment a couple of times—you can do a short-term debt instrument that has that rate of return. It happens when somebody has an existing business, an opportunity that requires capital, an opportunity that has the level of risk no bank wants to back. By having something that combines debt and maybe some warrants, or some other equity component as a sweetener, you can get the same 50 percent return and have a short liquidity time— certainly an added attraction.

My second criterion demands exceptional management, especially a solid CEO. Over time I have found that even if the rest of the management team is good, it's really only the CEO that people invest in. And having been a CFO—a somewhat humbling experience—has helped me crystallize the need for a top-notch performer in that position. Generally, an investment becomes a gamble on that individual and, as an investor with some experience, I've decided that, after ROI, there's hardly a more significant consideration in my deciding to invest or not invest. Obviously, if that person changes, the risk of your investment changes a lot, so how committed the management is and how committed the funding sources are become critical. If it's a start-up company, I cannot fund the whole thing out of my own pocket.

One of the common themes among my investment losers is not finding enough financing to take the venture all the way. It wasn't because the idea was all bad. (At least, no one but the people who turned down the investment would say so.) There need to be people with deeper pockets than mine as part of the deal structure, a structure in which my interests are aligned with theirs, so that they don't get a big return if I don't get a big return.

In addition, I prefer that investors as a group have control, certainly control if downside contingency occurs. If the management or founders as a group have control and want to keep control, they'd better have been in business a while and have had some revenue and perhaps even made a profit. If there is a 50-50 split—which is often the case in the early-stage deals between capitalists and workers—I think the capitalists need to have a way of gaining control if milestones are not met.

An essential criterion focuses on local connections. First, all my investments are in the Bay Area; the exception occurs where there is a strong local connection and the company is actually operating somewhere else or considering relocating to that area.

Another criterion of mine in deciding whether to invest is whether the opportunity is available for input to management, typically a board seat. Because of the skill sets I have, I usually can count on people asking for my help to set up accounting systems, or hire lawyers, or write their business plans, or evaluate the deals for them. Thoroughness of the business plan is very meaningful. I run across entrepreneurs—or would-be entrepreneurs—who actually hire other people to write their business plan for them. It's one thing to hire somebody who can do an Excel spreadsheet better than you can, but I have never seen a CEO able to run a company successfully who couldn't describe in writing what the plan was for that company—and do so in a fairly articulate manner.

So I think it is essential for you to write the plan demonstrating an understanding of the market, a careful forecast of the future expressed in numbers, complete with the assumptions for a forecast. Frequently a business plan has page after page of month number 10 as well as month number 24. However, what I'm more interested in is three or four pages of careful assumptions carefully described, plus prepaid expenses based on the industry average, and the amount of capital required in year number 2—coming from a public offering or other investors. Or else we're going to tap you if we can for another round.

What also gets my attention is a business plan that includes in its terms an action plan from someone who demonstrates that over the next 90 to 180 days, from the time the company receives the money, he or she can enumerate what exactly has to be done to make this business go. The more specific those kinds of milestones are, the more comfortable I am in knowing that I can measure progress after I've made the investment and calibrate how I should react; that is, whether I've made a mistake, or whether I should put money in if I'm asked. This is a very good way both to monitor the investment and to assess how management is doing and what you can do to help them.

I favor a short time to liquidity. I don't think of myself as a long-term investor, but I turn out that way in many of these ventures. A fax company that I helped start had a business plan that declared we would go public and have $50 million in sales in five years. It's got about $10 million in sales and probably another three years till liquidity—now that it's been in business six years. That's typical. And I've found that there are good enough opportunities in the public stock market that provide liquidity with moderated risk.

If I'm going to have a long-term, definite ending in a private company, I'd better have some chance of liquidity along the way. I don't necessarily want to pull my money out, but the company needs to have a plan for stages of investor returns. I'd like also, as a secondary criterion, to have the possibility of a very high return. Maybe you think a 50-per-cent-a-year return is high. To me, a very high return means it is an Apple Computer in the making, or a medical device that everybody in the world wants, or a solar energy company, alone among the whole industry, that actually makes something everybody wants.

Also, I look for people who have done it before, hopefully very successfully. This usually means that they are coming out of the same industry, maybe another company, and they're just going into business competing with the former employer. Or in some other way they have been successful entrepreneurs and are working now in something very closely related. And, finally, I look for some downside protection.

I'm quite willing to walk away from investments and lose all my money, but I prefer that there's some kind of second chance at getting part of my money back or parlaying it into something else of value. I think also that the fellow investors need to be able to contribute something besides money. Finally, the process ought to, on a whole, just be fun if it works; otherwise, it becomes too painful to think about.

What most entrepreneurs sell is a story, and what most investors, particularly the more sophisticated investors, want to buy is management. When you're out there selling to people who are investing $15,000,

$20,000 at a crack—your friends and members of your family—the story becomes a question of what they are buying. If you're going to succeed in raising the money for a larger, more sophisticated investment, and if the company, in turn, is going to succeed, you're going to have to show the more sophisticated investors that you've got the management team in place—or know how you're going to get it in place—and also show that the team has formulated a clear plan of action.

Management is the key to being able to deal with unexpected problems certain to arise. So if you are an entrepreneur with a great idea and a great story but you don't have the management expertise, get it. Even if you give up a significant chunk of your company to get the right management in place, you'll be way ahead for having done it. Qualified management is one of the most difficult parts of a business plan to evaluate because resumes can all be made to look great. How do you evaluate what someone can really do? I have found that I need to do a lot more due diligence every time I review a potential investment. Having done it several times, I have been surprised at instances of outright fraud, outright cover-up in which people were not revealing everything.

Personally, I'm a generalist. If it looks like it can make money, I'll take a look at it. For example, a potato chip plant in Colorado already had an empty building where the company was going to set up its plant, and it was already sourcing the chips from a Texas operation. From a look at the business plan, from all the numbers, all it needed was capital to get machinery in there and start producing, instead of buying, the chips. The company was going to be making money in no time. It was in the stores, a really ready-to-go operation. It already had shelf space and name recognition in the area. But it wasn't telling the whole story.

So how do you uncover that? It's a difficult thing from an investor's perspective. You have to be very careful. It's very important for entrepreneurs to reveal everything and to have integrity, or else you are building in your own doom. You're not going to succeed by hiding things. It all comes back to bite you. So make sure you tell a potential investor the bad news first, and if they're still interested after they hear the potential difficulties, you've got someone that's ready to go through the trials and tribulations with you. But if you're giving only this wonderful story about the future, and the investor buys into that, what happens when the first problem comes along? Now you've got problems beyond anything you have anticipated.

I, by the way, have an entrepreneurial background myself; I haven't always been an investor. I remember someone explaining the difference between institutional and private investing, a distinction sometimes dif ficult for a private investor to remember: The private investor does not have to invest! Sometimes the story is so attractive that you are lured into it and say, "Wow, this is hot; this really has sizzle." But you have to have that management team to keep the bacon frying or the sizzle fizzles.

Perhaps the greatest disservice that's been done to entrepreneurs is the saying that if you build a better mousetrap, the world will beat a path to your door. It's just not true! The shelves are lined with better mousetraps. If you have the right management you can take an inferior product, make it succeed, and make money. So don't buy into a story that just because you've got something unique and better than what's already out there that you're going to succeed. It takes a lot of hard work and correct management decisions.

In terms of my own investments, as I said, I'm a generalist. Generally, $50,000 to $100,000, sometimes a little more per investment. I've been a public investor and actually was a commodity trader for many years, which led me to understand risk and decide that the risk involved in investment in private companies made sense. In fact, it's kind of the same game. You expect to lose. You have to be willing to accept losses; the wins just have to be big enough to compensate for them. So as a commodity trader, I found that if I could be right 30 percent of the time I could make a lot of money, because I cut my losses short and my winnings were big ones.

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