Entrepreneurs thinking like an investor

Fast Company posted an article recently about the need for entrepreneurs to think like an investor when raising money. In my classes on entrepreneurial management and new venture creation, this is a theme that we try to instill in students contemplating the entrepreneurial journey. So many times, we talk about entrepreneurs being totally unrealistic about company valuations when dealing with investors or simply naive about understanding the investment process in angel or venture capital arenas. Here's some thoughts to further delve into the subject:

1. Understand the 5X and 10X Return requirements. Angel investors and venture capital folks need a relatively high rate of return on their investment. No kidding. But one needs to understand that an investor in your company is one in a portfolio of ten or more company investments made by Super Angels or VCs. Especially in a VC fund portfolio, the Power Law has been heavily documented (e.g, Sebastian Mallaby's book Power Law) where one or two companies will generate a high percentage of the returns in the 10- or 12-year life of a VC fund. Most funds require an average annual rate of return of 25% or more for the entire fund. If only one or two investments will generate these returns, those companies need to provide a return that is 5 or 10 times return on the investment. (Note: 10X return would be worth $10 million on a $1 Million investment. If the investment was liquidated in five years, this represents a 60%+ annual rate of return). A majority of startups (probably 99% or more) are not capable of generating this).

2. Return is generated in the exit, Most investments will never generate annual income to support the returns needed by angels or venture capitalists. Thus, the return for their investment will come from an exit by your company - a sale or an IPO, usually within five to seven years after the investment. This is bothersome for many entrepreneurs as they don't want to sell, they want to build a company for the long term. Why the five- to seven-year exit plan? VC funds have a life of 10-12 years. They need to invest, manage and liquidate all their investments within that time frame for their limited partner investors. If they invest in your company several years into the fund life, they will have a limited time to exit.

3. The golden rule of investing. Many entrepreneurs focus on maintaining at least 51% ownership of the company's stock as a way to control the company. They assume that as long as they have majority control, they can dictate the decisions and direction. VCs don't care about 49% or 51%. They know that the 'golden rule of investing (i.e., they who have the gold, rules) instead focus on terms of investment using preferred stock with rights and privileges, board control, etc. It's imperative to understand that most investors are only doing so to control the risk of their investment. It's imperative that entrepreneurs understand the control features and type of financing instrument in their investment documents to realize how this risk management process occurs.

4. Project and Reflect. One of the most difficult things to do in a startup venture is to maintain focus on the most important activities when there are so many things to do and so few people to accomplish them. In established companies, they have profitability goals, shareholder value targets and other metrics that provide focus to decision making. In young companies where there isn't an operating history and there aren't revenues or profits, focus is more nebulous. One principle I recommend to startups is to follow the 'project and reflect' approach made famous in a Harvard Business School Case study on seed venture fund Onset Ventures. In project and reflect, the team is to consider what decisions and activities will increase shareholder value in the eyes of the next round of investors. Much of the time, these activities are correlated with key milestones in path to market in the new product or service. To ascertain what milestones will create a higher stock price in the next round of financing, Onset Ventures simply asks the potential investors in the next round what accomplishment(s) would increase the share price when they invest. The team then focuses decisions and actions on these milestones.

5. Due Diligence on your potential investors. While investors will investigate all aspects of the founding team's lives and key aspects of the business in the due diligence process, many entrepreneurs don't do the same level of investigation of their investors. Granted, the investors have time and resources to go into detail, the founding team can conduct its own due diligence. First, review the investor's portfolio. Most put that online. Ask the investors for permission to speak with a sample of the companies they've invested in. If the investor fails to grant you such access, this may be a sign to move on. Second, definitely conduct an internet background search including social media reviews, blog posts and other info. Third, ask the entrepreneur for a CV/Resume and tell them you will check info like you would if you they were a prospective hire. Finally, talk with the investor on several different occasions prior to investment in a variety of different settings allowing a members of the founding team to meet with them as well. Why all work? Once you take the investment, you're in a new relationship that limits the company's options. You're trying to investigate where the investor received their funding and dry powder for future investments, their level of involvement in their portfolio companies. The level of value beyond money in how extensive is their social network, what areas of expertise can they provide as an advisor, etc. Finally, you're really trying to evaluate chemistry between the team and the investor.