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What a Good Deal Looks Like

12/6/2010

This is the last post in my series of lessons learned from the last day of my entrepreneurial finance class. Here you will read how our professor, with over 50 years of investment banking and venture capital experience, describes what a good deal looks like to him. As he likes to say, a good deal can be characterized by the following "easily identifiable but hard to assemble attributes."

Team: World-class managerial team.
-Cover the necessary verticals and horizontals (top to bottom and across functions)

-Relevant skills for opportunity

-Ideally worked successfully together in the past. This last point allows the team to function quickly and efficiently, bypassing "get to know you time."
Opportunity: Attractive, sustainable model.
-From a survey of entrepreneurs we read in class, 71% of entrepreneurs got their idea by replicating or modifying an idea encountered through previous employment. This means that ideation is usually experiential, not a light bulb going off in your head in a garage.

-Doing something with the idea in real life is better than planning and postponing. In the same study as above, only 28% of entrepreneurs had a full-blown business plan, and 41% had no formal written plan at all. Though our school prides itself on the "Business Plan Development" class it offers, our professor told us that it could be ok to proceed without a formal plan if one has experience in the field, since plans never really survive once they make contact with the real world.

-Offense: Create a competitive edge. This means having multiple options for expansion and an opportunity that is unique to the enterprise and the team.

-Number of ways to extract value from the opportunity. This could be through a positive harvest, like a sale or IPO, as well as the option to scale down operations to a sustainable, more profitable niche area, and liquidation when necessary.

-Defense: Defend your edge through continuous innovation.
Context: Favorable regulation and macroeconomics.
Deals: Sensible, binding the opportunity with people through correct incentives.
Financed: By individuals who add value in addition to their capital, increasing the likelihood of success.
Financing terms: Provide the right incentives for the provider and recipient of capital.

In class, we read an interview with past Disney CFO Gary Wilson. When asked what creates value, he wrote, "Creativity creates value. In finance that means structuring deals creatively." But we know that financing doesn't cure management problems and is only the tail end of the process; it doesn't make or break a business but rather just gives managers time to succeed or fail.
Capital: Access to additional capital as warranted.

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10 Lessons from a VC

11/24/2010

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In this penultimate week of my finance class, we had a guest venture capitalist come to do a case study with us. The class aimed to highlight the basics of venture capital in comparison with private equity (which we studied previously). Below are the top ten takeaways from the class, which was really engaging and interesting.

The most important factors VCs consider in a company are market size, management, and competitive advantage/product. The fastest way to understand market size is through calling customers; a few phone calls (primary research) will go much further than looking up aggregated, often useless stats in a database.To understand competitive advantage, look at technology and financial statements. In terms of financial statements, premium gross margins (45%+ as opposed to typical 20%) can often point to competitive advantage.
The actual product and technology are more important than past financial statements. Past financials, in the VC/early stage world, are irrelevant and almost always not predictive of the future. VCs care about growth and future profitability, not past financial results. Past business development/growth/management goal-attainment results are another story, though; those matter a lot. VCs invest in uncertain businesses where the future will not be like the past; private equity (PE) invests in firms where financial statement analysis is critical because businesses are more stable.
Time can be an advantage for the investor when it eliminates competition for the deal. If a VC has a small window of opportunity to see a deal first and have some exclusivity to it, this is a rare opportunity that he or she will try to take advantage of. On the flip side, many VCs like to invest together (social proof), so this has its risks as well.

Often times, VCs can use tight deal timing and uncertain financial statement reliability to their advantage. If the company is in a rush to close a deal and/or has financials that are not really reliable, this can help in negotiating a better price for the VC. In VC, the outcome is more important than the decision-making procedure because time is of the essence for capturing opportunity. The guest also told us that he typically knows within 15 minutes of meeting an entrepreneur whether he wants to make the deal.

In terms of price in such circumstances, it only needs to be justifiable to the board (and the VC fund) and show reasonable analysis; it is not the result of some careful projections or analysis. Prices are determined by gut and then vetted out through some bounds analysis and taking a look at comparables. Therefore, VCs aim to negotiate for the lowest possible price that is justifiable somehow by comps and rough projections.
Venture capital is about being a home run hitter. It's all about hitting home runs once in a while and losing on most other deals. You won’t be fired for taking risks, but you will be fired for missing opportunities.

In this way, it's all about maximizing the likelihood you get lucky by investing in companies that have any hope of getting huge. VC thus is an art that is about seeing big ideas and getting on the deals with the highest potential. PE is much more of a science than VC because there the companies are typically more established and will likely continue in the same way as they have in the past.
Venture capital is about relationships. The guest spoke of investing in a company as analogous to being married to the entrepreneur. The way that VC firms differentiate from others is through their connections and networks.

Our professor chimed in to add that from whom you get the money is more important than getting the money and on what terms.
During acquisitions, you need to always consider what will happen if you don’t acquire a company that will be sold to someone anyways. Often times, just by thinking about the alternative, it's clear that making an acquisition is the correct strategic decision for a company. An example is a car dealership that can buy a nearby location; it would clearly prefer to have that location rather than be hurt by additional nearby new competition.
The number of VC deals is roughly stable over time; what changes given market conditions are price and terms. We looked at graphs of deal flow over time, including number of deals, capital deployed, and average deal size. There were clearly swings over the past 10 years, but looking at a longer time horizon, the trend is stable.

Our guest explained that the number one determinant of whether our economy will grow at 3%+ per year (to sustain job growth, etc.) is the number of $1 billion+ revenue businesses started per year. Based on this and the above, he assured us that good ideas and people will always find capital available.
Great entrepreneurs will find attractive markets; trust the person more than the specific market. Smart people can adapt to changes in the market and are required to execute on business ideas, even ideas that are inherently poor or at a disadvantage. On the flip side, a great idea can easily be mis-executed or an opportunity missed by a suboptimal entrepreneur. Our guest believed that the biggest reason for failure among the deals that failed on him was management (the team not working well and not hiring fast and well enough).
Structuring a VC deal portfolio involves many trade-offs. When we asked about investing in one narrow space or industry versus achieving diversification, our guest explained that there is a trade-off between diversification and specialization in the field you know. You want to invest where you're experienced and familiar, but you also don't want to put all your eggs in one basket. However, if a particular market niche is really big, you want diversification within that and can have as many bets in play as possible. For example, many of the most successful investors in social networks early on invested in all of them instead of trying to predict which would succeed. As long as Facebook was in that portfolio, it couldn't be a loser in the end.
Evaluating exit offers is about weighing the risk of future execution versus the potential of huge outcome. We talked about the acquisition offers our guest's portfolio companies had received over time and the way they decided which to accept or not. It all boiled down to how big of an opportunity they thought they could capture; in many instances, one bird in the hand (accepting the acquisition) was turned down for two in the bush (potential huge growth) based on the traction and momentum of the business at the time and the projections of the size of the opportunity. This is obviously a guessing game, and one just needs to trust one's gut in making the decision.

I thoroughly enjoyed the class, even though the basic concepts weren't new to me. It was nice to just hear about the guest's stories and perspective that tied together many strategic concepts about VC investing that I had learned about before.

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