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This chapter is from the book

Prepare a Written Summary Before You Begin to Invest

We firmly believe that every investor should prepare a written summary before formally investigating the situation. A summary of one or two pages can crystallize your thinking about why this is such a great investment opportunity. It will also put in a concrete form what you want to discuss with your friends, your banker, your accountant, and others. All of them can help you to determine whether it is a good investment opportunity. After reading this book, you should be able to prepare such a summary. This summary should be a response to the following questions:

What Are You Investing In?

Here you are trying to define the entity that you are investing in. For example, specify whether it is a partnership, a subchapter S company, a limited liability company, or a corporate entity. Also, it’s a good idea is to have the name, address, and telephone number of the business. It is also helpful to describe in ten words or less the type of company you are investing in. Describe the industry and describe its stage of development, such as a start-up. Try to pinpoint the kind of business you will be investing in. Often, this information does not appear in a conspicuous place on the proposal. Before you go any further, you should wade through the proposal to understand who and what you will be investing in. This information will also be handy in the future when you want to talk to the company’s people.

Who Is Your Contact at the Business?

Many proposals list a number of contact people in the firm, but as an investor you need to know who you will be dealing with directly during the due diligence process and during the monitoring after you have invested in the company. Usually, it is the president of the company, although sometimes the vice president of finance will be your contact. Find out immediately who this person is and make sure you have a clear channel for gathering information from this person. If your initial contact is a broker, you should ask the broker to introduce you to the person who is going to be your contact at the business. Don’t let all of the information filter through the broker. Get it from the “horse’s mouth.”

Summarize the Business Situation

Prepare a thumbnail sketch of the company’s situation. Emphasize the strong points that draw you toward this investment. You should be able to do this in one paragraph, perhaps two. But it should be brief, and it should crystallize in your mind the business situation that you are getting involved with. If you cannot do this in a few words, ask yourself whether you really know what you are investing in.

Who Is the Management Team?

Although management is the most important section in the entire analysis, you don’t need to cover entire backgrounds of the individuals involved in the investment you are considering. Do hit some of the highlights that make you want to invest, such as the entrepreneurs’ experience, past achievements, and “go-power.” Make sure you put down the names and the credentials of the top two or three people. You need to highlight in only two or three sentences what aspect of their backgrounds sets them apart from other management teams that you have seen and why their backgrounds are pertinent to this investment situation. Remember, you are investing in a team. If you don’t have a good team at the top, it will be hard to win.

What Are They Selling?

In a very brief paragraph, describe the product or service the company is selling. State why the product or service is unique, and if it is not unique, explain why this product or service will succeed over other products and services that are offered by the competitors. You need not discuss the competition in detail, but it is important to differentiate the company in summary form from others in the industry. More than a paragraph here would be too much.

How Much Money Are They Raising and How Much Are You Considering Investing?

Every business proposal tells you how much money its principals are looking for, but the amount should not be expressed in ranges. For example, the business proposal should not say $5 million to $10 million. The company should know how much money it needs to do the job and should state that figure. In addition, you will want to know the type of money that the business is raising. Is it selling common stock, preferred stock, convertible debentures, subordinated debentures, or junior loans with warrants? What structure and format will be used in raising this money? You should know exactly what the deal involves on all levels of the balance sheet.

Is There Any Security for Your Investment?

Every banker looks for collateral when making a loan to a company. Even though you are an investor, your investment can be in the form of debt with collateral security (sometimes referred to as second liens). You may take a second mortgage on the assets of the business or you might have outside collateral, such as a mortgage on the person’s house. Venture capital takes many forms, but whatever the form, your prime consideration should be how to lower your risk. Collateral is one way to lower your risk. However, most VCs who invest using stock, options, and warrants are the farthest down on the balance sheet and usually never see any type of collateral, which is why they demand such high returns.

How Will the Money Be Used?

The proposed use of proceeds is not always set out in great detail in the business plans. However, after investigating and discussing these plans with the entrepreneur, you should have a good idea of how he or she is going to spend the money. You should be able to state in one short paragraph where the money is going. You should not have to use such broad terms as working capital, but should be able to specify where the funds are to be used. A detailed explanation of sources and uses is essential.

What Is the Past Financial Performance?

In this section, you want to summarize the sales, earnings, assets, liabilities, and net worth of the company. In three or four columns, you should be able to sketch out where the company has been and what kinds of trends it is setting. You may be surprised by what you can learn by dredging through the business plan and placing these items in your summary.

What Are the Projections?

As a VC taking a long-range view of the situation, you should look at the five-year projections for the company. Even though the fifth year is highly speculative, it gives you a clear idea of how the company will grow and, in essence, how much money you stand to make if it meets the projected goals. Without a summary projection in the same format as the financial history, you will not be able to develop a basic understanding of the company.

A word from the wise: Always make your own projections and do it with your own model. We know how easy it is to use someone else’s model, but don’t. Building your own model will give you much deeper insights into the business than you can ever get from reviewing someone else’s model. You need to look at the business from your own perspective.

How Will You Cash Out?

As we mentioned before, no venture capital company wants to remain a stockholder in a company forever. Every VC must realize the capital gains on the fund’s investment in the business. Even though your horizon may be three to seven years, you must have a clear perception of how you are going to get out of the investment before you go into it. You should be able to state in three or four sentences how you plan to get out of this situation.

How Much Can You Make?

The expected profit is the final test of a promising business proposal. If you own a certain percentage of the company, what will it be worth when you cash it in? We like to set out in a tabular format the cash that we will be expected to be put into the company over the next seven years and the cash that we can expect to receive back. This format enables us to summarize clearly the cash in and cash out. There are probably a thousand ways to determine this, but we use a calculator that gives us internal rate of return. If a company can’t show a strong internal rate of return and the situation entails all of the typical risks of a venture capital investment, it doesn’t deserve any more of your time.

What Do You Like About This Situation?

List in point form three to five reasons for making the investment. What is it that you like about the situation and is compelling you to invest? If you can’t express it now, you probably will never be able to do so.

What Do You Dislike About This Situation?

No investment opportunity is perfect. Every one of them seems to have some “warts.” You should be able to explain those dislikes in three or four lines. You should know exactly what you don’t like about the situation. If it goes bad, you will know what to avoid in the future.

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