Rating Qualities

7
Applicable

Venture Capital Investing

The Complete Handbook for Investing in
Private Businesses for Outstanding Profits
David Gladstone and Laura Gladstone | FT Prentice Hall © 2003

This book is a thorough, practical guide to the nitty-gritty of venture capital investing. This
comprehensive, well-organized instruction manual summarizes the homework you should do
before you make a venture capital investment, the paperwork needed to carry out the investment
and the ongoing work you will have to undertake to have a prayer of seeing your investment
pay off. If it is a little plodding, you can understand why. It covers a lot of ground. The authors
compare venture capital investing to a partnership at one point, to a marriage at another. They
don’t attempt to sell you on venture investing. In fact, by telling you how difficult and labor
intensive it is, they may even drive you away. getAbstract.com believes this book definitely
belongs in the library of anyone who has ever taken a serious interest in venture investing. It will
also help entrepreneurs who need venture capital financing by showing them how to evaluate their
companies according to the criteria that serious investors are apt to use.

Take-Aways
• Venture capital more resembles partnering than investing.
• Look for self-confident, autonomous, determined, resourceful and practical entrepreneurs.
• Seek a well-capitalized company in a growing industry.
• Check references and go beyond them.
• Assess strengths and weaknesses in the company’s various operating and staff functions.
• Pay close attention to cash flow. Cash is king.
• Write a summary statement of the pros and cons of investing in the company.
• Write a commitment letter, but remember that it spells out the business understanding, not the
legal understanding, so keep it clear.
• Remember that your lawyer works for you, not the other way around.

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 • Be prepared for problems - no pain, no gain.

Summary

Due Diligence

Venture capital professionals exercise due diligence when they consider investing in a business.
Due diligence is the process of researching, examining, questioning, analyzing, assessing,
pondering, following up and generally scrutinizing with some degree of skeptical attention any
investment opportunity before committing funds. If you are thinking of investing in a business,
give due diligence its due. Demand the following:

• Proper presentation of relevant numbers - Look for accurate, comprehensive data presented
according to generally accepted accounting principles. Assure yourself that the entrepreneurs
understand their own numbers and can discuss them in detail. If they don’t know much
about accounting, they should hire a professional accountant to prepare a properly formatted
accounting statement. Don’t only examine the past but also look toward the future. The
entrepreneurs should assemble a five-year forecast. If the business is not yet making money,
ask for a schedule explaining when it will be profitable. If the entrepreneurs or managers don’t
understand the numbers, aren’t comfortable discussing them or otherwise show an aversion to
this part of the process, walk away and don’t look back. Odds are that you will save yourself a
lot of worry and anxiety.
• A return of at least 25% - This is what your investment should earn; preferably it will earn
more. Venture capital investing is risky. Some deals won’t work out. High returns on the others
makes the whole process worthwhile.
• Good management - Good means competent, honest, ethical, experienced, energetic and
motivated to achieve.
• A unique market advantage - This doesn’t mean a completely revolutionary technology but
rather a way of doing something that improves on what people are already doing. Venture
capitalists don’t want to wait for society to change its ways. They want fast payoffs. The market
is ultimately boss. Don’t try to change the market’s mind. Give the market what it already
wants, in a uniquely better way.
• A way to take cash out - Usually, this means making an Initial Public Offering, being acquired
or even selling the venture capital (VC) stake back to the company itself.

“One criterion that every investor uses to test management is honesty.”

VC investing isn’t like buying stocks and bonds. It’s more like entering into a partnership.
Sometimes it is like a marriage, for better or worse. Make sure you know with whom you are
getting involved. If the people are unethical or dishonest, if they cheat on their taxes, squeeze their
suppliers or cut corners, be assured that they will also cheat you. Walk away.

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 “No investment opportunity is perfect.”

To discipline yourself, summarize the essentials of the deal in writing. Mention:

• The company’s correct name and address, and your contact person - not the broker, but the
person you will deal with on the inside.
• A brief profile of the entrepreneurs and managers.
• What the product or service is and what makes it unique.
• How much money the company is seeking, how much it is asking you for, what you will get for
your investment and why the company wants your money.
• Any available security or collateral that will make your investment less risky.
• Financials, both past performance and future projections.
• How you will get your money out and what your potential payoff and risks are.
• What you like and dislike about the opportunity.

What Is an Entrepreneur?

Entrepreneurs aren’t like most other people. Quite a bit of research has focused on
entrepreneurship, not all of it worthwhile, though some studies are worth reading. The better
studies focus on the mental and behavioral characteristics that seem to mark successful
entrepreneurs. What makes an entrepreneur who has actually started a business different from
all those who have merely spun fantasies about starting their own businesses? Look for these
character traits:

• Autonomous - Entrepreneurs want to be independent. They don’t need support groups or

mentors. They prefer to be on their own. In some cases, their autonomy makes them disastrous
managers, because they may not relate well to ordinary people who do need support groups,
mentors and the like.
• Achievement-oriented - Entrepreneurs aren’t go-along-to-get-along types. They are driven to
accomplish something.
• Self-confidence - Entrepreneurs have faith in themselves and believe that they can control their
fate. They don’t think of themselves as lucky, but rather as diligent, hard working and alert to
opportunity.
• Good judges of risk - Entrepreneurs can assess the risks and benefits of a situation in which
someone else, frightened by ambiguity and uncertainty, sees only risks. Because entrepreneurs
are willing to take risks that frighten other people, some regard them as risk seekers. But
successful entrepreneurs try to minimize risk. They recognize that there is no reward without
some risk, and they take the risk that is needed to get the desired reward, but no more risk than
necessary.
• Determined - Entrepreneurs don’t give up easily. They want and need to succeed. They stay the
course.

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 • Resourceful - Success doesn’t come easily, and entrepreneurs need to find solutions to many
unexpected problems. Don’t invest in an entrepreneur who can’t roll with the punches and
come back strong.
• Pressed for time - Entrepreneurs are so busy, they don’t seem to have enough hours in the day
to accomplish all their goals. They set deadlines and keep themselves under pressure. They
have a true sense of urgency.
• Feet on the ground - Entrepreneurs, at least the ones you want to invest in, know the difference
between fantasy and reality. They don’t let dreams carry them away. They have dreams, but
they know what’s real, too.
• Good communicators - Entrepreneurs can explain what they want to accomplish, and persuade
others to cooperate. They’re energetic, intense, emotionally stable and sometimes even
charismatic.
• Honest, ethical and fair - Contrary to popular prejudice, no one really succeeds in business
without integrity.
• See their investors as partners - The entrepreneurs you back will not think of you just as an
ATM machine that dispenses cash, but rather as a source of money and intellectual capital, as a
partner whose interests matter almost as much, maybe even more, than their own.

Analyzing the Company

Your analysis of the company in which you have been invited to invest should address three areas:
management, marketing and operations/production.

Management

Look at the company’s organization. Who are the officers, directors and owners? What does the
organizational chart look like? Who does what tasks; who reports to whom? Even in businesses
that take a team approach, someone has to be responsible for the undesirable, boring or
frustrating work. Unless an organization specifically assigns these tasks, odds are they’ll remain
undone and may undo the company itself.

“The entrepreneur you are backing should see you as a partner and not as an investor.”

Compensation is a particularly important issue. Ask to see payroll records, especially W-2 records,
and don’t hesitate to inquire about unusually hefty paychecks to any member of management
or any worker. Be equally inquisitive about apparently good managers who seem to be earning
relatively little. If they are good and underpaid, they won’t be around for long. Look at all the
aspects of compensation: pension, benefits, bonus plans and so on. Don’t ignore the workforce
below management ranks. Well-run companies have entrepreneurial incentives built into their
compensation structure from top to bottom. Union contracts, where present, may have provisions
that prevent entrepreneurial rewards to the rank and file. Make sure you understand the labor
agreement and the state of relations between management and the union. Get nosy about

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 workforce morale, grievances, insurance plans, policies and procedures, training and anything else
that might affect productivity.

Marketing

Marketing and sales both involve the company’s efforts to get its product or service to customers
and thereby earn money. Familiarize yourself with the company’s marketing program and its sales
model. Does it use an internal sales force or rely on manufacturers representatives, or some other
external agency? Who pays the sales force and how?

“From an investor’s standpoint, a company is little more than the people who work for
it.”

Understand how the company presents itself to the market. Is it selling a product, a service, a
feeling, an image or something else? What is its brand? Is the business seasonal or dependent on a
fashion? If so, what are the big seasons, and are there any social or economic trends underway that
might doom the product (or, conversely, make it even more desirable)? Who are the competitors
and what are their strengths and weaknesses?

“Every investor has to review his or her portfolio of investments to determine whether
there are business opportunities greater than the investment in the current company.”

How does the business treat customers and what do the entrepreneurs say about that? How
does the firm resolve complaints? Has there been publicity and what does it say? What are the
advertising and marketing policies, objectives and strategies? What are the pricing policies? Does
management take an interest in marketing or pay attention to marketing reports? Which ones?

Operations and Production

The production process includes every function from purchasing through delivery. Examine it
in detail. Know where the plants are, what equipment they use, whether it is obsolete or new, its
capacity, the number of employees in production, their skill levels and so on. If regulators affect
production, know which ones get involved and how. If the firm subcontracts to others, understand
the arrangement and the factors that might affect that relationship. Pay attention to quality and
cost control policies, and the customer service program. What metrics does the firm use to control
production and how it is doing against those metrics?

The Deal

Your investment decision will depend, of course, on a close, demanding study of the financial
statements. Understand all the issues that might affect your ability to earn a return. Companies
measure financial success in numerous ways. As an investor, you will be most interested in cash.
Earnings growth is meaningless to you unless it results in cash that you can take home. The price

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 you put on the capital you supply will depend on your analysis of risks and your comparison of this
opportunity to other opportunities.

“Most investors and venture capital firms do not use brokers to help them find
investment opportunities.”

Expect to negotiate. Since you already know that entrepreneurs are energetic, confident,
achievement-oriented and determined, be prepared for a real negotiating experience. Determine
what you will and won’t settle for, and discipline yourself to walk away from any deal that does not
deliver what you should reasonably expect.

“Judging people will be one of your most difficult tasks.”

Draft a commitment letter outlining the deal. Later, get lawyers to draft a legal agreement. But
remember the lawyers work for you. Their legal verbiage should do no more and no less than give
legal force and efficacy to your business understanding.

After the Deal

Remember: a venture capital investment is not like buying a stock or a bond. It is a partnership.
Whether your investment is in the form of debt or equity, keep a close eye on the company.
Monitor performance persistently. Raise questions. Make suggestions when appropriate. At this
point, it’s as much your company as anyone else’s. For better or worse.

About the Authors

David Gladstone is CEO and chairman of Gladstone Capital, which he founded. He is the author
of Venture Capital Handbook: An Entrepreneur’s Guide to Raising Venture Capital.Laura
Gladstone is a principal in Gladstone Capital.

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