Investment Evaluation Guidelines

I have been asked many times for a guideline when it comes to evaluating investments that we (or our Clients) make. People ask why we invested in Company X and not in Company Y, Why are we interested in industry A more than industry B etc.

Well, the simple truth is that we invest to win.

We tend to strip out a lot of soft factors and focus on results.
Did management deliver?
Can they do it again?
A lot of investment decision making is based on an understanding of industry trends, a trusted relationship with players that perform consistently above industry average and some form of defensible proprietary technology that is in demand because it solves a specific pain for a given market segment.

If a company has a specific target market segment in their crosshairs, we know that they have done their homework – when management states that they serve all industries, our alarm bells start ringing.

Following is my personal guideline for what really counts when considering investment in a startup or early stage company.

1) Market potential
2) The Team
3) Results
4) USP

Investment Process

• The success of investment in an early stage company depends on people and their ability to execute on a detailed business plan, therefore a lot of emphasis is placed on the team.
• The structure of the investment is vital and requires creative and often complex terms.
• Pricing is a key factor which needs to be carefully analyzed and negotiated.
• An interesting exit strategy is required in order to maximize a timely return.

Investment Selection

• Management Team: Experienced, in-depth knowledge of business, results oriented.
• Innovative Products/ Proprietory Technology: Highly differentiable, superior, specialized expertise, meets market needs.
• Business Plan/ Milestones: Well thought out business plan including milestones and contingency plans.
• Substantial Investment Position: Ability to obtain a substantial investment position, influence the selection of executive management and the strategic direction of the company.
• Valuation: Negotiate and obtain a fair pricing structure.

Initial Investment Valuation

• Underlying industry assumptions
• Realistic income statement over 3-5 years
• Competition
• Major criteria:
  • Technology value
  • Capital requirements
  • Market potential
  • Capital structure
  • Operational cash flow

Determination of NAV for privately held startup companies

• The original cost: An approximation of the fair market value at the time of the transaction.
• Write off: NAV calculation at cost, less any write-off deeemed necessary if subsequent performance fails to meet business plan forecast.
• Capital increase: NAV calculation in principle based on the capital increase price, less 10% to 29% discount if deemed necessary based on valuation factors.
• Write up: A write up is recognized when a significant event occurs such as increased profitability and achievement of milestones.

VCs.. arrGH!

Many venture capitalists expect entrepreneurs to go out on a limb for them – climbing high while vigilantly sawing away at a supporting branch.

When Clients ask what exactly is needed for funding, I can provide some very interesting answers based on my 20+ years of experience… Here are some of my personal favorites:

An impeccable board of directors
It may not be the first issue you are faced with but this is one of the really important ones. Your board of directors needs to be comprised of a broad spectrum of very skilled individuals experienced in the industry of your company. The venture capitalist firms all look for a strong board and that means a board that brings in money (read Sales), investors and strategic relationships – all the important things you need as an early stage company.

A winning team
You may have a great idea, but if you don’t have a strong core team, investors aren’t going to be willing to bet on your company. Think of this as an analogy to a horse race. Betting on horse races equates to betting on high-tech. Betting on a race is equivalent to betting on the industry your company is in. Betting on a horse is like betting on your company to succeed and betting on a jockey is what a VC is after. VCs want to bet on winners that have proven their abilities before. The team surrounding the jockey is also key but don’t get too caught up in having everyone on board before chasing funds. You don’t need to have a complete, world-class, all-gaps-filled team. But the founders have to have the credibility to launch the company and attract the world-class talent needed to fill in the gaps. The lone entrepreneur, even with all the passion in the world, is never enough. If you haven’t been able to convince at least one other person to drink the lemonade, investors certainly won’t. One other thing… If the founders do not have skin in the game, don’t expect others to invest their savings. To be convincing, founders need to go out on a limb, risk their personal savings, sell their car or get a second mortgage on their home to indicate that they too have risked all to make this company a success.

A compelling idea
“Every entrepreneur believes his or her idea is compelling. The reality is that very few business plans present ideas that are unique. It is very common for investors to see multiple versions of the same idea over the course of a few months, and
then again after a few years. What makes an idea compelling to an investor is that it reflects a deep understanding of a big problem or opportunity, and offers an elegant solution.”

The market opportunity
You should be targeting a sector that is not already crowded, where there is a significant problem that needs to be solved, or an opportunity that has not been exploited, and where your solution will create substantial value. Contrary to popular belief, it’s not about how big the market is; it’s about how much value you can create.

The technology
VCs ask – What makes your technology so great?
The correct answer is, ‘There are plenty of Customers with plenty of money that want to buy it’.
If you have a technological advantage today, how are you going to sustain that advantage in the future? Patents alone won’t do it. You better have the talent or the partners to assure investors that you will stay ahead of the curve.

Competitive Advantage
Every interesting business has real competition. Competition is not just about direct competitors. It includes alternatives, ‘good enough’ solutions, and the status quo. You need to convince investors that you have advantages that address all these issues, and that you can sustain these advantages over several years.

Financial projections
Your projections demonstrate that you understand the economics of your business. They should tell your story in numbers – what drives your growth, what drives your profit, and how your company will evolve over the next 5 years.

Validation
Is there any evidence that your solution will be purchased by your target Customers? Do you have an advisory board of credible industry experts? Do you have a co-development partner within the industry? Do you have Customers or Beta users to whom investors can speak? Do you already have paying customers? The more credibility and Customer traction you have, the more likely investors are going to be interested.

What I have learned is that a company needs good scores in ALL of the above areas and excellent scores in at least 3 in order to have a reasonable chance to secure funding.