As chronological sequences go, this chapter should be the first chapter. However, it seemed important that you be able to recognize a good investment before you go searching for one. So we began this book with the determining what is a good investment, following up with the due diligence process, completing the closing process, monitoring the investment and then finally exiting the deal. We now discuss where to look for good investments. Venture Capital has become a very mature and saturated market, so distinguishing yourself and your products is essential.
Before you can establish a marketing approach to finding good investments, you need to develop your own investment objectives. This is not as easy at it sounds. Making money is a very general objective, and although everybody says that they are out to make money, there are thousands of ways to do it. As an investor, you must make some basic choices or you’ll be pulled in a thousand different directions. Here are some important areas to review in establishing your objectives.
Every time you ask VCs why they are investing, they usually say they are investing to make money for themselves and their investors. But VCs have other desires, as well. For example, some major corporations invest in small businesses in order to have a “window on technology.” That is, they want to see what small companies are doing in a certain area of technology. So they invest not only to make money, but also to learn about new technologies.
Other large companies invest in small companies to develop information about an industry so that they can acquire companies in that industry. They also may invest as a prelude to making acquisitions, like a shark taking its first bite before it swallows the whole fish. Some large companies invest for public relations purposes. That is, they try to generate goodwill in the marketplace by investing in some small, community-based companies.
Some people invest to “save the world.” They feel that by investing in a small company with a great technology, they will be able to help the world. It may be a new medical product. It may be a new solar generator or alternate energy source that is going to wrest power from the hands of the oil cartel.
When you are looking around for partners to co-invest with, make sure you understand your proposed partner’s purpose for investing. If it is not consistent with your own, you should not co-invest. In all likelihood, you will end up at odds in trying to decide where the company should go.
Some investors have plenty of equity money to invest in small businesses and as a result, they can invest in common stock or preferred stock, or they can buy debt in the company. If the investor has equity-type money and plenty of it, there are many alternatives that the investor can provide. On the other hand, if the investor has a strong net worth but not much cash, the investor may be willing to guarantee a debt from a bank to a small business in return for an equity stake in the company. By doing this, the small business gets the money it wants, but it receives the money in the form of a loan, and it has to pay interest on the loan, as well as give some equity to the guarantor.
In another method, the investor may have great credit lines with the bank so that the investor can borrow the money and lend it to the small business. In this situation, the investor has access to debt-type money and needs to use a debt instrument for the investment in the small business so that there is money coming in to service the loan the investor took from the bank. Otherwise, the investor has a negative carry, meaning that the investor has to pay the interest on the loan to the bank and has no income from the investment.
Most VCs have short-term money. The partnership they form to raise the money has a finite life, and their investment must be paid back so they can meet the terms of their partnership. The general term of VC partnership money is five years.
The type of money you have to invest will play a big role in determining what type of investment you are looking for and how you can make money.
Some investors prefer to be involved in a particular stage of a company’s growth. There are many stages of development: seed, startup, and later-stage. Seed stage is when the business is just an idea. Start-up stage is when the company is just beginning to produce its product. There are later stages, such as second- and third-round financings. These later stages have relatively lower risk than the earlier stages because the company is most likely nearing cash flow positive, where it can carry itself. However, it doesn’t give the investor as great a feeling of accomplishment as it would the investor who had invested in the company since inception.
In addition, there are many varieties of turnaround investments, in which the investor finances a troubled company that will need a great deal of work in order to turn it around and make it profitable.
There are also LBOs, in which a group of management people get together and borrow a great deal of money and put up some equity to buy a company. This, too, is a special type of investing that takes a different type of investor.
You need to determine the stage of company development at which you wish to invest.
Some VCs are generalists. They will invest in practically any area of industry and have an appetite for anything from oil wells to high technology. Most investors feel that they must specialize in an area (or areas) in which they have some knowledge so that they can concentrate on finding the best investments in that industry. You too, will need to select a specialty area that you would like to invest in so that you can communicate this to the outside world. It is important to convey a specialty in an area or a type of financing in order to differentiate yourself in the market. Not only has the equity market become very competitive, but you may also be spending time on investments in which you may lack a fundamental understanding. You may also be sorting through a wide variety of investment opportunities, many of which will be a waste of your time.
Your investment timing may depend on the cycles you think are occurring in the marketplace. If your ultimate objective is to take the company public, you will have to keep a sharp eye on which way you think the stock market is headed. If you are ready to invest in a company but think the stock market is going to be in too difficult a period to have a successful IPO, you may want to curb your appetite for investing in companies that need a public exit. If, on the other hand, you feel that the stock market will be strong in five years, you may want to invest long-term and take the company public in five years.
Another idea is to invest in a company that you can sell to a larger company. When you invest in this mode, you must pick several target companies you think will want to buy the company and try to judge when they might be willing to do so. Your timing is important because a very acquisitive company may, after several years, stop acquiring in order to digest what it has purchased. Timing in this regard will be more difficult to predict, but you should think about timing your exit before you invest. First, you want to decide whether you are investing in the short term or the long term and whether some part of your portfolio is in that time frame. You then want to think about how you will exit—through a public offering, private sale of the company, or some other method that may have to be “Plan B” if those two exits don’t work out.
You need to determine the size of your investment, that is, the amount of money you will be willing to risk in any one company. If you decided that you don’t want to invest more than $1 million or $2 million, this would place you in some very small companies, and you might find yourself limited to investing to very early-stage companies. This will determine how you are going to invest your dollars.
On the other hand, if you only have a few dollars to invest, you may want to associate yourself with an investment group in which you can bring more to the table than just money. In every big city, there are a number of “angel investment groups” that invest in small businesses. You may want to join one of them. If you have specific expertise in a certain area, don’t be shy about letting local venture capital funds know that you have expertise in this area and money to invest. Let them know that you would like to co-invest with them and that you would be willing to do a lot of the work on the due diligence.
You must determine what distance you are willing to go to invest. Are you willing to invest only in your own backyard, or are you willing to board an airplane and fly to see a company? If you are going to invest in early-stage companies, they should be within a very small circle around the area where you live because usually, early-stage investments take a lot of your time, money, and energy. On the other hand, if you are getting ready to invest in a fairly large third-round financing in which you will not play a major role, time and energy will not be as necessary, and you may be willing to travel a longer distance.
VCs typically invest in companies that don’t have much liquidity, but there are a number of “penny stocks” in which you may want to invest. This gives you the right to sell your stock at almost any time, as long as there is a public market for it. This will give you liquidity, whereas most venture capital investments are illiquid.
Be careful, some small public companies are public for a time but then lose their trading status on the over-the-counter system NASDAQ, because they fail the net worth or earnings tests and get delisted. Stock in delisted companies is hard to sell.
There is a wide spectrum of risk. You can go for a high-risk, high ROI or you can accept a low-risk, low return. Generally speaking, there are some interesting ways to determine how high your risk is going to be, as discussed in previous chapters. You need to determine how much risk you are willing to take and communicate this to the outside world. If you are really interested in taking flyers, you will have a lot of early-stage, start-up investments reaching your desk for money.
Determine how active you are going to be in the company in which you invest. If you are going to play an active role managing the company, you will be looking for companies that need someone like you to help. The typical ad in the newspaper for companies seeking financing will read, “Active Partner Needed.” This might just suit you. If so, you will be looking for a different kind of investment than most VCs. Typically, VCs are involved in management but not in a day-to-day fashion. They are called in from time to time to help out with problems.
It is also possible for you to be a passive venture capital investor. Some VCs play little or no role in the small companies in which they invest. In fact, they make the investment, then more or less sit back and hope that the investment comes out okay. These investors rarely invest in the company a second or third time. They invest once and hope for the best. You will have to follow your own vision here and determine how active you are going to be in any one company. Obviously, you can’t be very active in many small businesses or there won’t be enough hours in the day.
You need to determine when you think you are going to have your money back in any company in which you are going to invest. Most VCs want to invest for five to eight years, whereas others want to invest for only three to five years. Some players will invest for ten years or more. You need to determine your time horizon for investing in any small business. When you invest, you want to make sure that your time horizon is congruent with that of the small business and the other investors.
Once you have analyzed each of these areas and written down your investment objectives, you will have a much clearer vision of what type of deals you should be looking for.
Now that you have identified your basic objectives, you need to get the word out about what types of deals interest you. You should put together a one- or two-page letter that describes what you are interested in and what you are willing to consider, then send it out by email and regular mail. You should set up a Web page to describe your interest. Then you need to circulate it among the various areas that may come into contact with small businesses in need of equity. You may also be able to reach many of them on the internet. However, with all the spam email, it may be harder to get someone to focus on your investment abilities, than getting a letter on their desk. The following describe some sources of investment opportunities.
A bank can be of help in a number of areas. First, the lending department will be interested in showing you situations that need equity funds. Banks always have loans that need an infusion of equity. Second, bankers often have small businesses come to them looking for cash. If the commercial banker does not feel that the small business has sufficient collateral to justify a loan, the small business person may then ask the banker to refer any investor who might be a good investment match for the company. Commercial bankers run into a large number of small businesses looking for money and can help you find investments.
The workout department of a bank is also a good place for problem loans. You may find the banker in a very precarious situation, trying to get the bank’s money back, and you may be the answer. If you like turnarounds (those businesses that show declining profitability but can be “fixed”), the bank workout department is a good place to visit. It usually knows of one or two companies that are in deep trouble and need some help.
The bank trust department also has tips on businesses for sale, usually because an owner has died and has left his or her small business in the estate. The bank would like to find somebody to buy the business and run it. Bank trust departments are trying to sell these businesses, and you might be the right person at the right time. Make sure the bank trust departments in your town know what you are looking for. Also, the trust officer will be planning people’s estates, and if they have decided to sell, they have most likely communicated this to the bank trust department. Even though you may not want to buy the business, you may well be the catalyst and the financial source needed to get the business sold.
Small and large accounting firms run into an inordinate number of businesses for sale and many that need money. You may be the right person to help an entrepreneur buy a business or you may be the right person to help out an entrepreneur who currently owns a business in need of money. Many accountants play the role of investment banker and help small businesses find money from individuals, as well as institutions. You should make sure that you spend time with these accountants.
Attorneys are much like accountants. They spend time with their clients and understand what clients are going through. If an elderly client is trying to settle an estate, the word will go out to the lawyer. You can back the existing management in the LBO of the company from the seller. You should communicate your interests to lawyers.
In addition, lawyers work with small businesses that need money because of operating problems or growing pains. They often know about the small businesses in their area that are in need of cash. You should let the lawyer know that you have money to invest in small businesses.
Almost every brokerage firm has a group of brokers known as investment bankers. These are people who work for the brokerage house in a separate area, not buying or selling stocks but acting as brokers on the sale or in the financing of businesses. Every department has a group of specialists in the small business area (sometimes called “middle market”) or the merger and acquisitions area, and you should get to know these people because they can help you find investment opportunities. They are compensated by the company paying a fee to the brokerage house.
There is a rather undefined group of individuals known as business brokers and financial brokers who help small businesses find buyers or investors. These people are similar to investment bankers but do not work for large brokerages. They usually work for themselves or for “boutique” investment banks that specialize in small businesses. Many times, these small brokers help one or two businesses a year find deals, and you may be the perfect fit.
You can locate these people by looking in the Yellow Pages under financial or business brokers. You can also look in the Sunday classified ads of your newspaper under business opportunities. There you will find dozens of business brokers listing businesses for sale. You should contact them and tell them you are interested in investing in small businesses. Ask whether they know of any in which the entrepreneur doesn’t have enough money. They will be eager to help you and some of their entrepreneurs get together because they stand to get a fee for selling a business.
Warning: There are many unethical brokers who are rip-off artists. Most have no association with financial sources. Make sure you are dealing with a quality broker who is affiliated in some way with a financial group or have strong recommendations from other businesses previously helped by them. These will be your best brokers.
Good consultants in the area of small business are few and far between. However, many of the big accounting firms have consultants who specialize in this area, and some independent consultants in the marketplace also look at small businesses and try to help them with their problems. You should get to know some of these people and tell them what you are looking for. These consultants often see small businesses that need money and could steer them to you.
Many conventions around the country are oriented toward entrepreneurs and small businesses, as well as venture capital. You should attend these fairs and try to determine whether any of the small businesses participating are worth your investment. Unfortunately, it has been our experience that most of these conventions are not good places to find investments. But who knows, maybe you will find something different in your town!
Every city and even some towns have an economic development organization whose investment officers are on the lookout for small businesses that might relocate in their area or might need help after relocating. Many of these businesses need equity capital, and you could be the person to provide those funds. Determine who these economic development officers are and get to know them. Make sure they know what you are looking for.
Most cities have industrial and professional trade organizations to help their small businesses. Get to know these trade associations and let it be known that you have money to invest in small businesses in their industry. Each of these trade associations has contacts throughout their industries, and they often know of small businesses that need money. They will be most happy to send you to the small business and earn “brownie points” from their members.
Like the economic development organizations, your local Chamber of Commerce will know of a lot of businesses in your area. Some of them will be looking for money. Make sure that you want to invest in the area, and get letters and information into their hands so they can pass the word along.
In talking to the outside world, you should tell your friends and associates that you are very interested in small businesses and are looking for investment opportunities. They may run across a company looking for investment capital and send them your way.
Although it is unusual for venture capital companies to syndicate their investments with individuals, it does happen. It usually happens when the individual has special information or abilities in a certain area, and they will want you for your expertise. You should let local venture capital companies know that you are interested in investing in anything they are financing and would gladly play a more active role than they may have time to play. For example, you could sit on the board of directors and provide management with advice. Under that scenario, you will find VCs very interested in hearing about what you are looking for. In addition, every city and town has a local (or sometimes many) VC organization. You may want to start going to their meetings and introducing yourself to other people in your field.
From time to time, you may hear of a small business in the area that sounds interesting. All you have to do is pick up the phone, call the company, ask who the president is, try to get through to him or her, and say you have investment capital and would like to invest in the company. You would be surprised how many cold calls get through when the caller is looking for an investment opportunity in the business. The next time you read about a company, don’t say, “I wish I had invested.” Call and see whether you can invest.
Placing advertisements in newspapers, periodicals, and trade journals can sometimes help generate investment opportunities. The advertisement should specify certain requirements, such as the stage of development (for example, startups) or the level of investment, so as to ward off nuisance calls. Some venture capital companies have gained tremendous opportunities from such advertisements, whereas others have had very little luck with them. The type of company and the type of investment you are looking for will determine whether you should use advertising. If you are looking for a very narrow investment opportunity such as radio stations, advertising in periodicals that are mailed to radio stations will generate an opportunity list from the radio arena. In addition, direct mail can be used to solicit opportunities from specific business areas, but like advertising, it also generates a large number of nuisance calls.
Sometimes suppliers to a specific industry, such as electronic components, can help you find growing companies that need financing. Many of these suppliers have a vested interest in helping their customers obtain financing. In one such situation, drug wholesalers wished to finance a chain of drug stores that was growing rapidly at the time. It turned out to be a good investment. Similarly, you could select an industry and go to the suppliers in that industry to find investment opportunities.
There are some other groups you can contact from time to time to let them know you are looking for investments. These include employment agencies that may be recruiting for small businesses and could pass along your message.
Financial planners are another source. They frequently work with the heads of small businesses to plan their estates. They may be able to get through to the CEO when no one else can.
Now and then, the staff of elected officials also hear from small businesses that are looking for money and might be able to send someone in your direction.
Universities, too, at times try to help small businesses and so are involved in the entrepreneurial process. Make sure that they know you are willing to invest in their small businesses.
Regional Small Business Administration (SBA) offices can be a source of small companies seeking venture capital. Most of these are start-up situations, and many of them have contacted the SBA as a last hope. When you contact the SBA office, remember that here you will be seeing last-chance investment opportunities.
To succeed in finding good investments, you must be proactive. You must seek out investment opportunities whenever you can. You cannot sit in your office and hope that good investment opportunities will show up on your desk. Good investments come to those who are looking for them. If you want to be successful in the venture capital investment arena, you will have to hustle. Opportunities will not come into your office by chance.
If you want to get a good reputation in the venture capital business, you should have a very quick method for handling the initial inquiries (also refer to Chapter 1). You need to be able to review a business plan or listen to a presentation over the phone and decide immediately whether you have an interest. If instead you ask people to mail in a business plan and leave them waiting for weeks while you ponder to see whether it is a good investment, you will get nowhere in the investment community. A quick “no” is much better than a “maybe” that turns into a “no.”
However, quick analysis requires a quick screening process for initial inquiries. The screening list presented here is a condensed version of the entire due diligence process. It contains the key questions that you must ask about the business.
What is the business of the company (ten words or less)?
What is so great or unique about the business of the company (25 words or less)?
Is the management knowledgeable and experienced in this industry?
Does the management consist of entrepreneurs, achievers, and aggressive and energetic people?
Is the management of top quality?
Will you have to hire a new Chief Executive or Chief Operating Officer now or in the near future?
Is the company profitable? If not, why not? Is the cash flow positive?
What are the historical figures and projections? Note dollars (in thousands) of yearly sales, profit, and cash flow.
What is the projected and actual sales growth rate in average percentage per year? Actual percentage? Projected percentage? Is it achievable?
Is there a company one can use as a role model? Has anyone else done this before? If so, who?
What is the deal you think you can get? What percentage of ownership?
How much money will you make? How did you compute this?
What collateral will you have? What is the downside risk?
Why do you like this situation?
What is wrong with this situation?
Does this rate as a good deal? Why?
Most investors and venture capital firms do not use brokers to help them find investment opportunities. That is, they do not hire investment bankers or brokers to find them deals. Investment bankers are generally hired by companies seeking capital. However, if you do decide to hire a broker to help find investments, there are a number of things you will want to look for.
In any business arrangement, you should look into the background of the person you are backing. After all, this person will be working for you and representing your company to the outside world. The broker who meets most of the following qualifications is the one most likely to point you toward good financing opportunities.
Extensive experience in helping finance business is usually a must. Without such a background, a broker will not understand the problems of a small business. Nor will he or she understand the sources of funds that usually finance small businesses.
A business broker should be a true professional, one who is knowledgeable about your investment approach and the type of investment that you are looking for. He or she should be working as a broker full time. It is unlikely that any part-time person can assist you.
Any broker you have working for you should have a strong financial background. A degree from a recognized business school is a plus. Prior experience as an investment banker or as an employee of a recognized brokerage firm is also a plus. Prior experience in venture capital investment would be even better.
If you are seeking investments in high technology or a specialty industry, the broker you are working with must have professional training in that special area. Without a degree from a technological school and knowledge of the technological area, the broker will not be able to gain the confidence of those in the industry and lead you to a potential investment opportunity.
Your broker may want you sign a written agreement stating that if the small business concern is unwilling to pay his or her fee, you will be responsible for it. Such an arrangement between you and any financial broker should have all the elements of a good contract. Once you have a full, written understanding of the relationship between you and the broker, you will be in a better position to use his or her services. Below are some of the items that your written agreement should contain.
In this section of the legal agreement, you should spell out in detail the service to be performed by the broker. Establish what is expected of you in the way of information. You should also clearly state the objective of this arrangement, such as “a venture capital investment of $1 million.”
Every legal document should specify the date that the relationship terminates. You should also specify intermediate dates by which certain milestones are to be completed. If either you or the broker fail to meet these intermediate dates, the contract can be canceled by either party. You will be in a position to call the broker and ask what progress has been made. If none has been made, terminate your agreement by letter, stating that you are terminating it because the specified progress has not been made.
The termination should be subject to written notices from one party to the other party. This clause will state how and for what reasons the agreement can be terminated.
State the amount of the fee in detail. It can be a flat fee that covers all out-of-pocket expenses or it may be a fee plus out-of-pocket expenses. If you are agreeing to the latter, make sure you have in writing an estimate of the out-of-pocket expenses in excess of some named amount.
The agreement should state whether any progress reports are to be produced by the broker. Normally, the broker should report to you verbally at least once every week and should frequently give you a written report of the work completed.
Any work completed by the broker, such as charts or work on the business proposal, should be owned by you. You have paid for the work; therefore, you should own it. If you do not have this clause in your agreement, any work completed by the financial broker may belong to him or her. If you should terminate this agreement for just cause, the broker may keep everything. This will force you to duplicate a great deal of work.
There should be another clause in your agreement specifying that the broker will not disclose any information divulged to him or her to any other persons without your prior written consent. This will prevent the broker, under any circumstances, from passing along information and potentially squeezing you out of a deal you originally found.
The broker should indemnify you in the agreement against any misrepresentations or wrongful doings by him or her while in your service. The broker should also indemnify you against violations of federal and state security laws. If the broker does not indemnify you for actions taken by him or her, your situation could conceivably be misrepresented to someone, and that person could sue you because of the misrepresentation. After all, your broker is your representative.
The soundest advice anyone can give you is to urge you to check out the broker. Obtain references from the broker and determine whether the broker is legitimate. Call any companies that the broker claims to have helped. Call the presidents of those companies and ask about the broker. Also, ask the broker for some names of companies that the broker was unable to help. Contact the president of those companies and ask them why the broker did not succeed. Any information you can develop about this individual will be useful in helping you to decide whether to hire.
Now that you have read this book and learned some of the “tricks of the trade,” you will have an idea of how to find a good investment, evaluate it, perform due diligence, close it, monitor it, and then exit the deal for a great return. As you can see, it is not an easy process. Thousands of men and women are doing this for a living every day. It takes time, great energy, and superior judgment. But for those of us in the industry, it is great fun. Every day we meet wonderful entrepreneurs and it is rewarding to see them make their businesses become successful and their dreams become a reality.
The venture capital industry and the LBO industry where we work each day are filled with excitement. There are new products and services coming to market, and we get to see them first and decide whether they are ones that will make money. We work on complex buyout transactions that are both taxing and rewarding. Completing a complex buyout is a great achievement.
As investors, we stand at the pinnacle of capitalism, determining which businesses get funded. It is an awesome responsibility and an exciting experience. We represent the branch of capitalism that allocates capital to new and exciting opportunities. For those of you just entering the industry, we welcome you and invite you to come see us. We would like to get to know you and co-invest in some great companies with you.
For all of you reading this book, we wish you happy hunting. May you fine the perfect investment and may it yield you great personal and professional rewards.