A View From the Trenches

Here are some insights distilled from over 30 years of venture investing. Some of the most valuable lessons were learned from the most painful failures, and there were many of those. Fortunately, there were enough successes along the way to keep my interest. The ratio of successes to failures gradually increased over time as some "wisdom" slowly sank in with each additional experience.

Over the years I've been involved in well over 100 different ventures as an investor, director, entrepreneur, fund raiser, or some combination of these. The industries included plastic injection molding, telecommunications equipment, computer software, casualty insurance, oil drilling, real estate, medical equipment, and electronic components, among many others. Several of these have gone public. I was also co-founder of Sixpence Inns of America, one of the most successful budget motel chains in the country.

I am currently an investor in about two dozen private situations, seven of them in an active or directorship capacity. Included are: The Pullman Bank, two medical diagnostic equipment companies, a safety supply catalog house, several internet companies, two computer software enterprises and a telecommunications firm. I am also the General Partner of several real estate ventures around the country.

Because of the extensive network built up over the years and because my company, LaSalle Investments Incorporated is an NASD broker dealer, I see on the average of 5 to 10 investment opportunities each week. I raise money for and/or invest in 3 or 4 of these each year.

For the guidance it may provide for you, here are some of my thoughts:

Bob Geras

Is Venture Capital Investing For You?

• Threshold of risk comfort level
  • Try to honestly assess your personal capacity to tolerate risk
  • Will you lose sleep over the investment?
  • Any potential rewards may not be worth sacrificing peace of mind.
• Your financial situation
  • Can you afford the loss with minimal damage to your security?
  • Will you need the liquidity in the near future?
  • You're likely to be locked in for a number of years, and probably a lot longer than you originally estimated.
• Can you do without the current income sacrificed by making this investment?
  • Since most early stage venture investments are with small and/or rapidly growing companies which are chronically short of working capital, it's unlikely that your investment can be structured to yield a current return.
• Your age
  • Since venture deals typically take a long time to work out, will such an illiquid investment fit into your estate planning?
• Ability to get involved
  • Experience
    • Do you have business talent and know-how to. contribute? If so, you may be able to negotiate a better deal by offering some expert guidance in addition to capital.
  • Other Commitments
    • Time demands may be greater than you anticipated. Often, if you are investing alone or with other individuals rather than with a fund or professional venture group, you are likely to spend a lot more time monitoring, planning or problem solving than you originally expected.
    • On the other hand, maybe you were looking for more activity. If so, you are likely to find many opportunities to spend time on various challenging projects with your portfolio companies.
  • Inclination
    • Will you be able to cope with the stress and uncertainties?
      • Regardless of how well thought out and competently researched the concept and business plan may be, projections of results are only as good as the assumptions made about future events. By its very nature, that exercise is merely educated guesswork. Because of that, the unfolding of reality as time goes on will result in the need to be constantly vigilant and quick to modify course as the new facts warrant. Frustrations and anxieties may build up because of the company's lack of financial or people resources to deal with these continual changes effectively
      • Being part of a young new venture can be like journeying in stormy, uncharted waters in an unproven vessel with an inexperienced crew without a sextant. A journey full of surprises, anxiety, excitement and exasperation. Is this your bag?
    • Will the challenge and non-monetary satisfaction outweigh the aggravation?
      • Venture investing usually gets you involved with people who are capable, dynamic and creative. Helping to implement someone's dream and being a part of the very heart of this free enterprise system can be a very stimulating and gratifying experience.

Where to Find Opportunities

• Lawyers and Accountants
  • Every law and accounting firm has corporate clients who may at one time or another be in need of funds for expansion, acquisitions or for other reasons. They also are continually exposed to entrepreneurs who are in the early stages of getting organized or developing a business plan.
• Bankers
  • Banks can be an excellent source for several reasons. They may know of companies who are not in trouble but are not quite "bankable" because they're thin on equity. They also are likely to have some problem loans which may provide opportunities for investing in worthwhile troubled situations described below under "bottom-fishing".
• Stockbrokers
  • Usually are exposed to deals generated by their corporate finance department or, more informally, through their network of clients.
• Small businessmen
• By definition, they and their colleagues are a potential source of opportunities. Joining business clubs and various trade organizations can be a good way to access this group.
• Institutional Investors
  • On rare occasions you may be able to get into a deal that a professional venture firm will finance. More commonly you may see deals that they will turn over to you because it doesn't meet their parameters for one reason or another. If they know you are "in the market" and if they are familiar with your interests and respect your abilities, this can be an excellent source of quality leads. Worth cultivating!
• Individual Investors
  • Other individuals, such as yourself, with money to invest and experience to contribute offer excellent networking and idea sharing possibilities.

Diversify to Spread the Risks

• You don't know ahead of time which deal is going to be a winner. Besides diversification, the group approach provides several advantages.
• Funds and Venture Partnerships have:
  • Professional management
  • Follow up money readily available
  • Access to professional venture capital network
  • More experience in:
    • evaluating and negotiating
    • monitoring, managing and troubleshooting
    • structuring and eventually cashing out
• Participating with professional venture capital firms
  • It is usually difficult for individuals to get into such deals. However, since they often have a professional staff, it is likely that extensive investigation of the deal has been done, and since usually several firms participate in any one deal, there will be many professionals monitoring the situation and be available to take action in case problems arise.
• Investing though investment banking firms
  • They have usually done extensive due diligence, and have the experience and personnel to monitor the deal.
• Groups of investors such as stock investment clubs
• Other more informal groups such as friends and business associates
• If investing with a group of other individuals
  • It is extremely important that one or several members of your investing group have knowledge of the industry involved to enable you to more effectively analyze the deal and to monitor the company's progress.
  • They must also have the time flexibility to be able to take a more active management role if necessary in the event of a crisis.
  • The ability to provide additional funds among the group, if necessary, is also important.

Types of Deals

• Early Phase
  • Seed Financing
    • Relatively small amount of capital to inventor or entrepreneur to prove a concept. Usually for market research, product development and possibly to develop a business plan.
  • Startup
    • Financing for completion of product development and initial marketing. Companies may be in the process of being organized or only in business for a short period of time but have not sold products commercially. Usually have management in place, have a developed a business plan and generally ready to do business.
  • First Stage
    • Provided to companies to initiate full scale manufacturing and sales effort.
• Expansion Financing
  • Second Stage
    • Working capital for the initial expansion of a company which is producing and shipping and has growing Accounts Receivable and Inventory. Showing progress, but may not yet be profitable.
  • Third Stage or Mezzanine Financing
    • Funds for major expansion of a company whose sales volume is increasing and may be break-even or profitable. Money used for additional plant expansion, marketing, working capital, or product improvement or development.
  • Bridge Financing
    • For a company which expects to go public in six months to one year. Often the money is repaid from IPO proceeds. Sometimes involves restructuring of major stockholder positions.
• Acquisition/Buyout Financing
  • Acquisition Financing
    • Funds provided to a firm to finance it's acquisition of another company
  • Management LBO
    • To enable operating management group to acquire product line, division or entire business from either private or public company. Usually results in revitalizing an operation with the entrepreneurial management acquiring a significant equity interest.
  • "Bottom Fishing"
    • You can sometimes find real values in companies that have run into problems due to circumstances other than the validity of the fundamental concept, viability of the product or the competence of management. Examples of such problems are:
      • a downturn in the overall economy
      • over-optimistic initial forecasts
      • inadequate funding
      • inadequate controls or lack of discipline on spending
      • unanticipated shift in competitive situation for which the company may not have had adequate resources, proper insight, or enough time to enable it to adapt appropriately.
    • However, if a thorough analysis of the reasons for the company's difficulties indicate that it's a viable situation which may be corrected by an injection of capital, restructuring or elimination of debt, a change in management, or modification of product or marketing approach, it may be worth considering. Some of the plusses are:
      • The original learning curve has already been paid for by someone else.
      • Many of the original assumptions have been tested and proven to be true or false
      • The principals (owners, creditors, and management) are usually now much more realistic about expectations and the pricing and other terms of your investment position.
    • This type of situation usually requires a much more intense "hands on" involvement by the new participants. There are often very sensitive legal issues regarding prior investors and creditors who may face substantial loss. You may also have to deal with a demoralized management team who may have lost confidence in themselves as well as possibly be harboring resentment at having to live with a much reduced equity position and management control than they previously had.

How to Analyze the Proposal

• The Business Plan
  • Even though, in reality, business plans are merely a guide and are usually modified extensively over time, the business plan can be a very revealing document. It is often the entrepreneur's first and only opportunity to tell his story and distinguish his proposal from the other opportunities that the investor has available to him.
  • How it impresses the investor will determine whether his idea will be pursued further or quickly wind up in the "rejection" pile. Because of this, any entrepreneur with an ounce of common sense will be sure that this document puts his best foot forward and tells his story in a well organized, concise and believable fashion.
  • It often will indicate whether the promoter has thought through his proposed course of action thoroughly, analyzed the potential pitfalls and detailed a credible plan to cope with them.
  • If the business plan is incomplete, disorganized, or otherwise lacks credibility, it's often a sign that the concept is similarly flawed or that the preparer wasn't smart enough to realize that the document was important enough to have deserved more attention than it got. In either case, it's a significant red flag.
• A Word About "Projections"
  • Invariably, in my experience, at some point during the presentation and/or business plan the phrase "AND THESE PROJECTIONS ARE CONSERV-ATIVE" will be made. And, guess what? Invariably they prove NOT to be. The typical explanation for the shortfall are those continually recurring "non-recurring events", which inevitably result in time slippage, cost overruns and lost sales.
• A Remarkably Effective Interviewing Technique
  • Remember that the entrepreneur is out to "sell" himself and his deal to you. As a result, especially during the first interview, he is going to try and determine what your "hot buttons" are, and detect what may turn you on or off about the deal. If he's a good salesman, he'll pick up on those clues you give him and emphasize the things he feels will excite or interest you most and play down the aspects that he thinks you may feel negative about. DON'T GIVE HIM THAT WEAPON TO MANIPULATE YOU.
  • Try to restrain your reactions by merely keeping silent and staring at him. Resist even the temptation to nod your head or make a comment. It will be very unnerving to him since he won't be able to read you and therefore lead you. This is likely to result in his nervously continuing to babble on about himself, his deal, his family, ANYTHING to get a reaction from you. You'd be surprised at how many unplanned revelations are made and how much interesting information gets volunteered during this desperate attempt to psyche out your thoughts!

• Three often cited fundamental characteristics of an interesting investment candidate are significant growth potential, quality management, and eventual liquidity.
  • Usually, the most appealing investment opportunity, especially to professional venture groups, are the ones that offer the potential to achieve a significant scale of operations in a relatively short time.
  • However, there are many other types of less dynamic situations which could also be very worthwhile.
  • As a matter of fact, since the smaller, more mundane companies are often passed over by the big venture groups, there is less competition for them and therefore a better deal for the investor can usually be negotiated.
  • The real question is how much potential reward is there for a given level of investment, risk, and effort, and over what time span will this occur?
• Significant Growth Potential
  • One attractive characteristic is the potential for the company to grow to a significant size in a few years. Attributes of a business with high growth potential are:
    • Significant advantage in terms of technical know-how or lead time
    • Market niche or segment in which these features or advantages show a clear economic benefit to the customer, i.e.: higher quality, lower cost or improved productivity
    • Market whose size is already large enough or growing fast enough so that a believably attainable share could represent substantial sales for the company in a few years
    • Availability of access to that market through established channels of distribution to already identified customers
    • High gross margins to allow for errors that inevitably occur in rapidly growing companies and to provide for substantial R&D to maintain a competitive advantage
• Management
  • The company should have quality management with the ability and experience to make this growth happen. The existing team doesn't necessarily need to be presently complete, but should have the qualities to be able to eventually attract a full team needed to build a successful company. These qualities include:
    • integrity
    • experience
    • knowledge
    • perseverance
    • leadership
    • creativity
    • stamina

  • In real estate the three most important ingredients for success are location, location, location. In venture capital investing it's people, people, people. If all the other ingredients are there, but you don't have the right people, the odds are stacked against you. No matter how attractive other aspects of the deal may look, remember that "YOU CAN'T MAKE A GOOD DEAL WITH A BAD GUY".
  • Good resumes are no insurance against possible failure. Always check into the entrepreneur's background. A successful prior track record is always a plus, but look beyond the surface facts. How much of the prior record was due to his particular talents and efforts and how much was due to:
    • someone else's efforts -a terrific product that sold itself
    • having been at the right place at the right time
  • After all, even a blind pig finds an acorn once in a while.
  • Also, how has he reacted during adversity? How did he function under extreme pressure, which are the conditions under which most companies must grow. Is he a survivor? Did he keep other people's interests in mind at such times, or only his own? What do his former business associates, bankers and investors think of him, his judgment, and his integrity?
  • He must also have an inclination to accept outside advice and listen to input from colleagues around him. A strong management team is crucial, because the business environment is continuously subjected to unexpected changes and management must be able to properly adapt in a timely manner.
• Liquidity
  • There must be a good probability that the business, if projections are met, could be merged, acquired or sold to the public to obtain liquidity for your investment. If projections are not met, there should be another way to get out such as a put option to the company or to the other shareholders.
  • Having registration rights are not always the answer. If management doesn't want to go public, there are many ways that they can undermine an underwriting effort.

Negotiating Terms

• How much non-monetary benefits can you bring to the deal?
  • As mentioned earlier, you may be able to negotiate yourself a better deal for less money if you have something to offer the company besides capital. Such contributions could include the following areas:
    • Contacts for
      • getting business
      • introduction to financing sources
      • obtaining outside consulting talent or directors
      • acquiring additional personnel
    • Experience in
      • direct operations of the company
      • general business moxie
      • specific industry related know-how
      • financial controls and analysis
      • evaluating and motivating management
      • hand-holding
      • negotiating with
        • customers
        • creditors
        • financing sources
        • potential suitors or investment bankers for a sale or public offering
• Pricing the Company
  • Pricing a venture deal is not an art nor a science but often the result of a mixture of relative negotiating positions, perceptions of future results, existing investment climate, and pure gut feel. Since so much depends on indeterminate variables and what assumptions are made about future events, the following quote sums up the dilemma:
  • "Forecasting is very difficult, especially if you're talking about the future." In a nutshell: look at the projections, adjust for a margin of error, take the earnings in the year you hope to get out, multiply that by the estimated PE ratio that might exist for a similar company in that industry at that time, determine your percentage ownership of that figure and see what multiple that is of your original investment then decide whether that seems satisfactory to you.
  • In other words, assess the various risks vs. the potential rewards and most importantly, your COMFORT LEVEL with the people, the concept and the deal. If the estimated potential rewards compensate for the perceived risks, and if your gut says "O.K." you're likely to make the investment. Obviously, the greater the risks, the greater the return you will be expecting, which usually means more equity in the company.
  • A generally acceptable range is a 30% to 50% compounded rate of return (depending on risk, stage of development, probability of reaching goals, length of time of investment and other factors).
  • For example:
    • A triple in 5 years is 25% compounded
    • 5 times in 5 years is 38%
    • 10 times in 5 years is 58%
• Investment Climate
  • The environment for fund-raising can dramatically impact valuations. The general state of the economy and stock market directly affect pricing of private investments.
  • A good climate increases confidence levels and expectations and increases the probability of quick returns from an IPO, especially for a later stage company. The converse is also true. Companies that raised money in 1983 at very high valuations saw their prices drop dramatically in 1984 when they raised additional dollars.

Structuring the Investment

• Addressing Mutual Concerns
  • Structuring follows no set formulas nor is there any perfect structure.
  • The appropriate structure will not make a bad deal good, but it can influence the ultimate outcome of an investment which is not meeting the initial expectations. In such a case you will want to have more control and say in management decisions in order to try to improve performance and protect your investment.
  • Each situation is different and structures vary widely. The objective is to reconcile differing needs and concerns of both investor and entrepreneur in a way that is satisfactory to both parties. If it's over negotiated either way there will eventually be resentment and other problems.
• Get a Good Attorney
  • It is a fact of human nature that people often have short or "convenient" memories. This sometimes results in what I call the "WHAT HAVE YOU DONE FOR ME LATELY" syndrome.
  • It is usually manifested by the entrepreneur developing a somewhat suppressed underlying resentment that he is on the firing line, working long hours every day and you, the investor, are going to reap a significant piece of the potential rewards by having merely cut a check. He obviously forgot that your willingness to take a significant risk by investing helped to put him in business and thereby afforded him this opportunity to build a substantial net worth if the company succeeds.
  • It is because of this phenomenon and because it just is good business to "get it in writing". It is important that whatever agreements and warranties are entered into be properly documented as close as possible to the time they are agreed to before memories begin to "fade".
  • Choose an attorney that is imaginative and who has some business sense so he can help structure a deal that protects you and accomplishes your objectives. There are far too many lawyers who are merely technicians and don't add much to helping you really think matters through.
• The Various Instruments
  • Senior debt
    • This is generally used for long term financing or later stage companies. Must be structured to be able to accommodate other debt financing and not burden the balance sheet too much so as to scare would-be suppliers or bank lenders. Advantages are priority on liquidation and current return through deductible interest payments.
  • Subordinated debt
    • Usually subordinate to other debt from financial institutions and often unsecured. Sometimes convertible or with warrants to purchase stock. Senior to Preferred and Common Stock on dividend payout and liquidation.
  • Preferred stock
    • Usually convertible into common. Senior to common stock on dividends or liquidation. Makes for healthier looking balance sheet than debt.
  • Common stock
    • Usually carries the most dilution because it is the riskiest. From the investor's standpoint it affords no liquidation protection, allows the least amount of control over management and usually carries no dividend, so there isn't likely to be a return until stock is sold.
  • Reduce risk and taxes by having a senior position
    • One way to reduce risk somewhat is to contribute capital in the form of debt with warrants to purchase common stock. The debt position is obviously in a prior position to common and preferred shareholders. Also, when the debt is paid back there is no tax consequence to the investor and he still has an equity play in the form of the warrants.
    • Another variation on that is to have a third party such as a bank make a secured loan with the investors guaranteeing it. Then in the event that disaster strikes and the bank forecloses, the collateral taken by the bank to secure the loan is more insulated from unsecured creditors than direct secured debt of major shareholders would be. Unsecured creditors may be able to successfully argue that such debt is "constructive equity" and inferior to their claims.
• Executive Compensation
  • In most businesses, compensation is a function of the company's ability to pay as well as the value of the employee's contribution.
  • Since most early stage companies need to shepherd available cash for operations and growth, salaries, of necessity, must be kept modest. However, I'm a firm believer in incentives tied to performance. Bonuses, profit sharing, stock options, and additional earn-in equity tied to profits are just a few ways to accomplish this.
• Contingent sharing based on results
  • A neat way to reconcile the sharing dilemma is to tie the entrepreneurs equity position to how close he comes to meeting his projected results. After all, since he is usually so intent on convincing you that his projections are "conservative", how can he then resist having his level of equity tied to how close he comes to meeting his own numbers?
• How much does management have invested?
  • The more that the people who have the most influence on whether the venture succeeds or not have at risk, the more comfortable I feel. That way there is the "stick" as well as the "carrot" for proper motivation in the event things get a little rough. They are much less likely to give up and leave you holding the bag.

Monitoring the Deal

Although the most important work in venturing may be analyzing and deciding which deals to invest in, the quality of follow-up monitoring and guidance afterwards can often have a very significant effect on how well the deal will ultimately turn out.

• Contingent sharing based on results
  • Choosing and continually evaluating a first rate management team lies at the very heart of a successful venture capital investment. Too often, once the investment is made, the auditing process is frequently skimmed over until the new enterprise is in deep trouble.
• Some specific items to watch:
  • weekly sales booked and shipments made
  • cash flow
  • changes in amount and aging of receivables and payables
  • profit margins
  • trends in overhead and other spending
  • timing of future capital needs
  • possible shifts in competitive position
  • potential changes in customers needs and desires
  • employee concerns, suggestions, and morale
  • new opportunities for increasing sales and cutting costs
• Factors affecting monitoring
  • the length of time you plan to be invested
  • the company's need for assistance
  • management's willingness to accept advice
  • the portion of your total portfolio invested in the company
  • your expertise relative to company needs
  • your time availability and the company's location
  • the experience, talents and availability of co-investors
  • the degree of potential influence on the company because of both percentage ownership and, very importantly, the quality of personal relationships with management.
• The right attitudes on both sides
  • Investors
    • There is a fine line between supportive, constructive help and advise on the one hand and distracting meddlesome nit-picking on the other. It is very important that the investor, while trying to adequately monitor the company, does not let paranoia make him yet another distracting problem for management to contend with. Such activity by an investor or director can undermine employee morale and ultimately become very disruptive to the entire enterprise.
  • Management
    • By the same token, management should have a very close working relationship, both financially and operationally, with the investor group or its representatives. Senior management should operate in an open-minded, flexible, questioning way in order to obtain everyone's views. Exploring alternatives and brainstorming important issues with all of the high caliber people involved (including other members of the management team) is a key aspect in making sound management decisions.

• Since selecting the right people is, by far, the most crucial element in making a successful investment, the following quote from the successful venture capitalist Frederick R. Adler seems very appropriate:

  "In a sense, every venture capitalist is looking for the man with excellent management experience and past profit and loss responsibility who is greedy, hungry, and yet honest and sincere.

  He must have the intellectual integrity to admit his mistakes and to recognize and reward other people's talents. This man must be technically qualified to do the job, but must not be so immersed in the technology that he loses sight of, the need to build a profitable business rather than a bunch of fancy products.

  He must be a man of ego. If he does not have a very large ego, he is not going to view the obstacles with sufficient confidence. Yet if he is too egocentric and one-sided, he will make some serious, dumb decisions because he refuses to take input from others.

  The man must be tough enough to make very hard decisions if the venture is to survive, and that means firing his best friend if necessary. Yet he must be smart and mature enough so that this toughness is tempered and so that the people he needs around him will not leave because his attitudes irritate them.

  The venture capital business is one of persistence. Every venture capital deal has experienced unexpected problems. They happen daily, weekly, or monthly, and there are enough big ones to scare every manager and venture capitalist. Good management overcome these problems. The weaker ones fall by the wayside.

  To be successful in developing a new project, management must be aggressive, but at the same time it cannot let ambition outstrip its pocketbook. A major problem in the venture business is that almost every early-stage project has a limited source of funds, unless it achieves instant success (a great rarity). Ambitions must be measured and desires reined in to the very tight limits of the pocketbook.

  People who are good managers take advantage of each other by interacting as much as possible. They "truth seek" rather than advocate. Building a company from a small base entails a world of possible mistakes, and the trick is to avoid those that are fatal. By talking to enough bright people, particularly those with direct experience in building a business, management should be able to avoid such mistakes. However, there are no supermen, and it is only by great effort and conscientious attention to detail that businesses can be effectively managed during their earlier growth periods.