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image from the NSCD
Situation (continued from prior post): After you and your fellow founders spend much time brooding over the pros and cons of raising money to build the product suite vs. bootstrapping it, debt vs. equity, etc., you decide to raise $4mm of growth equity capital. At the end of the day, the decision hinged on (i) the opportunity being just too great to raise only a small portion of it (inquiries from the key clients have intensified recently), (ii) timing – you are a bit concerned that another web / software company may get to market first, and (iii) the somewhat risky nature of the project that makes “putting up the company” as collateral for a bank loan outweigh the lower cost of debt financing.
Over the subsequent weeks, you prepare a presentation on the industry and the business, what you have done, the milestones you need to hit to succeed, the team you need to build, and what the numbers look like. You also built a highly detailed monthly financial plan that clearly forecasts the key drivers of the business and the dashboard that you will use to measure your performance against that forecast. With that material, you speak with several dozen potential investors – most of which are venture funds, although a few strategics are interested in tracking your development. After several rounds of preliminary diligence, you have received letters of intent and term sheets from several VCs.
Two of the firms, ARB Ventures and Operating Growth Ventures (OGV), stand out from the pack. ARB has an impressive track record and has been around some of the biggest software / internet success stories in recent years. ARB has a large fund and at $4mm, the investment in your company will be by far the smallest in their portfolio. The partners are a bit on the arrogant side and at times are not the best listeners. They have spent the least amount of time digging into the core business, the numbers, and the milestones. That said, the pre-money value of their deal is 33% higher than all other term sheets. You know the devil is in the detailed structure of the security, but that valuation difference is meaningful to you and your partners. Contrasting ARB, OGV has been around for many years and, while it has had some significant success during its life, it has stayed away from raising larger and larger funds. OGV tends to stick with industries and technology that it knows well and does significant diligence on every investment. Their list of preliminary diligence requests was almost overwhelming, but in all conversations with them, it was apparent that they fully analyzed all information provided and had a strong grasp of what the company had to do to succeed. The partners were calm, listened well and were genuinely interested in the intimate details of running the business. Further, through its LP network, OGV has deep connections with a dozen key potential customers of this new product line. While nothing is assured, they could help grow the business in many unique ways. Unfortunately, OGV’s pre-money value of the business is in the middle of the pack. Each firm wants an exclusive to move forward – who do you go with?
Find the partner that truly brings operating benefit and maximizes likelihood of success – that is more important than getting a higher early round valuation.
Valuing private businesses is not an exact science. While much complicated and not so complicated math, diligence and research can be employed to come up with values, virtually all of it is based upon different expectations of the company hitting certain performance hurdles over the coming years. In most cases, differences in initial valuation (and the “paper” value to shareholders implied in higher valuations) when the company is young can become moot when compared to the long term value added of the right investor. The investor that brings true operating expertise (as opposed to just words), industry contacts, access to key executives, and reasoned counsel at the Board level can bring long term value to the Founders and existing investors that can far exceed initial valuation differences.
Here is a simple example (using the “Situation” above as a guide relative to size and numbers): Suppose ARB proposes investing $4mm to purchase 20% of the company vs. OCV proposing $4mm to purchase 25%. The implied pre-money values are $16mm for ARB and $12mm for OCV, or $4mm (33%) more “paper” value to the existing investors at close under the ARB deal. That is an unusually large valuation discrepancy for a business of this size. Offsetting the higher ARB valuation, you believe that OCV would truly add operational benefits over ARB given their industry expertise, contacts, knowledge of the business drivers, and their reputation of being a respected advisor to portfolio companies. While difficult to quantify, you believe that OCV could increase the likelihood of hitting or exceeding your plan by 20-25%. Using different discount rates as a surrogate for increased likelihood of success or reduced risk to the plan, if OCV reduces the risk of the plan by 20% (ie. a 20% discount rate vs a 25% discount rate), then you and your existing investors are better off in today’s dollars going with OCV. Here is the very basic math:
While the above example simply shows that a lower discount rate means higher value today, something we learned in college, it illustrates the importance of having a group of investors and Board of Directors that add operating value to the business. Different investors / partners bring different operational value with the best ones maximizing the likelihood of success.
Here is a list of what I believe are the most important things to cover in choosing the right investor:
Do they bring value other than money? Almost all firms will talk about how they are really operators and bring incredible value to their portfolio companies. Your fiduciary responsibility to your existing shareholders is to cut through the words and slideware and do your diligence on the investors. You need to determine how real that value added is. It should be tangible – past experience / learnings from investing in the industry, customer / industry contacts that drive revenue or reduced cost, direct operating experience that improves the business, technical expertise that improves the product or the way the company approaches development, QA, BCP, access to strategic partners that can expand the breadth of the business, etc.
Do your diligence on them. Speak with executives from their current and past portfolio companies. Understand how they act as Board members – did they stay up to speed on the key business drivers and industry dynamics? Did they provide strong and relevant counsel? Did they really deliver on the “operating benefits” that they sold prior to funding? How did they respond and help the business in tough times? Did they communicate regularly with the CEO, or were they only engaged around quarterly Board meetings? Were they really “long term” investors like they said prior to close, or did they push for a quick exit.
Are they on the same page strategically? Do they share your same view of not only the direction of the industry and the opportunity, but on the major components of the company’s growth strategy and the tactics of how to get there? How deeply did they diligence your business, the way you manage it, how you set and track milestones, your technology / the application(s), your development methodology, how you go to market, how you will measure success, etc. While it is a bit obvious, the right long term investor will have done their homework, gotten intimate with all aspects of your business and success drivers, share your strategy and agree with your tactics.
Past investment success in your industry. How deep is their experience in your sector / industry? How successful have they been with their past and current investments? As you look at their portfolio, does your company fit well within an overall fund strategy or does it stand as an outlier – in a different sector, in a new market / channel, much earlier or later stage (revenue size, cash flow), a much smaller or larger investment, a different control position? Being different is not necessarily a bad thing, it could be a very good thing, it just is an additional data point you need to consider that could reflect how they might act as an investor / Board member in the future.
Is there a cultural fit? A bit of an intangible, but a cultural fit with your key investors is critical. You will likely be spending a ton of time with them over the coming years – figuring out how to capitalize on huge opportunities and hashing through tough problems. You don’t have to be best friends, but there has to be a mutual respect, complementary communication style, and shared passion in the business. Importantly, both of you – the investors and you as management – have to be good listeners. Having mutual respect and listening to each other is the best way to maintain a constructive dialogue and ultimately make the best decisions for the company.
How to get the most out of your investors / Board:
Make sure the Board and the new investors look at the business and measure performance the same way the management team does: Everyone needs (i) to be on the same page as to how success is defined – short term, medium term, and long term, (ii) to agree on the key business milestones that will drive that success, and (iii) to get information on a timely basis. Not only will it focus all of you on the right business drivers, it is the difference between reporting and analysis as “business intelligence” vs. plain old financial statements. That isn’t to say that the Board should get the same reports that management uses to run the business, but the Board reports should highlight the same key metrics the management team is using to track itself.
Build a financial model / business plan that is detailed, forecasts the key business drivers, sets forth the milestones that will determine success, and communicate progress clearly and often. The financial model upon which success is based must be highly detailed so that it reflects that true drivers of the business. Take the core fundamentals that you track on weekly / monthly / yearly basis and drive those out several years: number of clients, existing vs. new clients, seats of the product sold, price per seat, hours of consulting, development hours, staffing needed to drive that growth, hardware & equipment needed to support that growth, etc. The detail doesn’t need to result in a 50 page financial model, but it does need to be detailed enough to allow you and the Board to track progress on the key milestones and to manage the likely variability of the business. Among many other things, you need to understand clearly the revenue implications of more or less investment and the cash implications of more or less revenue.
Set performance goals that are a big stretch, but realistic – then do what you say you will do. Anyone that invests in or runs growth companies is highly goal oriented. The rush of excitement and accomplishment of building something from scratch or taking an organization to the next level is addictive and contagious. It is why we do this and it is why we can attract talented staff and sophisticated investors. That said, it is difficult to build a “winning culture” and achieve great things without a foundation of credibility related to goal setting and measuring and rewarding performance. That foundation requires that you set goals at the employee level, at the business unit level, and at the company level that stretch the organization well beyond its comfort zone but allow for frequent “dancing in the end zone” when milestones are achieved. Setting unrealistic goals erodes management credibility with investors, the Board and staff and ultimately damages company morale, resulting in a culture of disappointment rather than a culture of success.
View your investors and the Board as partners and advisors – not just groups that have funded your plan. If you have built your business to a certain level, you know that you don’t have all the answers and you need to rely on trusted advisors. (I believe the most successful C-level executives subscribe to the “Dirty Harry School of Business” – ie. Know your limitations. Therefore they surround themselves with smart people and seek constructive input freely.) This requires that you have open lines of communication with your Board. While it is still your responsibility to run the business day-to-day, you should set up regular informal and formal communication. Use them as a resource – after all, you sold them a portion of your precious business – make the most of them. Squeeze as much value out of them as you can. That will require you to keep them updated frequently on the progress of the business and let them know about good things and bad things before you have had full opportunity to determine a course of action. If they are the right investors and there is mutual respect in each other’s skills, then this should not be a problem.
Final words
OK, so you have decided to sell a portion of the beautiful business you have created. From the beginning you have been focused on building the company for the long term – don’t let potentially ephemeral “paper” value at one point in time prevent you from bringing on the investor / partner that adds the most value over the long term. Make sure that investor does their homework before close, understands the drivers of the business (and things to avoid), brings significant operating value to the core business and is a trusted advisor that you respect. If you then set stretch goals (not unrealistic ones), make sure everyone is on the page with respect to strategy and tactics, provide access to key information and intelligence about the business and its progress, and have open communication, then you should be able to get more than your money’s worth from the new investors.
-Bob
A couple funny examples of how having the wrong partner can be a problem.
http://www.youtube.com/watch?v=m5gCbvfw0T4&feature=related
http://www.youtube.com/watch?v=QTBAEcTNgNU&feature=related
