Conversations with Investors – Chapter Two

Dr. Earl R. Smith II
Managing Partner, The Federal Circle

Dr Earl R. Smith II

J. S. Gamble, Founder and CEO, Montis Group, LLC

In this series of articles, I describe several discussions that I had with investors in the Washington DC area. They range from angel investors to senior partners in well established funds. I have known most of them for many years. That allowed us to cut through the usual PR crap and get to the heart of the process of reviewing investment opportunities. When I told them that my objective was to provide a series of articles which would help companies seeking funding, each was very willing to help – it is, after all, in their interest to improve the process. I owe each of them a debt of thanks for agreeing to sit down and ‘open the kimono’ so to speak.

The first article in the series – Conversations with Investors – Chapter One – focused on Jim Hunt of The MITA Group. Jim is a fairly typical angel investor – a successful entrepreneur who has turned to investing on early-stage companies. My next interview was with a close associate of Jim’s whose background and experience makes for a different approach.

Vive la différence

Every investor is different – they have different backgrounds and approaches to the process. This is one of the greatest lessons that founders need to learn. Each investor has a common characteristic – they have money to invest. But their life and business experiences are always more important than their bank balance. In the first of this series, I emphasized the need to match the investment opportunity to the interests of the investor. Many meetings are wasted because founders did not take the time to match their opportunity to the investor’s interest. The lesson for this chapter is the need to match the presentation to the experience and tendencies of the investor – to realize that each investor is unique and will respond better if approached in terms they understand.

Visit with an experienced analyst

I have known JS for a number of years. He is Founder and CEO of Montis Group, which is focused on investing in and advising Early Stage Technology Companies. JS is an Advisory Partner of The MITA Group. In addition, he is a member of New Vantage Group, the Active Angel Investors of Vienna, Virginia, and a member of the Capital Access Network at the Dingman Center for Entrepreneurship at the University of Maryland. He is currently working with a dozen like-minded private investors to form a Group of Angel Investors focused on more active engagement with their portfolio companies.

JS has a more academic bent when it comes to analyzing investment opportunities. He earned an MBA in finance at Wharton and is very experienced at building and testing financial models. As a result, he is murder on unprofessionally drawn business models and financial projections.

Currently JS is invested in or actively engaged with several early stage Technology and Service Companies in the Mid-Atlantic Region. He served as Acting CEO of Smart Imaging Systems, Inc. and as an adviser to Agilyst, Inc., Semantic Labs and Wiser Together, Inc.

Prior to founding the Montis Group, JS was Senior Operating Executive in Broadband Cable and SVP of Wireless Operating Units with Comcast. He has more than 15 years of Full P&L (up to $1.2B in Annual Revenue) and CapEx responsibility. He had responsibility building teams focused on innovation, improving execution and launching new products and services to drive revenue growth.

Way back when, JS spent several years on the professional staff of McKinsey & Company, Inc. and Price Waterhouse where his clients were primarily telecommunications companies. He also served in various roles with GTE Mobilnet (Wireless Operations).

The Initial Screen

We met at Old Glory in Georgetown – a bourbon house that offers tables with a fine view of M Street. After chatting about deals that we were each involved in and people we knew, I turned to the interview. I told JS that I wanted to focus on how he decided whether or not to make an investment. My first questions was, “What percentage of the deals that come over the transom do you discard out of hand?”

He knew that I had already done an interview with Jim Hunt; so the first response was a question. “What did Jim say?” I grinned and said, “now, now – no cribbing. I’ll tell you afterward.” That was the first lesson from the interview. Angle investors in a given geographical region generally talk to each other frequently. They share information and track closely each other’s success and failures.

“Seventy-five percent of what I see is discarded out of hand,” offered JS. (Jim’s number was 70%). That means that, on average, three out of every four deals gets only a cursory consideration. His principal reasons for dismissing opportunities were 1) the business model does not hold up, 2) it’s not in my area, 3) the founders are looking for a passive investor and 4) I don’t know any of the principals or their advisers.

The first reason relates to how JS approaches the process of investing. Because of his background, he can take apart a business model and the attached projections quicker than most can review them. “I look at their model and projections. I take them apart and test them against what I know. If I find obvious mistakes, I walk away quickly.” His rule of thumb, “I cut the projected revenue in half and double the time it takes to reach it and then I look at the results. My experience is that that is probably closer to the way things will turn out – that is, if they are successful.” Other investors may get to the business model later in the process but JS goes there first. As a result, he may lose interest because your numbers don’t add up or make sense.

His second screen it very similar to one that Jim Hunt uses. Good investors know what they know about and are very disciplined about staying away from investing in what they don’t know. A particular type bothers JS. “I see these teams who have reinvented themselves to fit the latest, newest, hottest thing.” JS likes to see founders and management teams that are focused on what they know and have been successful with in the past. His investment is in the team’s ability to execute their business model – not in the business model. “Given a choice between a Superb Product/Model with Mediocre Execution and a Mediocre Product/Model with Superb Execution, I will take Superb Execution every time.” This is an important distinction which ran through all my interviews.

The third screen is particularly important to JS. He likes to invest in situations that call for an active participation by the investors. This is a variation of Jim Hunt’s third screen – ‘they don’t have any adult supervision’. JS prefers management teams that see a value in his or a co-investor’s participation beyond providing the funding. “I like situations that call for active participation.” To be sure, there are investors who like to take a more passive role. It is counterproductive to approach an ‘active participation’ investor with such a proposal.

The fourth screen is one that many angel investors have and founders need to pay attention to. Many of these angel investors will not look at deals that do not involve one or more of their significant contacts. It is important to remember that angel investing is a much more intimate process than venture funding. Relationships and endorsements generally play a big part of any angel investor’s decision to consider a deal.

The 25% Remaining

“So, JS, let’s focus on the roughly 25% that make it through your initial screening. What do you look for and what reasons cause you to discard them?”

“I look at the product or service that they plan to offer. My first question is does it work? You’d be surprised how many deals I see where the answer is negative or not yet. This investment round will get us there.” JS doesn’t like to invest in science projects and isn’t likely to fund product or service development. He expects the team to come with a fully developed value proposition. That’s the case with most angel investors I know. There are those who will fund development; but a team needs to know ahead of time if the investor they are approaching is likely to make such an investment.

His second screen dealt with the path to revenue. “I am fairly impatient with a team that has generated no customers. The proposition ‘give us the money and we will generate revenue’ does not impress me much”, he offered. JS believes that good teams are compulsive implementers. “The good teams are always selling – always working to generate revenues. The less impressive teams are always tweaking and fine-tuning their technology and avoiding the process of generating revenue as long as possible.”

JS likes to drill down deeper into the business plan and value propositions which underlie it. He sometimes finds himself pushing teams to consider details that they may have ignored. But his motive is far broader than testing the business model. “I want to see how the team operates under pressure. I look for weak links – team members who are not up to playing their role. I drill down into the team, beginning with the CEO, and their capabilities as a team at the same time I am stress testing the business model and value proposition.” He is likely to request one-on-one meetings with individual team members in order to come to an assessment of how their personalities and roles mesh. Gaps in the team are particularly serious negatives to JS that need to be recognized and resolved. He sees such team capability gaps and the plans to resolve them as a reflection on the judgment of the founders.

In his view the quality of the team is central to the chances of success. He explained. “Most angel investors focus on the CEO – and the CEO is definitely important. However, I try to go beyond just the CEO to judge the larger Team skills, ID any gaps – for example. sales or business development – and try to judge how well the personalities/skills complement each other to make for a more effective Team. Some gaps are common and don’t necessarily bother me. Companies can outgrow a Team member’s capabilities; or, conversely, Cos. can grow into the skill ‘sweet spot’ of an experienced Team member. What can bother me is the CEO’s recognition/non-recognition of the gaps and their clear or non-existent plans to resolve the gaps.”

This approach allows JS to gather information on a critical area – is the team willing to listen to alternative assessment, do they stay obsessively with their initial perspective or do they grow their understanding with detailed discussions and new viewpoints?

The 5% of the 25%

“OK JS, let’s start with a hundred deals. You say that only twenty-five of them get any attention at all. What percentage of those get a detailed analysis and now many are you likely to seriously consider for investment.”

Every investor that I interviewed paused when asked this question. I suspect that was because the process has become so natural for them that they don’t keep track of such things. Their interest is to find investment opportunities that are sufficient to satisfy their need to invest funds. That is a key to understanding how and why investors go through the process – often a frustrating one that can go on for long periods without surfacing a good investment opportunity. They have decided to invest part of their wealth in early-stage companies. Most founders do not grasp this dynamic sufficiently.

“I may take a closer look at about 20% of the ones that pass my initial screening”, JS estimated. So, to run the numbers, out of every hundred deals that come to JS, he discards seventy-five out of hand. Of the remaining twenty-five, roughly five get a more extended consideration.

“And how do you go about making decisions about these few,” I asked. “I am working to satisfy my appetite for investment, balance my portfolio, manage the overall risk and make good investment decisions which will provide a hefty return,” he replied. This response is important and every founder should work to understand what it means. Investors are working to balance a complex set of criteria, needs and objectives. Their decision is unlikely to be limited to whether or not they should invest in your company. In other words, you may be turned down for reasons that do not directly relate to your company.

We had enjoyed a couple of very nice bourbons and I a good cigar. Time and other obligations were tapping us both on the shoulder. But I could not resist one additional question. “JS, I am getting the feeling that you see your role as extending substantially beyond that of an investor. Would it be fair to say that you see yourself more as a venture partner who happens to be providing funding?”

“I think that is more than fair. Sure I see the companies as investments. But I am a proactive investor and have confidence that I can bring much more than funding to the table. I am more likely to invest in a situation which calls for that involvement than in one which opposes it.”
© Dr. Earl R. Smith II

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