Investing in a small business has been compared with getting married, and closing the deal is said to be the wedding ceremony. To carry the analogy even further, after the honeymoon is over, the investor and the entrepreneur will have to make a life together. For the next three to ten years, these two individuals will be working together, not so much on a day-to-day basis but indirectly. However, they will work together enough for it to feel like a full-time relationship.
Before you make the investment, you will have to determine how much you intend to be involved in the business. Most venture capital investment firms are not passive. Most venture firms are extremely active in the management of companies and have a consulting staff to help perform this task. These consultants may supply marketing expertise to help improve the small business’ marketing effort. The VC might also supply production expertise to help with problems in the production area or financial expertise to help with financial matters. Furthermore, the consultants can help with the overall management of the company. And almost always, the VC will help with hiring of any top executives for the company.
However, some venture capital firms are not staffed with consultants. Many will not invest in the company unless it has a full management team to run the business on a day-to-day basis. By and large, venture capital firms do not have expertise in marketing, production, or administrative matters. Most managers of venture capital companies are heavyweights in the area of finance and recruiting management talent for their investments. If they have been in business for an extended period of time, they may possess considerable knowledge of business practices.
As an investor, you will need to determine what role you will play in the business. If you want a very small role, be sure the management team is complete so that it will not have to depend on you.
All major policy decisions about the company should be discussed with the investor and the entrepreneur. Both of you have a vested interest, and you should talk about any major changes. It is very helpful if the entrepreneur describes any major decisions that need to be made in a memo. This memo should be the basis on which the two of you get together and discuss the situation. When entrepreneurs put major problems down on paper, they seem to be reduced considerably.
Monthly financial statements are usually required by venture capital firms when they invest in the company, and this is the minimum any investor should require. The importance of timely monthly financial statements is second only to that of timely monthly payments on debts owed to investors. If you are not receiving timely monthly financial statements and a report on the company, you need to visit the company and find out why. It is usually a sign that the company is having more than reporting problems.
You may have heard practically every excuse for not preparing a monthly financial statement. To date, none are worth the breath it takes to utter them. Simply stated, no firm can be managed without accurate and timely monthly financial statements. Any entrepreneur who begins to tell you that he doesn’t need them should be replaced. Without regular financial statements, there is no way that an investor can make reasonable decisions about the business’s health. Tardy monthly financial statements are a big red flag to every VC.
Not only should these statements be prepared monthly, but they should also be accurate. Every VC has been in an investment in which after the auditors have come in and adjusted the year-end financial statements, the VC had quite a surprise. There are various types of surprises, but the most common one is lower earnings. The most common “big surprise” is a company that will show profits for 11 months and a huge loss for the year, after the accountant has adjusted all of the sales and expense numbers.
The usual reason given for these year-end surprises is inaccurate accounting records for accounts payable and inventory. Also, some entrepreneurs blame the problem on standard cost systems, and as a result have a year-end write-down. Few financial statements do not have adjustments at the end of the year; however, it is the magnitude of the adjustment that you should be concerned about. The reason for any significant change in financial statements at year’s end needs to be explained fully. Any entrepreneur who gives the VC a big surprise at year’s end, and has not fully prepared the VC in the prior months for large write-offs, has destroyed much of entrepreneur’s credibility. When credibility is gone, your investment is definitely in trouble.
A monthly written report in letter or memo form stating exactly what is going on at the business is required by almost every venture capital firm. An example of such a monthly report follows:
MEMORANDUM
TO: A. V. Capitalist
FROM: O.K. Entrepreneur
SUBJECT: Monthly Report for October
Attached are the monthly financial statements for the nine-month period ending September 30. The profit-and-loss statement is understated in that our company will probably not pay taxes at the rate of 50% this year because of our net operating loss carried forward from last year. This should put approximately 95% of the pretax dollars to the bottom line.
As we near year’s end, it is evident that the next year will be an extremely busy year. Our backlog has increased fivefold over last year. You should also note that inventories have increased approximately 40% more than our forecast. This is due to three very large orders that are now working their way through our production line. We have had to add people to the second shift to make sure that the items come through on schedule. None of these three orders will be completed and shipped by our year’s end; therefore, we will start out the year with an extraordinary amount of sales in the first several months.
We have talked to four people since we began looking for a controller to relieve some of the duties of our vice president of finance. However, as of today we have not found a suitable candidate but may be able to find one within the next 10–20 days.
Finally, I am happy to say that the second generation of our product has now been completely designed and developed, and should be ready for introduction into the marketplace within six months at the national convention/trade fair. It will be an important milestone for our company; we introduced our first prototype only two years ago and have since built many of these products. At our next board meeting we may be able to see a second-generation unit.
The monthly report above mentioned several key items, each of which has bearing on the future of the company. It also included a brief discussion of the financial statements, which are fairly self-explanatory. The discussion of the financial statements brought out a point that probably was not obvious to the VC reviewing the financial statement. It is incumbent upon you to highlight in the monthly report any negative—or in this case, positive—developments.
The company should have regular board or investor meetings so that the investor can hear a verbal report and ask questions of the management. You can keep fairly well informed through financial statements and memos, but a face-to-face meeting two to four times a year is a necessity if you are to keep up with the business. It is important that the small business prepare for these meetings. Management should have an agenda and go through it as though they were holding a formal meeting with their board of directors and stockholders.
The first thing on the agenda should be the financial statements. Every management team should be required to review the financial statements against statements of past periods and projections. If management is presenting a new set of projections, a detailed explanation is in order. In general, the entire meeting should have a financial orientation, rather than a marketing or production orientation. As an investor, you are looking at the numbers, and the numbers speak louder than words. The entrepreneur should tell you how much cash the company has on hand and how much credit is in the bank lines.
As part of the meeting, the investor should be taken on an abbreviated plant tour and shown any new improvements that are being made in the company. All members of the management team should be present at these meetings and should participate in the discussions. An investor should have easy access to all of the individuals on the management team, and each should be questioned during these sessions.
In the early stages of the investment, the entrepreneur should be able to produce a cash reconciliation showing exactly where the money invested by the venture capital group was spent.
If the entrepreneur has completed any market research or customer surveys, the results of those should be shared with the investor, especially if there is a significant change from the company’s original perception. If the entrepreneur has news about the competition and their activities, this should also be passed along. If suppliers have changed policies or the entrepreneurs have found new suppliers, the investors are normally told of these changes at this time. If the entrepreneur fails to do so, you should ask your own questions about such items.
You may want to ask whether any industry studies or articles about the company or industry in general have appeared in any trade journals and whether you can get copies of them for background information. You will want to ask whether the company has hired any key people or whether it has fired some of the people that you have met before. Hiring a new director of marketing or changing a controller is a material action, and you should look for these changes. You should ask what changes in overhead have transpired and what additions or subtractions have been made, and you should ask for an explanation. If the company is opening additional offices, find out how it justifies this move.
Make sure to find out what kind of capital expenditures have been made since the last time you met. Any material changes in the backlog, either up or down, should be highlighted in the entrepreneur’s discussion. When audit time comes around, make sure you determine when the audit is going to be out; if it is going to be late, find out why. If research and development is going on, ask for completion dates. As an investor, you should make sure the company meets those completion dates. If there is a target date for introducing a product into the marketplace, you should know whether that target date is met. As an investor, you will always be seeking material information about the company in which you have invested. You don’t want to be inundated with a huge amount of statistical information, but you need to keep up to date on any material changes in the business or the industry.
You will probably find it helpful to subscribe to the magazines and newspapers in any industry in which you are investing. This way, at least once a month or sometimes every week (in the case of a newspaper), you can gather information about the industry in which your company is competing. It keeps you up to date. The more you keep up to date on the business and its industry, the more successful your investments will be.
Maintaining records of your investment will be the key to keeping up and understanding the investments you have made in a company. It is imperative that the following records be kept accurately.
The legal documents are your bible for every investment. You should have complete files containing accurate statements of all amendments, extensions, conversions, sales, exercises of warrants, and the like. The items in your files should be executed copies of the purchase agreement with all modifications. Any supporting agreements should also be enclosed. In addition, you should have conformed copies of all the securities, corporate charter documents and bylaws, specific documents to which the venture firm is a party, and copies of pledges, voting trust, escrow agreements, and mortgages. Any options or employment benefit plans and any franchises or patents, as well as any legal opinions and other miscellaneous items should also be included. All of these should be bound and indexed for easy reference. If you do not organize your legal file correctly, you will regret it later.
You should maintain a general file of correspondence between you and the company. The contents of this file should be arranged in chronological order but do not need to be indexed to specific sections. Instead, tabs can be placed on specific correspondence with meaningful data. The general correspondence file should also include any memos that you dictate to the file to record conversations with the management team. It is extremely helpful to put these notes in the file because they will jog your memory about things that have occurred in the business that you may need to remember in following a company accurately. The memo need not be typed up each time you talk to the entrepreneur. But if you take notes constantly, you will want to record the highlights of the conversation. At the top of the page, write the name of the investment and make sure that you put it in the general correspondence file. This will let you refer back to conversations that you have had with the people at the company and will put you in a better position to judge the progress of the company.
In addition to the legal file and the general correspondence file, you should keep a file of the monthly financial statements, as well as any annual audits. Other financial information, such as tax returns or flash reports on sales should also go in the file. In addition, there should be both projections and actual statements in the file. This will help you continue to monitor the company in which you invest. You may also want to file in this section the one- or two-page reports supplied by the company as to the financial operations of the business. It may be easier to keep them with the financial information so that you can follow the company’s progress without waiting for a lot of correspondence.
If you have been elected to the board of directors or if you are a visiting member of the board of directors on a regular basis, you may want to set up a file that includes all the information that you have been given at board meetings, except for the financial information that you will put in the financial file. This will give you an ongoing file that will help you follow the progress of the company from the standpoint of the board of directors. It may be critical for you to review certain events at the board level to determine whether the company is going in the right direction. For the above reasons, you may need a separate board file. If you are on the board of directors, this separate file will also help you remember what has happened at prior board meetings.
All venture capital funds track the financial progress of their investments by setting up tracking files. These are nothing more than spreadsheets that contain past key information as well as budget and projected information. When new information comes in, the VC can compare historical and projected information with current information to evaluate the progress of the company and compare budgeted information with actual information to see whether the company is on budget. These tracking files often contain all of the ratios in full so that a VC can quickly see if the company is having financial operating problems.
Most of the tracking files are kept on computer spread-sheets and are printed out or digitally conveyed at regular intervals for people to review. The files may also be kept in the common files area of a central VC computer where all the members of the venture capitalist firm have easy access.
When financial information is received that is not digital, it is keyed in and transferred to the tracking model spreadsheet. This is stored in the tracking model file, which is then used to compute all the necessary ratios and to compare them with past results or projected results. This type of detailed financial information can be extremely useful in monitoring a company and will indicate how strong the operating performance really is.
In general, entrepreneurs are unrealistic in evaluating problems. They often fail to recognize the early stages of failure. Entrepreneurs are by nature optimistic. They will cling to their dreams until the doors to their businesses are locked tight and the auctioneers have sold off the last piece of equipment. In all probability, you will have to be the first to react to the warning signals you receive about the business. This is not a difficult task.
These signals of problems are commonly called “red flags.” Normally, investors are the first to point out problems and burst the dream bubble of the entrepreneur. As such, you are apt to incur the anger of your entrepreneur. It is in your best interest to seek cooperation from your entrepreneur but at the same time, you should not let an obvious red flag go unnoticed. If you see the problem and your entrepreneur doesn’t, you are doomed to have a problem business. Listed below are a number of red flags that VCs often see.
If the entrepreneur is late in making payments on a convertible debenture or debts to the bank, the investor will see this tardiness as a very tight cash flow. Some entrepreneurs think it is acceptable not to make payments on investor’s debt so that they can use the money as working capital. If the entrepreneur’s business is not making payments to you, it is probably not paying other folks, including the IRS, payroll taxes, and suppliers. It is only a matter of time before the day of reckoning will arrive. When you find these early warning signals, make sure you try to become involved in the business early enough to head off any potential problems.
If the monthly financial statements start showing losses, you should become concerned. Losses can be a temporary aberration, but you need to determine that very quickly. Don’t listen to the entrepreneur who says the company will be profitable in the next month or quarter. Make sure you go into the details of the problem with the entrepreneur to determine exactly why he or she believes the company is going to improve. Do your own investigation on the numbers, if possible, so you can better understand the problem.
Tardiness in sending out financial reports and other items to the investor is a clear sign that the business is not operating well. Usually financial statements are late because of bad news. Every investor should know that when the statements are late, he or she is likely to get a financial surprise. If financials are late, make sure you contact the person responsible in the firm and find out why. No one can run a business without timely financial statements.
Sometimes the entrepreneur prepares financial reports quickly but not accurately. Poor reports are unreliable indicators of how the company is doing. They are definitely a red flag to anyone investing in a company. One entrepreneur sent financial statements to the VC that showed the company was marginally profitable. This was good news, because the business had been losing money. Then the VC discovered that several line items, such as rent and interest payments, had been excluded from the statement. What was worse, when the VC added up the expense column, the VC found an error that understated expenses by 20 percent. The entrepreneur said these were merely minor mistakes, but within six months the company was liquidated.
If accounts payable have increased rapidly, you should suspect that the company is not paying its bills. You need to find out why as soon as possible. If inventory has become very large, you should also become suspicious. It means that sales are not keeping pace with production, and the items are ending up in inventory. Similarly, ballooning accounts receivable may mean that the company is unable to collect some of the receivables that have been booked as sales but perhaps weren’t sales at all, merely products put out on consignment that will come back at a later date. Certainly, this is a red flag.
When your telephone calls to entrepreneurs are not returned consistently, this is a sign of problems. The entrepreneur may be afraid that you will ask questions about the business and find out it is in deep trouble. Another bad sign is the entrepreneur’s failure to schedule regular board meetings. This is a clear warning signal to the investor.
Unexplained large thefts of inventory may be an indication that the entrepreneur is stealing from the company and covering it up by reported theft. More revealing is theft that the insurance company does not cover. This normally means that the entrepreneur is unwilling to pursue the case with the insurance company because investigation by the insurance company is not welcome. An unexplained fire falls in the same category. Entrepreneurs in trouble often try to cover up their problems with fire. In the South, a large fire that destroys a business inventory has been called “selling out to a Northern concern.” As the story goes, “good old boys” will insure their assets through a Northern insurance company, then a mysterious fire will wipe out all the inventory, and they will collect from the Northern insurance company.
As discussed before, large year-end adjustments of numbers indicate that management is not running the company well. If the company has to write off a large part of the inventory or if the accounting firm is not willing to capitalize some expenses, the impact on the profit-and-loss statement will be disastrous. This type of adjustment is a sure indication that management is not running the company well. This is a very large red flag.
Because the decision-making process is handled by so few people in a small company, when one of these decision makers leaves, it is a sure sign of trouble. Continuity of management is essential in business, and the lack of it throws a warning signal not only to the investor but also to employees, customers, and other creditors.
You must determine whether an employee has been fired for good cause or whether the departing employee “jumped ship” because it will soon be sinking. If possible, talk to the employee and find out why he or she has left.
As an investor, you are probably following the backlog and sales of the company in more detail than the actual financial statement. When you see the backlog declining, this is a sure indication that the company is going to have problems in the future. Increasing backlog may indicate a problem in production or shipping. Decreasing backlog may indicate that the company is having severe problems in the marketplace. Any rapid change in the backlog needs to be explained.
At times, backlog builds up because the price of the product has been cut and the company is having a tremendous problem in meeting the new pricing structure. A big change in gross profit margin can keep sales increasing, but profits will eventually be eroded. Keep your eye on the backlog, because it may mean that the company will have to revise its lead times to meet customer demands. This backlog could ultimately affect sales. It also may mean that the company will have to expand its production capacity to meet the demands of its customers.
Inventory figures can give you a clue as to what is going on in the company. Inventory turnover that is low in comparison with the rest of the industry may indicate that the company’s product is not being accepted in the marketplace and that too much money is tied up in inventory. Out-of-stock items, especially on fast-moving products, can be a sure indication of problems on the production side of the business.
Any inaccuracies in inventory are a sure sign that the company is not being run well. Large changes in the records so that they match physical inventory may indicate that the production process and inventory are both being poorly managed. Eventually, these changes in inventory will have to hit the profit-and-loss statement and will harm the company. A properly managed and documented system is the backbone of a good company.
Every company needs to budget and plan. A company that plans poorly will surely not survive. A company with a sound planning system will be able to tell where the company is going. When a budget is missed month after month, you should determine the reason. In addition, you should become concerned if you find that the company has failed to meet the goals of its long-range plan. It cannot succeed in the marketplace if it continues on such a course. As a business grows from the entrepreneurial stage, preparation of financial and operating projections becomes more important to the decision-making process. Thus, the business cannot continue to prosper without timely and accurate data.
At times, it is necessary for a company to change its accounting methods but at other times, such changes are adopted so that creditors and potential lenders will not detect the problems that are brewing. The key signs to look for are changes in the depreciation or useful life of units, changes in the method of recognizing income (such as recognizing revenue before the company has had all the performance criteria), and changes in the method of valuing inventory, such as LIFO (last in first out) to FIFO (first in first out) for overhead rate or the amount of scrap rates. Eventually, they all show up on the profit-and-loss statement.
One of the easiest warning signals to pick up is the loss of a major customer. This is a sure sign that the company is doing something wrong and that it may eventually lose additional customers.
The same is true for suppliers and lenders. When a supplier drops a company or a lender refuses to lend, something is wrong with the company, and it should be a quick tipoff to you that the company is having problems.
It is the duty of management to get along with labor. An entrepreneur should instill employees with the same kind of fervor that he or she feels for the industry and the business. Whenever employees grow dissatisfied or go on strike, management is not doing its job right. Problems in the workforce are a sure tipoff that the company is in hot water. Keep your eyes out for labor problems, which are indicated by either a wildcat strike or a loss of employees.
Declining sales in a booming industry are an obvious problem, but sometimes the clues are more subtle. Sales may be expanding but the company’s share of the market may be shrinking. If it is getting less than its fair share in a growing industry, it is having a problem in the marketplace.
Also, if the company drops its price quickly, this probably means that the product is not being received well. Perhaps the product itself is at fault or perhaps it isn’t suitable for its target customer.
Signs outside the business can also signal trouble. Below are listed some of the common ones.
New developments and processes may change the way companies compete in the industry. An entrepreneur must be aware of all such changes to determine how they will affect the way that the company does business in the industry. You must determine whether the company has the flexibility to respond to these changes and stay in the market. Each time there is a technological change, the entrepreneur and the investor must determine what they need to do to meet this new challenge.
At times, the industry itself may go into a slump because the major consumer of the product is no longer demanding the number of units it asked for in the past. These general slumps come and go in almost every industry, and you need to determine why the slump has occurred, how long it will last, and what can be done to reorient the company’s products to take advantage of some other market that may be developing.
Many industries are regulated heavily, whereas others are not. Whatever the case, every industry is subject to some regulation. Each time the regulations change, the industry is affected. Government has been known to regulate a company out of business by making it impossible to perform. This has happened several times in U.S. history. For example, the Small Business Administration has changed policies on its lending programs and put some users of the program out of business. You need to keep your eyes open for new regulations that could kill your company and the investment.
A host of early warning signals can emerge from the analysis of key ratios in a company. These include not only current ratios and the ratios of stockholders to total assets, but also ratios of working capital turnover in debt to equity. All of these factors will give you a clear picture of what is going on with the company.
If receivables turnover (net credit sales divided by the average net traded receivables) begins to change rapidly, you’d better find out why. If daily sales and receivables continue to change, you also need to find out why. Any number of profitability, productivity, and market ratios can be found in a standard textbook on business ratios. Each one of these will give you an indication of what is going on. The sooner you begin analyzing the company in terms of these ratios, the better you will be able to determine what problems a company is having.
Here are a number of things that you may not pick up unless you have had years of experience watching for telltale signs.
An entrepreneur once said that he had decided to move from Massachusetts to Florida because the weather was much warmer and he thought that he could run the business just as well from Florida. Even the most casual observer will recognize that you cannot run a business from a great distance. Most small businesses need hands-on management. So when an entrepreneur is going to move to a different town, you’d better make sure that the entrepreneur is going to move the business too. If at all possible, you should prevent the entrepreneur from moving.
Moving the business or a major plant within the business is perhaps the most dangerous change anyone can make with a small business. The physical disruption alone can affect almost every aspect of the business. Not only do you lose workers, but it often takes six months to a year to resume operations fully in the new location. Don’t finance companies that are about to move. It is just too traumatic, and you always end up losing money on businesses that move.
Sometimes an entrepreneur will come in and tell you about an investment that the entrepreneur is going into personally. This is always a big red flag. Whenever an entrepreneur puts his or her time and attention into anything else, you can be sure that the business you invested in will suffer. No entrepreneur can run two businesses. If your entrepreneur is going into another business, your business is simply not going to do as well. Use all your persuasive powers to convince your entrepreneur to ditch the idea. Emphasize that the business can make all the money that the entrepreneur ever wants to make. Every time an entrepreneur changes investment objectives, the investor suffers.
All too often, an entrepreneur will come into your office and suddenly announce, “I am out of money and I cannot meet Friday’s payroll.” Invariably, the entrepreneur’s cash flow projections showed enough money to get along for another year. Somehow the company has gone through all of the money that you and other investors have given it. What is worse, the entrepreneur inevitably comes in at the last minute and expects the investor to bail out the company. Resist doing this at all costs and make the entrepreneur get through this crisis alone. If you make it easy for the entrepreneur to get out of this situation, it will happen again and again in the future. The second thing to do when you find that the entrepreneur has led you to the brink of disaster is to look for a way out of the investment. Your other option is to fire the entrepreneur and get someone in who is more responsible.
Entrepreneurs who are in love with technology and engineering often create problems. They no sooner finish a prototype product than they are ready to develop the next product, even before they have run any profits out of the first one. This will show you that your development people are not marketing people and that you have just invested in the wrong kind of company, a development company. You should always invest in marketing companies. Whenever you find yourself in a development company, try to get out as soon as you can. Development companies are rat holes in which investors dump millions and millions of dollars, never to see a cent in return.
An inventor entrepreneur will develop some great products for you. However, the same entrepreneur will also invent products that are unrelated to the business in which you have invested. If you have invested in a company involved with biotechnology, you may find your entrepreneur hot on the trail of the next great solar-energy product. Every entrepreneur believes that each product will launch the next great technological revolution. They want to put money into all of these products. This is the wrong type of management team to invest in. Get out of the business or you will lose every nickel you have put in.
This is a personal sample of some of the nutty things that we have run into as investors. Whenever you see these, start working on a way to get out of the deal.
When you ask a VC the question, What makes a good company? the VC will always say, “Good management.” But that goes without saying. If the company shows strong growth and the VC makes money, it had good management. If the company gets in trouble and loses money for the VC, the company had poor management. So what does the VC mean by good management? The VC means that management knows that the problems a small business fears most are: (1) lack of financial monitoring and control and (2) undercapitalization.
Most entrepreneurs can put together a good business plan and solid projections, and can understand the cost of the required capital from banks and VCs. However, only a few will set up a system to monitor progress and analyze the information they are receiving. As an entrepreneur, you should want to know the weekly sales figures. Some in retail operations even want to know the daily figures. Every entrepreneur should be watching the figures closely. When cost figures do not coincide with those projected, find out why. When sales do not match projected figures, find out why. When the projections do not work out precisely, revise the future projections to determine how much capital you are going to need.
The most successful entrepreneurs have been “cash flow freaks.” These are people who know exactly what is going on in their companies from a numerical standpoint. They know when they will run out of cash, the so-called “drop dead date.” They know what they have to do to increase cash flow. When things get rough, they know how much money they need to carry them through the next stage. They know precisely what they are doing in allocating their scarce resources properly. A monthly profit-and-loss statement is almost an afterthought for them. They ride herd on the company’s cash on a weekly and sometimes daily basis.
Undercapitalization has always been a serious problem for small businesses. Too often, the entrepreneur will fail to raise the amount of money needed. The entrepreneur will raise $2 million when the company needs $5 million. The entrepreneur does this so that he or she won’t have to give up as much equity to the VC. This approach is shortsighted. Most businesses need more money than originally projected to reach profitability. When the entrepreneur needs the extra money, the VC may charge a high price. Always make sure the business has enough money so that there will not be a difficult moment later.
Smart management recognizes the need to have sufficient capital in the company. It does not tie up excess capital in accounts receivable or inventory. It seeks ways to increase the capital in the company. When the company grows, management knows the company must increase its capitalization. Be a good investor and make sure the management maintains adequate capital for the company.
Many an entrepreneur can run a company well when it consists of a small, intimate group but cannot manage the business when it begins growing into a larger company. This failure often relates to the selection and management of people. As can be expected, no business can grow and remain a one-person operation, nor can an entrepreneur remain a chief with many Indians. In order for a company to grow, the business must attract top-notch middle management to the team. There are five basic reasons that many small businesses fail to build a strong middle-management team.
Senior management often fails to understand precisely what jobs need to be filled. Entrepreneurs are accustomed to dealing with undefined job responsibilities. They expect the team to join in and work. However, as a company grows, specialization becomes important. Certain jobs must be segregated and defined so that suitable individuals can be hired to do those specific jobs. As an investor in the company, you must make sure that management has good job descriptions.
Once the job has been defined, top management may use a poor selection process. It is easy, for example, to let “good ole Joe” continue to be controller of the company because he has been the bookkeeper from the beginning or to hire a relative out of loyalty rather than ability. These practices do not ensure strong middle management. As an investor, you need to monitor this.
To attract middle management to your company, you need an effective incentive plan. The members of the entrepreneurial team have a high incentive because they own a large share of the company. Their egos are submerged in the business, and they want to make it a success. New members of the management team won’t have the same rewards. To motivate them, top management should consider the various traditional methods of compensating top-notch middle management. These include stock options, stock performance rights, good pension and profit-sharing plans, bonuses based on formulas of sales or accomplishments, and the like. If you do not set up a proper reward system for your middle-management people, they will not perform. As an investor, helping to define the reward system is part of your job.
Because middle managers do not get the same satisfaction out of the growth of the company as entrepreneurs, they need to be rewarded through traditional review programs that let them know when they are succeeding and when they are failing. A good review program will give you an early warning of any problems with middle managers. It will also give you an opportunity to correct the problem. You must make sure that the business has a review system that is in concert with the company’s incentive system.
Sometimes a company outgrows the abilities of the initial middle-management team simply because the managers are not given a chance to develop their skills through seminars and other educational methods. This situation can be avoided by having all the members of the middle-management team come together to share their ideas and discuss the problems they are having within the company. This interaction permits marketing to become acquainted with what is happening in production and allows finance to understand the problems of marketing better, as well as other aspects of your business. This kind of internal professional development program is necessary for any growing company and should supplement a regular development program. As an investor, make sure the company continues to develop its employees.
When a company has a severe operating problem, as an investor you will be trying to make one basic decision: Should you try to remove the current management and find a new group to run the company? If you have lost confidence in the management team and this has turned into a crisis situation, removing management might be the best thing you can do for the company. In general, there is a rule in the venture capital community that an entrepreneur only gets one chance. This means that if the entrepreneur screws up and brings the company to a very difficult situation, the VC will try to exercise the legal rights and force the entrepreneur out or sell the business.
In analyzing this situation, you will want to determine the best method of getting back all of your money. You need to minimize your losses. First analyze the earning capacity of the company. Can the problem at hand be solved, and how quickly can it be solved? How much will it cost to carry the company while the problem is being solved? If the problem is solved, will the company be sellable? Before you invest any additional money in the company, you need to analyze the company in the same way you did when you made the initial investment.
Each new dollar that you invest is like a new investment. You must ask the question, What will be my return on investment? Throwing good money after bad money is one of the greatest mistakes investors make. Meeting another payroll just to keep the company alive so you don’t have to write off an investment is the easiest way to end up with a lot of money in a bad deal.
Second, after looking at the earnings power, you will have to examine the “bricks and mortar.” This means that you must look at the assets of the company to try to see what it would be worth in liquidation. If you move in, liquidate the company, pay off the bank, and have the remaining amount coming to you and other investors, what will you end up with? In doing this analysis, you should look at suppliers who might offset against the inventory, any mechanic’s liens that are in place from work that has been done for the company, taxes that could conceivably jump in front of everybody else, and any other creditors that may come out of the woodwork and put a claim on the assets. And don’t forget the legal fees, which add up very quickly in a workout situation. Once you have had a chance to review this situation in detail, you will have to choose the “earnings power approach” or the “bricks and mortar approach.” When you have decided which road to follow, you will need to stick with it for a while.
Whenever you have to analyze a company in crisis, the out-come will be less than satisfactory. In fact, most analyses of companies in trouble are inconclusive. Nonetheless, as an investor you will have to make a decision concerning the company in trouble. There are five basic options open to you as an investor.
To fix a problem, whatever it may be, you are going to have to invest more money in the business to keep it going. You may have to hire additional people or do whatever else is necessary to solve this specific problem and save the company. Most entrepreneurs will plead with an investor to put more money in and go forward with the company and that the end of the rainbow is just around the corner.
In one venture capital situation, the company was in the cement business, which is a very cyclical business based on the demand for housing. In the early 1990s when the housing industry was in shambles, some new projections suggested that a turnaround was about to take place. The entrepreneur and the venture group bought the cement company in the fall and used the capital during the winter to carry the company. By spring, it needed an injection of capital, and the equity partners put in additional capital. By the end of the summer, the housing industry had not come forward, and the equity partners were called upon once again to place additional equity in the company to carry it through the winter. Only a few of them put up additional money. By this time, the partners owned approximately 75 percent of the company and the entrepreneur 25 percent. When spring came and another capital infusion was needed to carry the company through the summer, the venture partners put up more money and diluted the entrepreneur down again. The expansion of housing starts did not come soon enough, and this time the venture firm sold the company for a pittance, took a few bucks, and left town.
The important thing to remember here is that each new investment opportunity that you are offered should be treated as though you had never had an investment in the company. Don’t think about the money you have sunk into the company. If your feelings about a new investment in this company are negative, you should tuck your tail between your legs and walk away like a wounded dog. You should not continue to “throw good money after bad.” You should select one of the other alternatives set out below.
Many VCs have gotten out of bad deals by merging them with other businesses. Invariably, it seems that every business is worth more as an operating entity than one that is shut down. This is certainly true of every service-oriented company. Merging the company in which you have an investment with a larger entity that can bring in money and management to the distressed company may be the only way to get your money back.
There was one venture capital situation involving a retail tire store where the alternatives were to inject additional money into the company or sell it. Because the VC had lost faith in the entrepreneur, the only thing to do was to sell the business quickly. As you can imagine, the tire business is made up of leased locations, inventory, and people. Without these three ingredients, you have nothing of value. It was necessary to move quickly and find another tire retailer who wanted to enter the marketplace in which this tire company was located. It was the only way to save the investment.
You will be faced with quite a few situations in which you will want to find a buyer for the company. Before they even go in, some venture capital firms work out a scenario in which they identify companies that would be potential buyers, should the company get in trouble. You may want to do this.
It you were smart enough to make your venture capital investment in this problem company as a loan with an option to buy stock or convertible debenture, you are a creditor in this company, rather than an investor, and you can foreclose against the assets of the company. If the company is not paying you principal and interest as agreed, your loan can be called in default, and you can begin to seize the assets and try to operate the business or sell the assets in a general auction to get your money back. This is a very difficult method of operation, and most VCs do not achieve it successfully.
If you were able to get a secured position on the assets through a UCC-I, you are a secured creditor, and as such you have the option of moving in and foreclosing on the assets. In one venture capital situation, the investment group had to foreclose on the assets of a large radio station and began operating it. One of the main reasons the VC group had to take over the assets was that the previous owner couldn’t get any ads to be played on the station. In operating the radio station, the investors would listen to the radio every day as they drove to meet the payroll. One day as they were driving along, they heard many high-scale advertisements being broadcast. When they arrived they asked the radio disk jockey how he had been able to sell so many good ads. The disk jockey coyly replied, “Oh, I didn’t sell any ads, I just like to listen to the ads on the air so I put them on free.”
VCs are usually not good operators. As an investor, you may not have the time or the inclination to run the business. On the other hand, you still have the option of holding a foreclosure sale, selling the assets at auction, and taking what money you can get out of that to apply to the money owed you. In the instance above, selling the station would have been the best alternative.
Some investors now look at bankruptcy as less of a bad place to be, especially if the company has large debts from banks. When the bank begins to move on the assets and foreclose, the only way to salvage anything for the stockholders is to take the company into bankruptcy. The new bankruptcy code is quite lenient toward business owners (it was written for debtors). It allows the creditors to take the company and work with it for a number of months to try to restructure its liabilities and pay them off over an extended period of time.
In one situation, bankruptcy was used to hold off the senior creditor for three years while the company operated as “debtor in possession.” This meant that the management team continued to stay in place to run the company and held the bank at bay. The senior creditor was unable to foreclose on the assets, and the company continued to show improvements; in a short time, the company came out of bankruptcy and was able to pay back its debt. This is easily one of the few times this has happened for small businesses in bankruptcy. Usually they get liquidated or the assets are sold to a new group that buys it from bankruptcy.
Liquidation has been mentioned along the way, but it is the least desirable of all of the alternatives, simply because it usually doesn’t pay off. Sometimes a business that is asset-heavy, such as a paper manufacturing plant, may be worth more dead (liquidated) than it would be as an operating entity. As an operating entity, it is going to continue to lose money. If an investor is placed in this position, the investor definitely needs to seek liquidation of the company’s assets to recover as much money as possible. None of these choices are easy. As an investor, your principal concern is to find a way to salvage your investment.
Every relationship is based on trust. If you have entered into a financial deal with a company that you do not trust, you have made a grave mistake. You are sure to have some doubts about the firm in the initial months, but if your checking has been accurate, the firm should prove trustworthy. Assuming you both trust each other, there must also be a desire to help each other. The company wants to make money, and you want to make money. You both have a common objective. One should not be making money at the other’s expense. You should be on the same level and, therefore, should have a desire to help each other. From time to time, you may be asked to help with various problems encountered by the company. Remember, you are partners.
More than anything, the secret to a successful relationship is the ability to talk to each other and to communicate both the good and the bad news to one another. If two individuals can openly discuss the things they like and dislike about a relationship, as well as tell one another what things are good and what things are bad in a constructive critical approach, the relationship will most likely be a successful one. In turn, the business will probably prosper.
We remember one story of an entrepreneur who was highly motivated, well trained, and an achiever of the first order but was unable to admit failure. This flaw dominated his personality to such a degree that not only did he refuse to admit small errors, but he would also not accept the fact that his company had lost $1.75 million at the end of its second year. When he received the audit from a large accounting firm, he would not accept it. He made the accounting firm restate the figures and give him a qualified opinion. The financials showed the company had made a profit and was in good financial condition. The accountants’ opinion had a section that said the financials were correct, subject to the adjustments made by the entrepreneur. The entrepreneur presented these financial statements to his board of directors, to his bank, and to his investors. He seemed to think that if he could somehow get through the year without anyone except the accountant knowing his true condition, he would have time to turn the company around and cover up past mistakes. This entrepreneur was unsuccessful in his cover-up, and the company was liquidated. Many people lost a great deal of money.
In relationships with investors, boards of directors, and employees, the players should be open. Save all the conniving and devious actions for the competition, as long as the actions are legal and acceptable in the marketplace where the products are sold.
The amount of time you as a venture capital investor want to spend with the company will depend on a number of factors.
The amount the VC has invested in the company, compared with other investments, will determine how much time the VC spends with the company. This will be a decision you will have to make. If you have invested $500,000 in an early-stage company, you may not spend nearly as much time as if you have had invested several million dollars. The larger the amount invested, the more upset you will be if you lose it. The more the invested funds mean to you, the more attention you will give.
If the company has a management team and does not need assistance, you do not need to spend time with the company. If the company needs a financial adviser or someone to discuss marketing, you may perform that function. The more help the company needs, the more you should be concerned, and the more time you will need to give to the company.
If management is willing to accept advice, most investors are willing to give it. If management resists every suggestion, obviously a VC will not waste time making suggestions to management. There is a fine line to walk. Entrepreneurs should be hungry for advice on major decisions but not on day-to-day operations.
If you are not experienced in a certain area where the company has a problem, you will not try to advise the company on the matter. If the entrepreneur has good financial information and is a financial whiz, the VC may not try to help with financial decisions.
Usually if a VC is the lead investor, the VC will spend more time with the company. This arises from the responsibility to the other venture capital investors. Although the lead VC is under no legal obligation to ensure that the other investors make money, the VC reputation is on the line with his or her friends. If you are the lead VC, you will have to do a lot of extra work to help keep the others up to date.
If the company is in distress, the VC will have to play an active role. Every VC spends time working out problems rather than reviewing new deals. In fact, many VCs say they are not in the venture capital business at all but rather are in the business of working out bad deals. They are always trying to avoid losing their money. It seems that the good companies take care of themselves.
Often, a strong bond will develop between the entrepreneur and VC. A certain chemistry that exists among people in venture situations draws them together. Great friendships have arisen from these relationships, even in dire circumstances. You will find that many of your greatest friends are the managers of the portfolio companies.
As you know, investing in small companies is very time-consuming. You need to work on the most pressing problems first. If the new investment is a small problem or if it is operating well, you can invest most of your time in solving more serious problems. Make sure the entrepreneur does not interpret your lack of attention as a lack of interest in the company. The amount of time spent on an investment is usually inversely proportionate to the success of the investment. In general, you cannot make a company successful, but you can often save an investment when there is trouble.
There are some basic things that you should try to do as an investor in the company if you want to monitor the company. It is extremely important that you follow some of these suggestions to save yourself from waking up one morning with a serious problem on your hands.
When you make your investment, make sure that your entrepreneur understands your objectives and understands that you believe this is a partnership in which you both share a great deal of information about the business. Make sure you set the right tone on the way in to the investment. Exhibit a great deal of interest and enthusiasm for the business, and you will find that the entrepreneur will understand your interest and supply you with plenty of information.
Make sure you understand what business you are in and what products the company produces so that you do not come across as a complete fool when you are talking to the entrepreneur about the business. The entrepreneur does not expect you to be an expert in the business, but if you do not know one product from the other or continually show little knowledge of the industry, the entrepreneur will conclude you do not have as much interest in the industry and, therefore, will stop giving you information. Stay on top of the business and its products so that you can talk knowledgeably with the entrepreneur.
It is also important that you know who the competition is and that you continue to seek information about them. Every time you see information about the competition, clip that piece out and send it to the entrepreneur to show that you are keeping up with what is going on in the business. If there is a study coming out on the industry, try to read it and share your thoughts about the industry with the entrepreneur. By being an informed investor, you will be sure to gain additional information from the entrepreneur. Be a knowledgeable person, and the entrepreneur will seek you out to discuss the problems of the business and the industry.
You may not need to join a local trade association to gather the information about the industry, but you will definitely want to subscribe to industry magazines. They may be boring reading from time to time, but one or two articles will come along that will let you know more about the industry than you did before and will be a source of information to discuss with the entrepreneur running the business. Because it is important to keep up with the industry, a subscription to the industrial magazines is a must; joining the trade association is an option.
You need to know all of the people in the business in which you have invested. Know the top five or six people; get to know the secretary to the president. Let them become part of your group. At a minimum, write down all of their names, so that when it comes time to meet them again, you will have their names on the tip of your tongue. Do not walk up and say “Hello”; say, “Hello Joe, it’s been a long time since we have seen you.” Make sure you know the people in the industry, and keep talking to them. If on an occasion that you have a marketing question are unable to reach the president of the company, call the marketing vice president and ask the question. This will let the management team know that you are out there and that you are part of the team. You do not want to be a pest, but you do want to be part of the team.
The greatest way to obtain information about the company is to spend time with the chief executive officer. It is an unwritten law that the people who do not spend time with the president are not going to know much about the company. The CEO is at the center of all that is going on in the company. If you do not spend time with that person, you are not going to learn much about the company. It is essential that you and the entrepreneur become close friends and go forward to try to make money together.
It is also essential to building the relationship with the CEO that you continue to communicate. You need to praise people when they do things right and criticize when they miss the mark. Help them build a team by praising them when they do a good job. Make specific observations, but always qualify them with, “We are not experts in the business, but....” This will let them know that you are not trying to present yourself as a manager or leading authority in the industry, but rather as a person who is greatly concerned about the company and one who is offering friendly advice.
Do not ever let up on tracking the performance of a company. It is imperative to keep up with sales and earnings of the company, as well as all of the financial ratios. If you let down your guard in this area, you are apt to wake up with a big surprise one morning, even though you are the best of friends with the CEO. Tracking performance is one of the critical aspects in watching the company grow.
The quickest way to blow it as a monitor of a company is to do one of the following.
If you appear at the company only when it is having problems, you will be considered an enemy and not a friend. Enemies (vultures) appear only when a company is having problems. This is the most often heard criticism of bankers among small business people. Bankers are never available until a problem occurs, then you cannot get rid of them. Although a banker may be satisfied with this kind of relationship, you as an investor cannot be.
It is very easy to react to every problem that the company has rather than being part of the planning process. If you do react each time, you will again be considered an outsider. Be part of the planning process and understand what the company is trying to achieve. When it misses the mark, come down on the company in terms of negative feedback, but do not react emotionally.
Being a Monday-morning quarterback is an easy skill. It is easy to second-guess a management team. However, it is hard to dish out negative feedback without looking as though you are second-guessing them. Be sure you do not say, “If we had been in your shoes, we would not have done that.” If you are part of the planning team, you were there when the decisions were made. Try to work your way out of problems and not compound them by discouraging management.
Everybody wants the company to make money. You do not want to be so involved in the company that you become a pain to the management. You want to be a plus to the management team, rather than a thorn in its side. As long as management is following the best path for the company, you should try to be part of the team. In times of trouble, praise works better than pain.
During the period of time you are working together with your entrepreneur, you both will have one objective—growth. You want to see the company grow as fast as possible and see it become as large as possible. You want to see sales increase, and you want to see profits improve. Those are your basic objectives in investing in the company.
If the company has grown sharply and is now becoming a large organization, you will start to look toward exiting your investment through a liquidity event. You want to be able to sell part of the investment when the time is right. You receive no bonuses because of the company’s growth and success. You receive your rewards when you are able to sell part or all of your investment and make a large profit.