If you want to become good at early-stage investing, you need to learn how to size up the fundamental elements of an opportunity. Many investors use checklists or think of evaluation as a process of judging an entrepreneur, or an idea, or a particular set of facts. Based on our experience in doing over 100 early-stage deals, we believe that an investment opportunity has four essential elements, that, when brought together in the right form, represent a high-potential opportunity to make money. If only one of the elements is out of sync, failure is predictable. The elements are represented by the Harvard framework (Figure 11.1), which was developed by William Sahlman 1 and Howard Stevenson 2 is described in Chapter 12.
Good judgement comes from experience and experience comes from making bad judgments. So it is with evaluating early-stage deals. If you made a single investment in one of the big Internet wins of the late 1990s, you may not know a thing about early-stage investing. By the same token, if you had 10 failures in multiple industries, you might not know anything either. But you will if you keep paying attention. Reading business plans, studying in business school at angel seminars, learning an industry by working in it; these are all ways to develop expertise that will promote your success in investing. But in both entrepreneurship and angel investing, there is nothing like doing it. Nothing.
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The evaluation stage is the great time killer of all the stages and you will do well to manage your time carefully. Some angels think that evaluation starts with the first meeting and continues right up to the moment of writing the check. In order to structure this book effectively, we address evaluation as a single isolated entity, but bow to the correct idea that evaluation occurs throughout sourcing, valuing, structuring and negotiating. Given the potential time drain, the best angel investors are careful and strategic in their approach to evaluation.
Angels take a variety of approaches to this stage, with some doing substantial due diligence before a meeting (reading the plan, talking to people they know ) and others granting a meeting without looking at the plan at all. Some angels rely on their intuition while others crunch a lot of numbers. Almost all angels source carefully, make good use of co-investors, and focus on the entrepreneur and the team. Evaluation success will come in doing deals, emulating winners, and not making the same mistakes more than two, three, or four times.
Case Study AOL: The one that got away
Frans Kok shares with us the story about his decision not to invest in America Online (AOL).
"In about 1986 I was asked to take a look at America Online. My recollection is that they had about 10,000 subscribers at that time who were paying a little less than $20 per month. That gave them a running rate of $2.4 million in gross revenues per year. I thought that that was impressive. In addition they were adding more subscribers every month.
The system was extremely complicated. Computers were not using the same operating systems so there were a lot of protocol compatibility problems. There were no databases that could be accessed. So the "nerds" would establish a connection and ask each other how "things" were and what was up. The connections were terribly slow. My reaction was why don't these guys pick up the phone if they want to talk to each other?"
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| Evaluation success will come from doing deals, emulating winners, and not making the same mistakes more than two, three, or four times. | |
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| —David Amis, Howard Stevenson |
AOL was in the process of raising $5 million on a $20 million valuation. Based on revenues and subscribers I told them we could work with them and raise maybe $2 million based on a $6-$8 million valuation. AOL management was not interested and the rest is history.
Recently, I heard from a third party that at about the same time the technology guru at Alex Brown had the same reaction with respect to the superiority of the telephone. I guess I can stop kicking myself."
Chapter 12 The Harvard Framework
Rather than judge entrepreneurs or their business plans as winners or losers, it is most productive to look at the investment opportunity as an interconnected combination of four elements: people, context, business opportunity, and deal. The right combination, which is often manageable, means a high-potential opportunity. A bad combination, or the lack of any single element, is a recipe for failure. Most important, within any investment opportunity, there is usually some potential for a win, if only the right investor would join it, or if the right changes would be made. If you integrate this philosophy of investing into your thinking, you will be a far better investor.
A short lecture on entrepreneurial evaluation, Harvard style
Bear with us while we explain the framework developed by William Sahlman and Howard Stevenson at Harvard Business School. This is one of the areas in the book where you need to be mentally engaged and really look hard at incorporating this methodology into your evaluation process. At the very least, if you decide to discard it, you will do so having a much better awareness of your own framework.
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You have seen the framework (Figure 11.1), let's review each of the elements:
People
The people in the deal, including the entrepreneur, team members, investors, advisors, and any significant stakeholders.
Business opportunity
The potential business opportunity, which includes the business model, the size (which implies the potential returns), the customers, and the window within which it can be seized.
Context
The macro-situation, which includes external factors, such as: technology development, customer desires, the state of the economy, industry trends, etc.
Deal
The structure of the deal, its terms and pricing.
Not only is each element critical by itself, but the way they interact is also crucial. For example, in one opportunity at Capitalyst 3, a Web developer with $5 million in sales was raising its first round of capital on a $10 million valuation.
Two comparable companies in the marketplace were worth over $1 billion each, despite having $300 million and $20 million in sales respectively. Most companies in the industry were valued at $1 million per employee, and this company had 40. However, NASDAQ had just dropped about 20% (April, 2000), and voices predicting the end of the tech stocks' ride were appearing daily in the press.
Therefore, the context was that the potential existed to sell the company soon for a substantial return to one of its competitors. However, if the market turned in a big way, the potential valuation could come screaming down. The business would not fail, as it was choosing its customers and was already at cash flow break-even, but the investors might get stuck as minority shareholders if it became difficult to sell.
In this case, a deal structure with a note convertible to common would allow the investors to convert if the company sold or went public, thus getting their upside, or call the note after two years if the company was not able to exit but was generating positive cash flow. The deal structure can impact the attractiveness of an investment opportunity by addressing contextual or other factors.
Challenges with the business opportunity, or the time frame, can sometimes be addressed by finding a key member of management or an active angel who can help the company to move much faster through active use of their network.
Between people, opportunity, deal and context, there are a variety of multirelational issues and opportunities. Invest in companies that have outstanding elements or at least good combinations and you will hit some winners.
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Three Bases
When assessing an entrepreneur, there are three "bases" to cover: their goals, their knowledge, and their capabilities (see Figure 13.3).
If these bases are not covered, you might find some unpleasant surprises after making an investment. For example, many investors have been left stupefied by entrepreneur decisions not to sell at an attractive price. In fact, these decisions probably supported the lifestyle business that the entrepreneur had dreamed about all along.
Covering all bases, however, can result in identifying a homerun 4 hitting entrepreneur. In fact, some investors, such as Craig Burr, OH 5, and Arthur Rock, seek out winners and create business relationships that result in a series of investments.
So identifying a high-potential winner is as simple as covering the bases, except for a thousand or so variables. Here they are briefly.
Knowledge
Industry, market, technology, customers... the entrepreneur's knowledge of the opportunity is relevant to assessing their ability to evaluate the opportunity as well as modify it during implementation. Do they know enough to know what they are getting into?
The best way to assess knowledge is through direct conversations with the entrepreneur and by relying on other stakeholders who have relevant experience for assessing that knowledge (such as an old plastics entrepreneur for a new, temperature-retaining fast food container start-up). Potential co-investors and past associates of the entrepreneur can be quite useful.
Capabilities
Sales, management, product development... the entrepreneur's capabilities are relevant to their ability to implement. Can they make it happen?
Track record is the best indicator of capability. Most of the successful investments described in this book were led by entrepreneurs with winning backgrounds, such as StarMedia (MBAs with management and financial experience), idealab! (successful software entrepreneur who founded his first company while still at high school, and sold one company to Lotus 1-2-3), and RealNetworks (BA and an MA in Economics and a BS in computer science from Yale University, plus 10 years' experience at Microsoft). However, notable exceptions would include Microsoft (college drop-out), and Lotus (transcendental meditation instructor).
Goals
Career, financial, personal... the entrepreneur's goals are the undercurrent driving their actions and are relevant to big picture issues; such as when and how to exit. Does the entrepreneur share the investor's goals?
Indirect discussions and observations will reveal the most about the entrepreneur's goals. Do they think about strategic sales or salary?
As Howard describes one failed deal:
"The loss was a result of an egomaniac that refused to compromise or even recognize possible limitations to the market opportunity or to his talent!"
It is critical to get at the underlying beliefs and objectives of the entrepreneur as they will eventually win out or create a major break with some stakeholder group. Here are some of the key questions for each reference point:
Goals
What are the underlying goals and are they relevant? What are they communicating indirectly about their goals?
Knowledge
Do they know what to do? Do they understand this business? Are they known and respected by others within this field?
Capability
Can they do it? Can they get others to do it? Can they implement?
Winning angels who have learned to assess salesmanship, financial acumen, resumes, and business models, often miss by not identifying the underlying goals of the entrepreneur or by not realizing they are incapable of making things happen. Enough said (we hope).
Reprinted with the permission from Winning Angels: the 7 Fundamentals of Early-Stage Investing, Pearson Education Limited, 2001.
NOTES
1. For more information, see Some Thoughts on Business Plans by William Sahlman (HBS Publishing 1996, pp 30-31).
2. Howard originally created a framework for real estate which Bill Sahlman adapted for the entrepreneurial finance course at Harvard Business School.
3. Capitalyst can be found at www.capitalyst.com.
4. For our non-American readers, we will try to include cricket, football, rugby and other sports analogies in the next version (we all know that football is the true world sport). In case you don't know what a homerun is, it is when you run around all three bases and then score a point! Some American angels will also say "hit it out of the park." This is a reference to hitting a baseball past the back fence of a baseball field, which is as automatic homerun, and the best you can do.
5. As mentioned previously, some of our angels preferred anonymity, so we will use initials (not necessarily theirs) to quote them.
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