Investing in Start-Ups: Lessons Learned Should You Do It? It Depends Here is how it usually starts: An old friend announces that he /she is leaving “Corporate America” to follow their entrepreneurial dreams and is starting a new business. Naturally, they need money to do this. Then comes the sales patch: would you or anyone you know like to invest in my great new idea? Silence is followed by an awkward pause, and then by more silence. Then you think about it: On the one hand, you want to support your friend in this new endeavor and selfishly, you want to make a lot of money should the new venture be successful. On the other hand, you know that 90% of all start-ups fail and that the ones that “live” are often average businesses with little or no real competitive advantage. Although, not terribly compelling, you may be tempted to “go for it” thinking that maybe this investment will be your “lucky break.” So what should the prudent investor do? The answer is: gather facts, analyze the business and the people, look for red flags, conduct more analysis, research competitors, and then after a detailed objective review of the operating environment, make a rational decision. Lessons Learned About Why Good Ideas Can Fail The global credit crisis, coupled with a reduction in the number of traditional corporate jobs, has forced many people (including myself) to consider working for or investing in Start-Ups. Having analyzed about three dozen new businesses since 2008—in diverse industries ranging from Fashion Design to Mortgage Risk Management to Recycled Forestry Products—what I can clearly state is Start-Ups (as a group) face similar issues and problems that need to be analyzed / vetted objectively, before an investor commits capital to the venture. The following provides two reasons why new businesses with great ideas can fail, as well as some of the “red flags” that investors should look for along the way: Money Runs Out: • What often happens is that the Start-Up’s founder is a visionary with unique ideas and perspectives but little practical managerial experience. Without a “numbers person” around to serve as a counter-balancing force, the founder often spends too much money on validating and promoting the market opportunity, and too little on establishing proper infrastructure to operate the business. • Initial funding (often from “friends and family”) often dries up more quickly than expected, forcing these “angel” or “seed” investors to invest more money or alternatively, watch the company experience an interruption of business. People—especially those that have not been through this before—often become fearful (rightly so) at this point. Several bad outcomes may follow, including customer confusion (which causes further delays in revenue generation), market share gains by a competitor, or worse: the company and its great ideas “die on the vine.” • So why does money run out? Usually it relates to nobody “minding the store” as respects monitoring cash flows, and/or a lack of formal processes governing spending decisions. Cash flow is the lifeblood of any business. Monitoring the corporate bank account provides an early warning detection system of problems. It also helps management to better plan for contingencies. No Strategic Plan: • Let me start off by saying that it is perfectly normal for Start-Ups to alter their initial strategy after entering the marketplace in order to survive. Think Darwin’s Theory of Natural Selection. Taking this a step further what causes an aircraft to “lift-off” differs from what keeps it flying safely. What I mean here is that without a strategic plan—including alternative business models and funding options—most businesses are destined to either crash (when competition enters), run out of fuel, or both, thereby causing investors to lose their entire investment. Weak Execution of the Strategic Plan: • Forbes published an article in November 2011 entitled “The 10 Reasons Why Strategic Plans Fail.” The reasons include: 1) having a plan simply to have one; 2) not understanding the actual business environment the company is operating in; 3) a lack of commitment by management or shareholders to make and/or implement; 4) not having the right people involved from the onset of the plan’s execution; 5) writing a good plan but shelving it (for it to be effective, it must be used and continually refined); 6) an inability to change / adapt as market conditions warrant; 7) having the wrong people in key leadership positions; 8) avoiding important decisions when marketplace realities change (including the entrance of new competition); 9) a lack of accountability in execution of the strategic plan; and 10) unrealistic goals and expectations, a lack of focus or limited financial and human resources. Signs that a Business Is Failing: There are several common Red Flags that investors should look for before deciding to invest in a Start-Up company: • Contracts are being booked but revenue is not being collected • Key members of the management team are working remotely and not actively engaged in the day-to-day operations of the business • Corporate financial statements do not reflect off-balance liabilities, such as aging vendor payables, nor accrued interest for preferred / convertible debt • Delays in funding payroll or paying basic operational expenses (rent, utilities) • Over-reliance by the CEO in input from outside stakeholders on how to run the day-to-day operations of the company • Infighting among management team • Below-market salaries for staff • Irrational product pricing (are there logical assumptions or are pricing decisions pulled out of thin air?) • The lack of a clear reward and punishment system (i.e., financial incentives to drive growth, clawing back of compensation for underperformance) About Us The Zuckerberg View is a blog produced by Carlan Advisors LLC and The Zuckerberg Institute, Carlan’s educational division. Carlan Advisors LLC was conceived in 2003 by Kenneth S. Zuckerberg. AIF® AFA®, an institutionally-trained securities analysis, portfolio manager with a proven record of positive return generation (as a professional investor) and shareholder value creation (as a corporate adviser.) He has analyzed more than 750 public and private companies globally over the past 25 years and has performed forensic financial statement analysis on several of the most recognizable global financial institutions, including AIG, Berkshire Hathaway, and Lehman Brothers, as well as several of the financial guarantee / mortgage / title insurance companies (Ambac, ACA Capital, LandAmerica Financial, MBIA, and Radian) that figured prominently during the Great Recession and Global Credit Crisis of 2008. Originally founded as an independent research boutique providing analysis on demand, Carlan has shifted its focus to corporate consulting and advisory work. Mr. Zuckerberg focuses on Business Planning, Analysis and Strategy, Financial & Operational Due Diligence, and Investor Relations Consulting. (Please visit CarlanAdvisors for additional information.) The Zuckerberg Institute is a center for executive education and financial training, offering learning programs for professionals in diverse industries, such as asset management, banking, insurance, investment brokerage and law. (Please visit TheZuckerbergInstitute for additional information.)
Posted on: Tue, 05 Nov 2013 13:52:31 +0000
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