Conversations with Investors – Chapter One

[2]

From

The CEO’s Handbook Volume Four - The Money Chase [3]

Dr. Earl R. Smith II
Managing Partner, The Federal Circle [4]
DrSmith@Dr-Smith.com [5]
Dr-Smith.com [6]

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

Jim Hunt of The MITA Group [7]

In this series of articles, I will describe several discussions that I had with investors in the Washington DC area. They range from angel investors to senior partners in well established funds. I have known most of them for many years. That allowed us to cut through the usual PR crap and get to the heart of the process of reviewing investment opportunities. When I told them that my objective was to provide a series of articles which would help companies seeking funding, each was very willing to help – it is, after all, in their interest to improve the process. I owe each of them a debt of thanks for agreeing to sit down and ‘open the kimono’ so to speak.

Visit with an Angel Investor

I have known Jim for many years. Like many angels in the area, he was a very successful entrepreneur. A seasoned veteran of the technology industry, over the past twenty years he founded and ran four successful technology companies. Jim founded and served as President and CEO of Ernst & Young Technologies, Inc., leading it to $75 million in profitable sales after just three years of operation. He then orchestrated the sale of EYT in late 2000 to Cap Gemini and served as President of the newly created Cap Gemini Technologies. Prior to his work at EYT and Cap Gemini, Jim ran a number of firms including BDS, Inc., a systems integrator focused on sales to the federal government. In addition to Jim’s primary responsibilities as a line executive, he has helped launch and advise over a dozen companies in the high technology sector, with particular focus on software for federal and commercial markets. Much of his expertise has been directed at federal government market penetration for software application companies, system integrators, and IT service firms. In short, Jim has the experience to know what he is doing when considering an investment.

The Initial Screen

We sat down at a local watering hole and got caught up on the goings and comings of people and companies we knew. Then things turned to the ‘interview’. I told Jim that I wanted to focus on how he decided whether or not to make an investment. My first questions was, “What percentage of the deals that come over the transom do you discard out of hand?

Seventy percent of what I see is of no interest to me”, was his reply. That means that only three in ten get any extended consideration at all. His principal reasons for discarding opportunities were 1) it’s not in my area, 2) the team does not have the necessary experience and 3) they don’t have any adult supervision.

The first reason related to Jim’s area of expertise – what he knew about and felt comfortable getting involved in. What disturbed him was the tendency of some founders to lump all funding sources into a single category. “My history and investments are out there and easily found. People who don’t take the time to see if their company matches my interests don’t understand the process very well. I don’t pay much attention to them.” Jim’s statement is certainly true for all the other investors I interviewed for this series of articles. It is very easy to discover the interests and investment preferences of any established investor. People who do not take the time to match their company with those interests do themselves a great disservice.

Jim’s second screen is another one that I encountered in all of my interviews. He avoids ‘generalists’ who seem to be the ‘jack of all trades and master of none’. His focus is beyond the core technology of a company. “It takes a wide range of skills to build a company. A limited number of them relate to the underlying technology.” Jim looks for balance in the team. Do they have people who can handle the financial and HR needs of the company? These may be outsourced; but they need to be covered. Is there somebody who actually has successfully run a company – managed an extensive staff and budgets? “If these are not present, I am unlikely to spend much time looking at the business plan”.

It was Jim’s third screen that drew my attention. I had had experiences with the same syndrome – avoidance of adult supervision – and knew how important oversight was to the success of a new company. “If a team balks at supervision, I don’t spend much time reviewing their business plan”. The core truth is that everybody gets supervised in one way or the other. Recognition of that fact is a measure of maturity and evidence that the team understands how businesses are built. “If the team seems to see the process as I give them money, they go and do what they think best with it and I get the results, I decline to play that game”.

How much time to you spend on each investment opportunity at this stage”, I asked?

I see about a deal a day normally. Most are discarded quickly. Of those that I have some interest in, I generally spend about an hour to an hour and a half deciding if I want to see the team and go further into their business plan”, was the reply.

So, Jim, let’s focus on the roughly 30% that make it through your initial screening. What do you look for and what reasons cause you to discard them?

Jim has four screens that he applies to those that survive the initial culling. The first is a more detailed review of the experience and past successes of the team. He focuses on the ability of the team to work together. “I want to see the tracks in the snow – evidence that they have met and mastered tough challenges in the past.” For Jim, resumes are not enough. He calls upon his wide network to check on the backgrounds and reputations of all the people on the team. A weak link means a weakness in the judgment of the founders.

Jim’s second screen is a deeper push into the question of ‘supervision’. If he ends up funding the team, he wants to know how they will relate to him as an investor. Both of us had encountered the hard-headed, technocrat who has little use for people with business backgrounds and experience. We’ve also had our share of midget Napoleons who seem to take a purely instrumental approach to other people. Good businesses are built through the combined effort of lots of minds. Like most investors, Jim avoids founders who tend to push such help away and assert their own omniscience.

If the teams pass the first two screens, Jim then turns to whether it has a “clear and credible path to revenue”. His diligence in this area extends far beyond the spreadsheets that come with the business plan. “I check through my own network to verify their assumptions and reach out to their potential customers”. I am amazed at how few founders actually think that this might occur. Successful and well-established investors will always conduct such diligence. In many cases, the investor will quickly end up knowing a great deal more than the founders about the company’s chances. How founders respond to this development is a very valuable character check.

All investors have their quirks and Jim’s fourth screen evidences one of his. “I look into the cash efficiency tendencies of the team. I don’t invest with a founder who drives a leased car. I avoid teams with multiple family members on the payroll. If a cash-poor, start-up team has state-of-the-art electronics, I generally turn away.” Jim has a aversion to investing in teams that seem to have a sense of entitlement – particularly if that leads to excessive spending on instant gratification toys.

10% of 30%

Jim, of the 30% that survive your initial screen, how many get all the way through and are seriously considered as investments,” I asked?

About one in ten,” was the reply. To put that in perspective, over a ten-month period Jim might see three hundred deals. Of that three hundred, thirty might get a second and more intensive look. Out of that thirty, three might be seriously considered for investment. That alone should tell founders why the money chase so often yields null results. The odds of success with each investor are somewhere around three percent.

Time was getting on and we both had places to go but I could not help asking about the next stage. “OK Jim, you have decided that maybe a team and their business plan may be worth an investment. What do you focus on next?”

His first response was, “I get to know the team better – watch them work together and see how they meet and overcome challenges – both with the business and in getting along.” Jim believes that the team holds the key to the businesses’ success. Their ability to work closely together sits at the center of their chances. He looks for indications of dissonance and conflict.

Sure, I do all the normal things like cleaning up the balance sheet, resolving existing personnel issues and aligning compensation plans. I drive deeper into the value proposition, investigate the intellectual property that the team controls, probe potential customers and work with the team to sharpen their business plan. But my investment is, first and foremost, in people. I am an early stage investor and people are the primary asset for such companies.

© Dr. Earl R. Smith II

~~~~~~~~~~

Related Articles:

~~~~~~~~~~

Dr. Smith [5] is Managing Partner of The Federal Circle [4]. The Federal Circle partners with teams and existing companies. We help them up their game and win big in the Federal space. We also arrange funding for acquisitions and expansion by acquisition. Our model is based on the belief that, if you select the very best and work with them in a highly professional and focused manner, the results will be truly amazing.

Dr. Smith provides coaching services to C-level executives. He serves on boards of directors, builds advisory boards as business development engines and acts as a senior adviser to CEOs. He is the author of a number of books [9] and writes regularly on business, funding and entrepreneurial subjects.

Books by Dr. Smith: