Introduction
We have previously discussed aspects of investing in ventures and private-equity business projects several times. As we know, ventures and private-equity projects tend to be highly risky. Furthermore, most such projects have unique key characteristics. It is thus typically hard to come up with generalizations regarding what is advisable and what is not when investing in these types of projects. Indeed, this very lack of a set of criteria for a firm’s success could be a root cause of the high risk seen in such ventures and private-equity projects.
That being said, there are still a few general guidelines for investing in this class of equities. In the following, I briefly discuss the five most critical guidelines.
Is there a market?
First, estimating a particular venture or private-equity project’s overall market potential is critical. Regrettably, many promoters of new ventures and private-equity projects are overly optimistic when making such estimates. Two useful considerations add to a more realistic scenario here:
Is there already a proven market? If so, what size is it? Is the proposed project likely to lead pre-existing customers to switch? Why?
Are there already competitors in this particular market space? If so, how strong are they? It is typically good that others have found the target market attractive, but it is also a question of realism when assessing one’s likelihood of success against these specific competitors.
What is unique about this venture or private-equity project?
I typically look for five types of confirmations when dealing with this question. Although not all of these need to be positively confirmed, it is crucial that the bulk of them are confirmed.
Is the target group sufficiently clear and relatively narrow and focused? Is the specific value proposition of high interest to the target group? It should be noted that, because most new ventures and private-equity projects are difficult to pull off, a common ameliorating approach is to modify the original business preposition to some extent. However, if this adaptation in turn leads to a loss of focus regarding the target group, then (in my experience) this pivoting can actually lead to negative consequences! Sticking to a relatively narrow target group is often indispensable, and any experimentation should focus on how to serve the target group better.
Is there a unique technology, or is the technology relatively standard (and thus easy to copy)? A unique technology – ideally protected through patents – is key. If the actual product that is being brought to market is technologically unique, that tends to be even better than developing an innovative production process. Although the latter type can lead to cost savings and/or better quality, the former is typically the one that prospective customers more readily appreciate!
Regarding the route to market, is there anything unique about the project’s marketing and distribution? With the advent of cloud computing and big data analysis, many innovative ways of identifying new routes to market have emerged. Finding alternatives to the established marketing and distribution methods is key here. Furthermore, the recent wave of computer-based marketing enhancements is critical. These enhancements can help a business to connect to its target group more directly, more quickly, and less expensively!
Is there a radical innovation at play? This might lead to an entirely new approach to product offerings and/or marketing (or even an entire business model)! A relatively high degree of novelty is typically important, but achieving truly radical innovation is not always easy! As always, however, this is a matter of degree!
Is there a revenue stream? In previous discussions, we raised a warning flag regarding ventures and private-equity propositions that are nothing more than good ideas and that have no proven customers or revenue streams. (However, investments in such projects, when in an early phase, can still prove beneficial, provided that there is a reasonable valuation.) In general, a proven revenue structure is preferred. A subsidiary question relates to assessing the robustness of a particular revenue stream.
The Financing
Procuring realistic financing for a specific venture or private-equity project is fundamental to its success, but realism tends to be a particular bottleneck in this process. Paradoxically, although not being able to finance a given project often indicates that the project is not attractive enough, it can also indicate a lack of available venture capital. Many have pointed out that the availability risk-capital in Silicon Valley has put this region ahead of many others. At least three additional considerations regarding the financing side should be acknowledged.
Is there enough financing available for the venture to survive at least through its next performance milestone?
Is the business realistic and not having too much debt financing (including land financing)? Keeping a venture’s break-even point relatively low is crucial; thus, equity is more critical than debt.
Do the business’s owners include one or more investors who are committed to participating in the subsequent rounds of financing? In my experience, having some investors who can be counted on is valuable. It is more realistic to count on financing from subsequent rounds when a degree of participation can be counted on. (It goes without saying that the project should be on track and should not be a failure in the making; even the most committed investors should stay away from throwing good money after bad!)
The Management Side. To ensure a project’s success, having a good manager is imperative. Here, I look at three issues:
Does the manager-in-charge have the necessary competence to successfully run this venture? In particular, does the manager have enough technical expertise? For such a venture to succeed, it can be equally important for the manager to have a high degree of dynamism and energy!
Does the manager-in-charge have “skin in the game”? The people in charge might not have enough funds of their own to become large investors, but it is very important that they be willing to actually invest as much as they can to show their full commitment to the project. Actions such as taking out a mortgage can be very meaningful here!
On the other hand, for a managing director, having a too-high stake in a given project can be dysfunctional as well. The overarching goal is to run the business in terms of what is actually optimal for the project itself (rather than for the manager). Financing decisions often are critical. Above all, the question is whether the company should take on expensive debt to avoid diluting the manager’s ownership stake or whether it should issue more equity (such as when a cash-strapped manager is unable to participate) and thus become diluted? The manager might argue that an equity valuation does not fully reflect the company’s value. Thus, the board and the owners might face a dilemma and experience tension on this matter.
Does a manager have enough experience and learning from failures? Many good managers of ventures have made mistakes in the early phases of their careers. Did they make these mistakes with integrity and honesty and try to act in the best interests of the investors, or have they shown a tendency to think too much about themselves?
Above all, failure in a previous stage can be okay – it is even expected in Silicon Valley – as long as the manager seems to have learned from those experiences.
Exit strategy. Investors need to consider how to eventually terminate their engagement in a particular venture or private-equity project. This can happen in one of two ways:
First, the venture or private-equity project can be sold. For investors, it is key to be paid in cash in such instances. Some buyers prefer to compensate the previous owners in the form of stock in the new venture. This can be tempting if the ownership proportion of that stock is high, but, in general, stock ownership without control of the venture is risky. Sometimes, hybrid solutions have to be found, and owner-managers often have to be ready to accept earn-outs, typically in the form of additional compensation if the business succeeds. Obviously, such compromises can be both necessary and desirable!
Second, instead of being sold outright, the project can go public via an initial public offering. This results in a listing on a stock exchange and typically opens up the firm for massive dilution and liquidity, thus creating an opportunity to reduce exposure. Many investors prefer to keep a small fraction of their initial investments in the firm.
Conclusions
In this piece, we have discussed five aspects of investing in ventures or private equities:
The market
The project’s uniqueness
The project’s financing
The project’s manager
The method of exiting the investment
Attention to these issues is critical, but it should be stressed that, because all ventures are unique, attention and effort do not preclude continued risks. The possibility of failure should always be considered, but careful attention to the five principles described above will enhance the likelihood of a project’s success.
Questions from the Lorange Network members:
What has been your own experience in venture or private equity investments, and how did they fare along the five questions raised in this article?
Managers-in-charge must be in a “Goldilock zone”: they must have some “skin in the game” but not too much. How can one assess what is a reasonable balance of personal commitment on the manager-in-charge’s part, without falling in the downsides of the other extreme?
What examples of hybrid exit strategies have you seen, and what are their respective merits and limitations?
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