Investment Do’s and Don’ts

What makes a good investment? Here are thoughts to guide us that seem to have stood the test of time in the venture community. These considerations aren’t my own but come from a number of well-respected sources. And, in fact they are basically a list of “do’s” – or what to pay attention to.

An Industry Specific Term – “Domain Expertise”

Since this term features prominently in these Investment Do’s and Don’ts, I thought I had better provide a broad definition that fits the term in its upcoming context. Since there is no absolute or dictionary definition, I looked around on Google and picked a couple of favorites.

I found that Accenture defines “domain expertise” as “the extent to which a provider has experience with and understanding of the client’s business, industry and technical contexts, processes, practices and requirements”.

AlleyWatch defines “domain experience” as “an accumulated body of applied knowledge in a particular human endeavor”.

The important distinction here is “applied knowledge,” meaning knowledge that is gained through the process of using that knowledge towards the completion of work. Another way of thinking about domain experience is to say a person is in possession of a high level of skills or a group of complementary skills.

Together, ‘expertise’ and ‘experience’ will help us make sense of the do’s and don’ts.

What kind of investments are we talking about here?

While the following highlighted factors are in this context being applied to smaller, start-up and private investments, most of the criteria can apply to publicly listed companies as well. (As will be discussed later, “valuation” is perhaps the strongest outlier to such commonality.)[1]

Five Basic Criteria

The following are the five basic criteria to be considered before making an investment. As discussed, some “do” matter and matter more than others. Others “don’t” matter or don’t matter as much. See below.

1 -The Founder(s)

Overtime, this has been the most important criteria. Think of Bill Gates (Microsoft), Mark Zuckerberg (Facebook) or Sergey Brin and Larry Page (Google).

One is looking for founders with domain expertise. It is important for founders to have a deep personal conviction about the business they are building, an ability to withstand being hit over the head with the trials and tribulations that are sure to come and to be able to overcome false starts.

Being in the innovation business (i.e. to be in a business with a great upside), one is looking for disruptive innovations driven by individuals with passion and determination rather than rote knowledge and credentials.

Another important aspect of being a founder (either alone or with a partner(s)) is to have someone who is an entrepreneur – someone who can execute on a great idea. This means being able to orchestrate a lot of moving parts, including the right timing, the right allocations of capital, etc.

It is interesting to see how Google, as an example, moved their most entrepreneurial founder back into the direction of the company a few years back.

2 – The Idea

One has to have a good idea and knowledge about the idea, along with passion.

3 – The Business model

The planned business model can be particularly important as it may distinguish one business from another in a relative space with similar technologies and/or business plans.

4 – The Valuation

If the founders are great and the idea is great, there won’t be a lot of choice over the valuation with multiple potential investors. Broad mistakes can be made, but that’s another issue.

5 – The Technology

It may sound counterintuitive to say that owning the technology is the least important factor in terms of deciding to invest but a company such as Uber doesn’t actually have the key technology that makes Uber work. Uber doesn’t work without Google Maps (and, in an article on Bloomberg February 3, this technology risk to Uber is highlighted in Google’s own efforts to work on a competing service).[2]

Instead, it is recommended to focus on “domain expertise” and the “founders” – and Uber is a perfect example of a strong founder with domain expertise launching a (to date) successful disruptive business, while making use of another company’s technology.

Partners and the Capital Structure

This needs to be right and it has to be right from the very beginning. As with architecture and construction, the foundation has to be chosen and built correctly or the edifice above will have problems.

A key consideration here is how the ‘business pie’ is being split up and to know very clearly what you and others own – the types of shares you own and the types of shares everybody else owns and how the company is structured (e.g. for contingency planning: if then, then that; if this, then that’; etc.). Who owns what shares and why do they own them? What happens if there is a disagreement? Who gets to make that final decision?

You have to assume you will have problems and that partners (investors) will fight and disagree; as such, you always need to know what the company’s capitalization table is telling you. The capitalization table can be all-important – it drives all the pain and it is where mistakes are made.

More on the Capital Structure (Term Sheet)

It is important to understand all of the specifics involved in the “term sheet” for the investment.

Basics here include the amount being raised and the dilution to the entrepreneur (what is the amount of ownership that the investors are buying). Next is the relationship between the investor(s) and the entrepreneur. As some say, everything else is just noise.

Key considerations are liquidation preferences (plain vanilla 1x is fair) – if the company is sold for less than the valuation used at the time of the investment, then it is fair that the investor(s) get their investment back.

The Option Pool Allowance

Another thing to pay attention to is the use of an option pool. Key issues here are whether it is the right percentage amount, based on additional hires that will need to be awarded an expected level of company options (there are standards here).

The key question is whether this option pool is calculated on the basis of the “pre-money” investment valuation of the company or the “post-financing” fully diluted valuation.

For the entrepreneur, a post-financing option pool is important. Using a pre-money valuation often is referred to as the “option pool shuffle” – and is a way investors can reduce the pre-money valuation in an unexpected way and reduce the pre-investment value of the company’s shares for the entrepreneur and his existing employees.

More on Valuation

As noted above, this article is focused on valuations in newer, non-publicly-listed companies. As such, the issue of valuation is likely going to be determined at each investment stage by a small group of investors using commonly accepted metrics for the given type of business. And, this type of an investment averages a 7-10 year commitment (exceptions noted).

As such, a preferred private investing model can be compared to farming where every year you have to plant a crop. In terms of investing, this means laddering investments over time; and, if investing in funds, this means investing into multiple funds, not just one.

Part of this timing can relate to the fact that technologies are constantly changing and it is hard to cherry pick. I’ll always recall in my days as an investment advisor talking to someone from the American Funds Group and hearing them say that they consider an investment analyst to be successful if they ‘get it right’ 60% of the time.

The flip side of when valuation becomes important is the public market. Here one wants liquidity, which isn’t an easy private market consideration.

The Biggest Risks

Basically – don’t get into business with the wrong people (founders and other investors based on the capital structure) and make sure you understand the business you are getting involved in.

Summary

The above discussion is not meant to be all-inclusive but rather to touch on some of the key factors to be considered by both investors and entrepreneurs when they look to build and invest in businesses.

(1) Some of the information in this article comes from a recent interview Barry Ritholz conducted with and angel investor Howard Lindzon. (podcast: http://media.bloomberg.com/bb/avfile/Masters_in_Business/vTP5ohtqCUSE.mp3)

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