NEW ENGLAND CAPITAL VENTURES

Selling Institutional Money

At one of the Harvard Entrepreneurship Club meetings, a young graduate asked me “It must be really easy and fun to do what you do – isn’t it?” My immediate intention was to loudly exclaim NOT A CHANCE – HELL NO but at the risk of loosing his interest in what he clearly wanted to passionately pursue, I calmly retorted a coy “Yes, I am sure it is”, before I was pulled into another conversation. If he was smart, he probably got the message I tried to shrug away in my smile.

One of the key job descriptions of any broker-dealer, investment banker or a VC is to sell money. That may sound simple for some folks and one might tend to associate this to bankers giving out loans, but the private equity / venture business takes a different approach to this process. So what entails selling money in this business, why is it so important for everyone and why is this so darn difficult to get deals done? While it is impossible to generalize answers to these questions given the nature of the industry and uniqueness of each deal, let’s try and structure some facts for the sake of arguments. This will at least give a directive for those who have a perception, contrary to reality.

Selling money is selling risk, for both – investors and entrepreneurs. Investors take on risk when they write a check and entrepreneurs give away some risks by mitigating contingencies temporarily. The risk changed hands in this case but it did not go away. If anything, when risk changes hands for a value, it inherently increased for both the parties. In some cases – doubles or triples depending on valuation and execution parameters.

Let’s chat a bit about why a venture deal increases the amount of risk the entrepreneur takes, rather than reducing it. Before I dive into explaining this in two areas – execution and financial; the common sense answer is – now the guy’s got to perform, especially when he’s playing with outside cash. And he needs to perform within confines of defined time frames, sales, product development, etc. And if he does not, that’s a risk. This is where execution risks kick in.

Execution risks have an inverse relationship with financial risks. Higher the execution risk, lower the financial metrics defining your valuation. And as discussed earlier on the blog, for a majority of the institutional investors, the valuation game is a big deal, as it dictates how well the exit strategy is being met. If you are closely reaching your milestones with the constantly shifting strategy at an early stage, you are in a good shape. I am also going to mention the prevalence of market and people risks in this equation – which in many ways, is tied to executing your strategy. Aligning operations towards economic dependencies of your business model and making sure that key personnel are retained and hired is important.

Financial risks are usually dormant until there is a resource contention issue. This is pretty common when high-stakes deals are focused entirely on operations and little on how well the financials are being managed. The CFO is a misnomer for a lot of companies at early stage as the supposition is: there is always a next round. Fiscal prudence on staying reasonably within budget and not creating a crunch at the 11th hour reflects well on the entrepreneur. For investors, if he has managed $1 Million well and achieved more than expected, I am sure he can do a lot more with $10 Million. The reality is, most entrepreneurs approach me when they are in a do-or-die situation – which actually drives investors away. The wild squandering of venture money during the late 90’s is a perfect example of this situation. At the early and growth stage, no one is asking you to be a highly leveraged firm with high liquidity ratios. Remember PETS.com – the little white sock puppet dog that spent over $50 Million in two quarters for advertisements without paying attention to logistics, manufacturing, vendor contract management, reporting metrics, or any of the old school ideology around sound business practices?

Switching gears to the investors to discuss how selling money and taking on risks makes/mars their fund is important. I would be less inclined to sell you (the entrepreneur) if the size of my fund is $500 Million and you seek $250k on your A round. Same way, I would be more inclined to sell you at favorable terms if the life of my fund is 7 years and I am in my 7th year with more than 25% (a rough guess) uncommitted. And by sell, I don’t mean I am going to write a check to buy a piece of your company the minute you walk in the door. The uniqueness of the deal makes for a longer due diligence process and thus, a longer sales cycle. This is true especially with institutional investors, which are amongst the most sophisticated and structured compared to angels & corporate ones.

My sales strategy will typically depend on a matrix that defines the following:

• Size of the fund,
• Focus (expertise) of my team: Telecom, Life Sciences, Hardware tech, Software tech, Manufacturing, Retail, etc.
• Type of fund: subordinate debt, private, corporate, hybrid, economic development funds, etc.
• Fund strategy: e.g. 50% direct investments and 50% FoF – Fund of Funds Investments
• Stage of the fund: e.g. Year 2 on a 8 year fund vs. year 7 in a 7 year fund
• Amount committed till date and amount retained for future participation on syndicated (co-investor) deals.
• Current Yield (Not Nominal Yield – as venture funds speculate on opportunity cost of investments) on fund returns: What is the firm doing with the fund cash at bank?
• Performance of current (exists and on-going investments) & past investments (which sometimes have a lay-over with the current funds): Exit valuations, # of IPO’s, # of M&A deals, # of LBO’s, etc.
• Return strategy: Is the fund expecting a 10x return or a 5x return. This is further dictated by the type of investors in the fund, and whether or not they are high risk speculative investors in start-ups or providers of growth capital.

Given this, it does not matter if I invest $10 Million or $100,000. The amount of work needed to get both these amounts on the term sheet is the same. No wonder early stage is becoming rarer on the institutional side.

The risk factor for VC’s is a well known parody after the 90’s. With all the due diligence and strategy in the world, investing is still a speculation – a bet - for a lack of better words. I am betting money to bet on you; commonly known as ‘gambling’. But I am doing my homework to maintain some risk adversity – besides, this sort of betting is legal in all 50 states in the US (and around the world). This inherently contradicts the definition of a sale, where you would expect value now or in the future. With VC’s, there is no confirmed future value of goods or services that might translate into cash with every deal. My options are useless if you the company goes under. Where else can I play black jack with $20 Million on the table?

As I was explaining a friend of mine over diner last night, philosophically speaking, venture capital is more a state of mind and than a mere conduit to enabling ideas. The investor writes a check to the entrepreneur, not the company. The entrepreneur IS the company. The investors’ job is to see if the entrepreneur can even afford to ‘buy’ the money, i.e. the ability to judge a person. That’s an art they don’t teach you in any b-school.

Lastly, selling is a niche. There are times when the venture does not need $5 million but just $1 million. The investor sees the big opportunity, the entrepreneur does not. The investors’ job in the sales process is to expose his ideas and sell the big picture. Should we aim for a $20 Million exit valuation for a potential M&A or should we aim for a $200 Million IPO.

The old saying goes “The easiest kind of relationship for me is with ten thousand people. The hardest is with one”. Selling money is selling one to person as well as to a group of people at once.

Interestingly, the Merriam-Webster dictionary defines the verb sell as ‘to deliver or give up in violation of duty, trust, or loyalty and especially for personal gain’ and defines a venture as ‘to expose to hazard; to undertake the risks and dangers of; to offer at the risk of rebuff, rejection, or censure’. I will leave you to philosophize this paradigm before you start a venture or plan to fund some company.

posted by Janak Joshi @ 9/01/2007 03:18:00 PM