Dan’L Lewin, Corporate Vice President of Strategic and Emerging Business Development at Microsoft, was the keynote speaker at the Australian Innovation Shoot Out held in Mountain View, California last week. In his address, he stated his view that this coming decade, 2010 to 2020, will be the greatest technologically-disruptive period the world has ever known.

The audience of well over 300 included many Australians, such as Queensland Premier Anna Bligh; Victor Perton, Commissioner to the Americas from Victoria; and the host and chairman of the event, Nigel Warren, Australian Consul General & Senior Trade Commissioner. And they all beamed with pride.

Lewin’s statement was, in fact, a challenge to entrepreneurs and inventors around the world, though he was careful to position such disruption as inevitable and thus a great opportunity for entrepreneurs.

The US venture capital industry seems to be on the same page as Lewin, with fund managers finally beginning to loosen the strings after a period of sustained stasis.

Technology investors in Silicon Valley raised about US$14 billion in 2009 to finance new companies. That is down from US$36 billion raised in 2007, according to the National Venture Capital Association. However, investments went up from US$3 billion in the first quarter of 2009 to about US$4.25 billion in the third quarter of 2009. That trend line suggests continued increases into Q4 of 2009 and Q1 2010.

A serious question is on the table: What will it take for entrepreneurs to be successful in this challenging decade?

Entrepreneurs as risk takers: Not so

There has been a strong case made that entrepreneurs are unique individuals who succeed despite the environment surrounding them. They are risk-averse predators.

Two French scholars, Michael Villette and Catherine Vuillermot, have produced a study called “From Predators to Icons” in which they found that successful entrepreneurs look for customers or partners to a transaction who do not share the same value of the goods or services exchanged (they under-value what they sell to him or over-value what they buy from him). The entrepreneur repeats this sequence until the opportunity disappears. And most interesting is that throughout the business cycle the entrepreneur hedges his bets and minimises risk and the chance of failure.

In the case of technology entrepreneurs, from a business standpoint, they should minimise their business risk as much as possible. But the highest risk in technology is developing not just a product that is needed but a product that the customer over-values and perhaps never thought was possible to own. Taking risks on innovation is necessary.

Innovation and questioning everything

Innovation is critical to entrepreneurial success. Given the profound expectations of this decade, innovation has a very high value.

Successful, serial entrepreneurs tend towards disrupting the status quo as a starting point. Steve Jobs is famous for stating that he wanted to “put a ding in the universe”.

Busting the status quo requires one to question everything, turn it on its head and inside out.

Start by trying a real-life experiment with an innovative product or concept and test with several real people in different potential customer segments — the broader the better. The idea receives fast, reliable feedback from many different and potential customers long before it hits the high risk marketplace, which may very well turn a cold shoulder to it.

If the problem is discovering new ideas, spend time with a lot of people outside your immediate work and social networks; people from other walks of life, even other parts of the world.

The concept of seeing other parts of the world includes seeing how people do things either in their workplace, at home, at leisure, or getting from one place to another. Seeing first hand and observing how people function provides the raw data to ask: Why do they do it that way?  Is there a better way?

Another way to help stimulate creative and useful thoughts is to connect seemingly disparate ideas or issues drawn from widely different fields. The resource is simply exposing oneself to experiences, things and people that bring entirely different perspectives and hierarchy of interests to you. The wisdom in this is that the more frequently you can attempt to understand, categorize, and store new knowledge, the easier it is to consistently recombine these to create innovative ideas.

Underlying all of this is “questioning the unquestionable”, as Ratan Tata, chairman of the Tata Group, expresses it. There are many examples of serial entrepreneurs questioning the status quo of everything to see what would happen if they changed it. Taking away what is currently done and creating a new way to achieving the same outcome is a challenging stepping stone to innovation.

Steve Anderson started as a journalist, working first at The New York Times and the next 30 years interpreting business to investors. He is now Managing Partner, Marquis Advisory Group (San Francisco and Sydney).

“Six months ago there were no M&A deals being done of any kind,” says Josh Bolot, Corporate Advisor at Investec Bank, an international specialist bank, from his Sydney office. “Heads were down. Pessimism reigned. And during this period, corporations were focused on their balance sheets and reducing debt. But today, we are seeing an increase in activity from our clients who are contacting us about preparing for and engaging in acquisitions.”

The MergerMarket Preliminary Global M&A Roundup report for Q1-Q3 of 2009 substantiates Investec’s experience. The Asia-Pacific region in the report, which includes Australia and New Zealand, reported that M&A activity in the region continued to “fare better” than other global regions, with 1,359 transactions announced at a total value of $210 billion – “a drop in both value and volume of approximately 25% on the same period in 2008. That compared favourably with the global picture, which was down 40%.”

In New Zealand the climate was very much the same as Australia.

Scott St. John, CEO of First New Zealand Capital noted, “In the first half of the year there was very little activity, as the companies here engaged in recapitalisation of their balance sheets.” But the climate has changed.

The recovery of Australian and New Zealand companies has transmitted to the Australian and New Zealand emerging growth and technology companies that have established a significant United States presence.

US private equity funds have become very attractive growth-plus-liquidity alternatives for these ventures. Although the debt component for these deals has now diminished to the point where most deals are all-equity, the typical structure requires the existing equity holders to sell 60 percent or more up front to a private equity fund or a syndicated group of funds, while retaining the balance. These deals often include an equity “kicker” bonus for performance and continuing management of the venture, with substantial assistance from the fund managers for two to three years.

The plan is usually for an IPO or trade sale, so that the fund will realise the expected 20 percent rate-of-return hurdle.

This is an alternative that is well suited for rapidly growing companies seeking capital and other assistance in situations where the founders and shareholders are not ready to cash out and the expectation is that the valuation will be higher in the future.

In this scenario the interests of the founders / early shareholders and the private equity funds are fully aligned and the valuations in a first round take-out are usually attractive compared to alternatives.

Australia’s M&A strength

Australian companies have been quite active in M&A in the banking, mining and some technology sectors.

ANZ bank announced in September 2009 its second acquisition in two months, A$1.6b to ING for its stake in wealth management and insurance operations in Australia and New Zealand. In August the bank had announced that it would pay A$550m for several Asian assets of Royal Bank of Scotland.

Then, in October, Macquarie announced its intention to buy Fox-Pitt Kelton Cochran Caronia Waller, a US-based boutique bank for $130m cash and assume $16.7m in long-term debt.

The trend started influencing the service sector as well. Indian Ocean Capital, a Perth financial advisory business, announced it was doubling staff levels. Director Gary Castledine said the current economic downturn and the large number of mergers, acquisitions and closures of Australian advisory firms had “created significant uncertainty in the sector. It’s our view that things will start to improve towards the end of 2009, at which time we will have some of the best in the business on board to make the most of the upturn in investment opportunities.”

Paladin Energy, an Australian uranium mining company, completed an institutional placement of up to A$430m to position itself for more consolidation in the global uranium sector. And Newcrest Mining chief executive Ian Smith said that the gold mining company had assigned two teams to look for merger and acquisition opportunities globally during the next 12 months.

What changed and who changed it?

The global recession has been termed a “balance sheet recession”. Companies had too much debt and when consumption declined they were left over-exposed.

Josh Bolot of Investec notes that many Australian companies began focusing on reducing and restructuring the debt on their balance sheets in the eye-of-the-recession storm.

“The equity markets engaged in balance sheet restructuring, with a majority of ASX100 companies raising cash – some even going back to the market for a second time,” he says.

“The global fiscal stimulus has helped the market here,” says Scott St. John. “Our government, quite rightly, played its cards very carefully and has been conservative in the way it has protected and managed NZ’s balance sheet. However, the global efforts that have stabilised markets generally definitely flowed into New Zealand.”

Stock markets have responded. Today, the Australian All Ordinaries index is up 60 percent since 31 December, 2008 (in US dollar terms).

Is the trend sustainable?

There are many in the private and public sectors who think the worst is behind us and that M&A will continue to be active, though it may not return to the valuations of recent times.

In Australia and New Zealand, the recession trough was not as deep as in other economic regions. Graham Mitchell, Director of Investment New Zealand noted that “the recession was not deep in New Zealand. Banks are better capitalized and there have been no bank failures, and as a result New Zealand is emerging from the recession earlier than other countries.”

Michael Malone, Managing Director of iiNet, the Australian internet service provider, wrote in the Company’s 2009 annual report, “The focus for iiNet in the 2010 full year will be to continue to enhance customer service, improve brand recognition and launch new content, while looking for value creating acquisition opportunities to build to scale.”

The Australian firm Challenger Financial Services CEO Dominic Stevens said back in August that “there would be merger and acquisition opportunities in the year ahead and consolidation had already started”.

Global M&A activity has continued to be sluggish. “The 1,759 announced deals in Q1-Q3 2009 is the lowest since Q3 2003,” according to MergerMarket’s Preliminary Global M&A Round Up. But that does not seem to be the case for Australia and New Zealand.

Interestingly, according to Josh Bolot, “prices of target companies have not been lower at this time as a result of the economic downturn. The difference is that transactions are more likely to be funded from cash reserves or offering scrip as consideration, with the ability to source significant debt funding remaining constrained.”

Another factor is the sources of debt funding in this new wave. New Zealand is seeing large funds located in Europe and elsewhere that want part of their portfolio in equity investments in a politically secure country,” noted Graham Mitchell. “Over the next five years we expect to see that increase.”

Mr. Mitchell added on the sustainability topic, “The New Zealand government recognizes that it is in a unique position of being on the front foot today, and is interested in using investment to drive it forward. And the New Zealand government has a strong appetite for growth.”

Where are the Hot Spot sectors?

According to MergerMarkets Preliminary Global M&A RoundUp, by volume only, the biggest sectors for M&A globally have been Industrial & Chemicals (17.7%), Consumer (13.7%), Financial Services (11.4%) and Energy, Mining and Utilities (10.9%).

In Australia, the announced deals speak for themselves as being in finance and mining. New Zealand has seen more activity in technology, particularly cleantech.

Sustainability sustenance from past recessions

In the depression of the 1930s provided some excellent examples in the US that recessions are the time to grow. DuPont invested in research and development and employed a lot of unemployed scientists. At the end of the depression, 40 percent of its sales were from products that had not been around at the beginning of the depression.

Fast forward. Intel, the microprocessor and chip maker, continued to invest heavily in new products. Proctor and Gamble is investing in the biggest production expansion in its 170 year history by opening 19 new factories.

Boston Consulting Group’s study of mergers and acquisitions in the United States from 1985-2001 found that deals done in recession returned 15 percent more to stockholders than mergers during good times.

If M&A activity is an accurate indicator, many companies spent their time and money wisely during the downturn.

Steve Anderson started as a journalist, working first at The New York Times and the next 30 years interpreting business to investors. He is now Managing Partner, Marquis Advisory Group (San Francisco and Sydney).

It makes sense to build a company’s investment plan that has the interlocking qualities of Lego pieces, tightly fit, all supporting and connected to each other.

To do that takes a carefully constructed financing plan with these specific elements:

Fundamentals of long-term finance plan

1. A high level objective of what the business will provide its customers. (For founder Ole Kirk Christiansen it was “play well”)
2. A starting point product or service that meets that objective.
3. A customer policy that supports the business objective.
4. A description, not definition, of what investors, including founders, commit to and contribute to the objective.
5. A detailed, line-by-line item of how much cash it will take to get to positive cashflow with a commitment to keep to this plan.
6. Exhaustive list of the first, best investors (those that can commit to item 4) for the seed capital investment that will take the company to product or service ready for commercialisation.
7. A complimentary and exhaustive list of the best venture capital investors or strategic investors that can commit to item 4 and will fit very tightly with the seed round investors, that will take the company to cash positive/break even.
8. A complimentary and exhaustive list of the best venture capital investors, strategic investors, and others that can commit to item 4 and will fit very tightly with the seed round investors, the second or ‘A’ round investors, that will take the company to a successful level warranting either going public or being purchased.

Some will say this is too hard and conditions are unpredictable. A response to that is that without this plan it is too hard and unpredictable.

Strong fundamental foundation with flexibility to change

Business has not always been rosy for Lego. In 2004, the company lost its compass and began missing deadlines for new product development. It made a $344 million loss that nearly sent it to the grave.

Today, Lego has gone from last rites to stunning success, enjoying double-digit sales gains and swelling earnings in the children’s toy industry despite competition from video games, iPods, the internet and other new technology options. That is against a five percent drop in toy sales in the United States in 2008, a period in which Lego sales were up nearly 19 percent.

Question: What does this have to do with a “Lego Block Approach to Funding?”

Answer: Flexibility to change while enforcing fundamentals.

Internal and external changes were necessary to crank the company up to its current performance.

• Employee pay is tied to management key performance indicators. One result: product development time reduced by 50 percent.
• Company changing marketing and sales: opened its first concept stores in the U.S.
• Next year the first board game designed by Lego will hit the market.
• A virtual reality game will be introduced.

Necessary qualities of management

These few examples of willingness to change require a management team that has the ability to be cash conservative in the implementation of every asset while aggressively creative about what the company will provide the customer that the customer wants.

Andrew Grove, former CEO of Intel, is an example of this kind of manager.

Intel’s foundation business, and great source of profits for a long time, was its memory chips. Then along came serious competition that was able and willing to provide a similar product at a price as low and lower than Intel could go.

In Dr. Grove’s book,  Only the Paranoid Survive, he points out that every company will ultimately be confronted with a perfect storm in which internal and external forces, usually unanticipated or initially ignored, will come together to make a company’s core business strategy not work.

The rest is history. Intel moved dramatically to microprocessors from just memory chips and began “Intel Inside’, selling its invisible product value to consumers.

And this turn was directed from a man who insisted on discipline in his organisation that began with starting time at 8:00 AM for every person. Late? Sign in what time you arrived.

Lego block approach to funding

• Build one block at a time.
• Only use blocks that can connect to each other.
• Interlock the blocks to each other to build a solid foundation.
• Allow the creativity for changes to emerge on the solid foundation.

Steve Anderson started as a journalist, working first at The New York Times and the next 30 years interpreting business to investors. He is now Managing Partner, Marquis Advisory Group (San Francisco and Sydney).

Photo: Guillermo

Also in this series:

Part 1 – Funding in the US – Holy Grail or Holy Hell
Part 2 – The benefits of Australian VCs and US VCs
Part 3 – Five must-sees before Australian VCs will invest
Part 4 – When seeking investment, preparation is everything

The US venture community – worth approximately US$2 billion – is very small compared to private equity and miniscule when compared to the trillion dollar hedge fund industry. But it is a very important capital source for new businesses, which create new taxable revenue and new jobs.

Annual venture investment is one-tenth of one percent of the US GDP, but it creates 11 percent of private sector employment and $3 trillion in annual revenue, according to the National Venture Capital Association.

And while Silicon Valley is the best known and probably the largest centre of venture capital firms and activity, it is not the only place where venture capitalists are aggregated. Austin, Texas; Boston, Massachusetts and New York City are active centres for venture investors – and there are other, smaller communities of venture capitalists throughout the US.

Basics to begin capital raising plan

When determining whether a company is ready to seek capital from US venture firms, Australian and New Zealand businesses need to consider these basics:

• The business has been self-funded and received follow-on investments from local angel investors and/or venture capitalists.

• Revenue growth is significant and the company is near break-even or into profitability.

• The product or service makes such a significant difference to customers that they cannot do without it.

• The current management team has built every aspect of the company for its next growth stage.

Preparation to proceed begins with having the following:

• A due diligence “package” of everything the potential investor wants to know about the company. Preferably, all the documents will be held on a secure website.
• A revised business plan – including a financial plan – that includes the execution of business in the US and other anticipated markets for the next three years.
• A list of all the venture firms in the US that have invested in your business sector in the past two years, the partner that led those investments and a list of the companies in which they invested.
• A PowerPoint presentation that takes 10-12 minutes to present.
• A fund-raising plan that is based on achievement in six to nine months.

Entrepreneurs seeking to build investor confidence during the pitching process should incorporate several facts based on reality and the economic history of business development centres such as Silicon Valley.

The dot-com era is the bogey-man in the closet. It shattered the confidence of investors, particularly venture capitalists, and scared them away from cavalier investing. But take a look at this:

According to the US Bureau of Labor Statistics, Silicon Valley’s high-tech industry employment fell 17 percent from 2001 to 2008. But out of this whipping, three industries stood out as successes despite everything. Employment numbers in pharmaceuticals, aerospace and scientific research all increased. And across the board, wages rose an average of 36 percent over that same period.

The point here is that entrepreneurial businesses can bring new employment, new revenue and can improve society.

Setting the stage with US venture capitalists

In order to keep a level playing field with an entrepreneur’s potential partner – the venture capitalist – both parties need to start the relationship with equal amounts of information on each other and respect for one other.

Compare the contents of the due diligence package the entrepreneur prepares for the potential investor with the information the entrepreneur has on the potential investors. On a balance scale, generally the due diligence of the company significantly outweighs the due diligence the company has on the venture capitalist.

The question is: How do you get the information from the venture capital firm?

The answer: You ask for it.

Information gathering before first venture capital meeting

Questions to ask portfolio companies:

Talk to the founder/CEO, COO or CFO of portfolio companies that are closely aligned with the entrepreneur’s business. Ask them the following questions:

• What specifically, for a strategic or management contribution, has the VC firm provided that made a positive difference to the business?
• What did the founder/CEO or other find out about the VC firm after the investment that they wished they had known prior to the investment?
• What are they like in Board meetings in terms of working with other Board members, sticking to the agenda, following up on prior agenda items, frequency of new ideas not previously discussed?
• Who in the firm has provided the best advice?
• How much of the investment fund does the VC firm have left to invest?
• Have they been true to their pre-investment philosophy with the company?
• What were the contract negotiations like?
• What was the company’s size and revenue at the time of the investment?

These are questions that should be asked of at least three of the portfolio companies, so that there are comparisons to triangulate and determine where reality sits.

Questions to ask the venture capital partners at the first meeting:

• What is the current size of available funds to invest?
• What percentage of the original fund does that represent?
• How much does the firm typically hold back for further support investment and/or a second round for each portfolio company?
• Who would be the company’s primary partner in this relationship and what is their experience in management as it relates to our business?
• Who else on the staff would be available and what is their management experience as it relates to our business?
• How many boards does each partner usually sit on at one time?
• What are the partner’s other responsibilities in the firm?
• How close are current portfolio companies to exit?
• What does the firm see as the best exit for companies like ours yours entering the relationship?
• What do their customers – portfolio companies – think is the major contribution the firm makes to their success?
• What are the firm’s weaknesses?

It is important to begin the first meeting with these questions, before the company’s presentation. This first meeting is the beginning of a potentially long negotiation that will continue from now until the exit. It is very important to establish this relationship as one of equals.

Steve Anderson started as a journalist, working first at The New York Times and the next 30 years interpreting business to investors. He is now Managing Partner, Marquis Advisory Group (San Francisco and Sydney).

Photo: PDR

Also in this series:
Part 1 – Funding in the US – Holy Grail or Holy Hell
Part 2 – The benefits of Australian VCs and US VCs
Part 3 – Five must-sees before Australian VCs will invest

There is no better place to begin capital raising for Australian and New Zealand entrepreneurs than in their home country.

Seed capital for venture capitalists in Australia has historically consisted of government money that attracted funding from the private sector.

The intent was, and continues to be, to encourage and, therefore, capture the benefits of the inventiveness and energy of its citizens rather than forcing them to seek success overseas. Unfortunately, the Commercial Ready Grant Scheme was withdrawn and that has caused a shortfall in available capital.

The venture capital industries in both Australia and New Zealand are faced with a conundrum. They are restricted in the cash available to do new deals because they need to conserve funds to support portfolio companies. That has been compounded by the global recession. (Economic signs are improving in some places, but my suggestions here are designed to be equally relevant in good times or bad.)

Given this rather dismal current environment, what are the best steps to take for entrepreneurs with a gnawing ambition and a killer product or service?

Fundamentals, Fundamentals, Fundamentals

Like the real estate adage “Location, Location, Location”, the entrepreneur seeking capital for the first time, and every time thereafter, must engage in fundamentals.

Fundamentals of what? The fundamentals that have been used successfully by the founders of all those companies that succeeded.

There are four classic stages of a fledgling business: Concept Stage, Seed Stage, Product Development Stage and Market Development Stage. These are not set in stone, but have been sufficiently documented to rely on as a map.

Idea to Concept

This occurs in the first few months when one, two or more people gather together to flesh out the details of a new technology or service, and the business model. Where will the revenue come from? (The answer is never simply “the customer”.) This group of founders, or discoverers, shoulder the cost of this stage themselves. The primary product of this stage is a brief business plan (ten pages or less) that serves as road map and concept clarification that everyone agrees to. This is the first test of the concept because the plan must answer fundamental questions:

• What is unique about this product/service that addresses a severe customer pain level so well that they will have to buy it?
• What is the size of the market? (How many customers are there for this product or service globally?)

Take a break here in thinking and planning from being in the box (traditional business models) to the challenging, but increasingly common request to think “outside the box”. Within the traditional context of building a business, who would have considered the concept of a “freemium” created by a New York venture capitalist? How can revenue be generated if the product is given away for free?

How can we fund this?

This is the “seed capital” stage. This is where the concept grows from just a concept to a company and product or service. It takes money, and it most commonly comes from the founders, their friends and family, angel investors and, in some flush capital periods, from venture capitalists.

Each of these investors needs to know what the business plan is for X Pty Ltd, with specific milestones of what will be accomplished in how many weeks or months, and how much cash it is going to take to get these milestone steps completed. The Stage II Business Plan is more complete than the Concept Stage Business Plan because the founders have learned a lot more about their business.

The highest hurdle is addressing and then articulating the concept product or service in terms of customer benefits. Why must they need this product or service compared to their other options?

The business plan at this stage is more sophisticated and detailed than the Phase I plan. Someone in the organisation has to be able to verbally articulate in convincing terms, without hesitation, why this is a high-quality investment.

In preparation, do the following:

• Define the assumptions made by describing the customer’s needs, but also in the financial plan.
• Describe in detail potential customer applications and the benefits the customer gains.
• Create a quality description of the marketplace in terms of size, geographic distribution and characteristics, including how the product or service is going to be delivered to the customer.
• Identify target customers for beta testing of your product or service and the reason for their selection.
• Outline your current management team and their background as it is relevant to the business.
• Develop a financial projection that primarily describes the application of the investor’s funds in detail.
• Describe the milestones that the business will accomplish during the next 12 months. These should mirror the financial projections.

Putting planning into reality

This is where the rubber starts hitting the road. The company is now using hard cash provided by the investors, and every hour counts. The faster and better this stage is executed, while spending every cent as though it is the last cent, the more likely the business will succeed.

Somehow, the motivation to save cash in product development creates a ferociously creative environment that in most cases places the cash where it does the most good and establishes a business culture that will always benefit the company and its investors. At the end of this stage, the company will have to have a product or service ready for customer purchase and use.

Product and service development is a dangerous period because team members can become distracted away from the focus on the original product. Specifically, keep the process and the product or service focused. Milestones of each of these stages will need to be reported to the investors.

The quality of the product and meeting the milestones is a direct reflection of the quality of the team. Document this product or service development professionally so that it can be replicated effectively is important to the business, and will be very important to the next stage of investment. Your best investors now and in the future will understand the importance of this stage.

Putting reality into the marketplace

It is in the crucible of the marketplace where all the work begins to pay off… or not.

Beta testing provides valuable feedback for the reality stage. However, there is a danger that additional customer requirements will suddenly arise when you enter the market. Given the strong desire for customer acceptance – and associated revenue – this can cause significant chaos and company division.

It is vitally important to keep focused and measure the sales and marketing results, within the financial plan. Every variation needs to be scrutinised to determine whether it is an anomaly or a significant indicator. Trust your preparation to this point, but be careful not to follow your plan off the cliff.

Setting the stage for next investment

About six months into the reality in the marketplace is the time to make another assessment of the business and the business model, adjust the business and the financial plan to reflect what has been learnt and begin setting the stage of the next investment phase.

It is also a time to assess whether the current team has the ability to take the company forward. The latter is very difficult for the founders. They may be among those that cannot take the company to the next step, and it is also difficult for them to accept the fact that people who dug into the business during the toughest days may not have the ability to continue to contribute. Some people are just better in early-stage companies. Some are only good at middle stage companies. And some can only function well in later-stage companies. It is just the reality of growth businesses.

Selecting venture capitalists

The crux of success is selecting the best financial partner. Venture capitalists come in many different forms, and it is very important that a company selects an investment partner at this stage that provides more than the capital. A venture capital firm that has invested steadily and successfully in early-stage mining companies is probably not going to be a useful and supportive investor in high technology or consumer products or internet services.

For investors, as with managers and entrepreneurs, experience counts.

Steve Anderson started as a journalist, working first at The New York Times and the next 30 years interpreting business to investors. He is now Managing Partner, Marquis Advisory Group (San Francisco and Sydney).

Photo: PDR

Also in this series:
Part 1 – Funding in the US – Holy Grail or Holy Hell
Part 2 – The benefits of Australian VCs and US VCs

If the corporate vision is to grow a business beyond a ‘lifestyle’ size, and the founder is not independently wealthy, seeking capital from investors outside of family and friends is unavoidable.

In a downturn like this one, the amount of capital invested and the frequency at which it is invested is substantially reduced.

Despite the reduction in investments made by the venture capitalists in Australia, New Zealand and the US, recessions have been a popular time for startups.

More than half of the companies on the Fortune Magazine 500 list in 2009 and nearly half of the companies on the Inc. Magazine 2008 list were founded during a recession or a bear market.

That is not to say that starting a business in these times or any time is not risky. In the US, only 66 percent of startups survive at least two years, according to the US Small Business Administration. That survival rate drops down to 44 percent by the fourth year and is at 31 percent by the seventh year. This kind of data probably has universal application, much like the 80/20 rule. What is true in the US is generally true in Australia and New Zealand.

The notion that an entrepreneur’s idea can rise from nothing to a national or global success on the smell from an oily rag should be quickly discarded. Like it or not, venture capitalists usually need to be engaged as investors, but their cash infusion is only the fuel. The best bring serious support to success.

Venture capitalists in Australia and New Zealand come in a variety of sizes and strengths, from small, single investors to multiple-partner organisations. The venture capital industry in Australia is relatively young, starting in a recognised form in May 1984 with the initial government sponsorship called the Management and Investment Company Program.

In the United States, venture capitalism in its current form started in the 1950s. And in the US there is a distinction between what would be considered “angel” investors (individuals interested in placing their own money into startup ventures) and venture capitalists (investing other people’s money that has been committed to an investment fund into early-stage businesses).

The musts of engagement (getting the money) in both Australian, New Zealand and US camps have subtle differences that need to be understood.

The foundation of building a global business begins with recognising the financing steps and building them into the financial and business planning of companies starting in Australia or New Zealand, and migrating the business and its funding to the US where the market is bigger and investment pockets deeper.  

Five must-sees for Australian VCs

Just as an entrepreneur must understand the company’s customers, it makes sense for the entrepreneur to look at the product or service from the venture capitalists’ point of view. The VC’s point of view is always: “Will this business provide an appropriate return on our investment within three to five years?”

They make that judgement not by having their head spinning with the excitement of a “cool” technology, or its equivalent, but some fundamentals: market size, team competency, advantage, and capital requirements to reach the end game of a sale to a larger company or a public offering.

1. Market.
It must be large enough that the company can increase its revenue and profit to a level that, upon the sale of the company or an IPO, provides a satisfactory return on the investment. Domestic markets for both Australia and New Zealand, which is where most entrepreneurs begin their sales revenue climb and market penetration, are limited due to the size of the two countries. These home markets are excellent places to determine commercial viability of the product or service and the company, but they require expansion into other markets.

2. Personnel.
One critical measurable of the entrepreneur is how much “skin in the game” they have, or how much of their own assets will they lose if the company does not succeed. From the venture capitalist’s viewpoint, the entrepreneur must think like an owner of the business. The other characteristics looked for are:

• Enthusiasm about the business.
• Persistence (demonstrated ability to overcome obstacles).
• Communication skills to management, customers and investors.
• Ability to set realistic goals and achieve them.
• Ability to successfully accelerate the business.

3. How much capital will it take?
It is my personal experience that Australian and New Zealand entrepreneurs tend to underestimate the funds required. Being realistic about the fact that developing a business will usually take twice as long as originally estimated helps in determining how much capital it will take, including incoming revenue from sales.

4. Customer demand.
Why will customers buy this product/service rather than its competitors? And if this product/service is making a paradigm shift, do customers need it and why.

5. Experienced management.
One of the key resources in short supply in Australia is people with serious management experience. Most of those that have it are working somewhere else. It is one of the reasons that entrepreneurs start without the advantage of having a management team that has demonstrated its success before, and one of the reasons that venture capital investments are initially small and that business plans of Australian and New Zealand companies map a move to the US for a second, larger round of funding and adding experienced management.

US VCs – Positioning for Success

Venture capitalists in the United States have a strong preference for predictable results. The leading element of the predictability is a management team that can rapidly build a business that is large enough to produce a big payoff for them. Terms such as “outstanding management” and a “sense of urgency” are qualities that are only known about people who have done it before.

They would rather invest in a great, competent management team with deep experience in the market they are entering with a good plan than a great plan with a good team.

To overcome this, Australian entrepreneurs need to build their business’s revenue growth and momentum so that it is outstripping the competition, and use that experience to determine the abilities of their management before entering the US looking for a big B round of venture capital.

All the other four musts have to be there, too. But with full consideration for the multiples that the size of the US market and possible the EU market will impact on the business.

Steve Anderson started as a journalist, working first at The New York Times and the next 30 years interpreting business to investors. He is now Managing Partner, Marquis Advisory Group (San Francisco and Sydney).

Photo: PDR

The decision of whether to pursue funding from Australian VCs or US VCs is not necessarily an either/or proposition. Both VC groups service the interests of Australian entrepreneurs. You just need to appreciate them for their benefits.

From the macro perspective, the US VC as a financial resource sector has been active in its current form a lot longer than anywhere else in the world. The “current form” of venture capitalists in both the US and Australia is a formalisation of what were informal syndicates of investors who pooled their capital and invested it in ventures. Those still exist, but are a variation on what is commonly thought of as venture capitalists.

The benefit to the entrepreneur of this long history is the development of a US VC business culture that has many years of entrepreneurial investment experience. This has resulted in established, but informal, standards of operation.

The culture and standards of Australian VCs is not that much different, but it is different. And that is a good thing.

Preparing an investment strategy

Australian venture capital activity hit a high in late 2008, with 129 transactions. If you are timing your investment strategy, typically there are more investments made in the fourth quarter of the year than in any other quarter. But that is when the checks are delivered, not when the process begins. Think in terms of six months from start to finish.

It’s not surprising that the pace of “new” investments – that is, first time investments in new portfolio companies – slowed in 2009.

Strategy preparation to-do list

• Determine the non-cash contribution your company needs from your investor.
• Determine why the management team will succeed, if not, find who is needed.
• Select VC firms that invest in your industry.
• Compare your company with companies that secured VC investment from the list.
• Make sure the market size is large enough to reach attention-grabbing revenue.
• Isolate your primary (top three) customer targets.
• List three compelling reasons why the company’s customers will continue to buy its products or services (a sustainable, growth business).
• Determine how much capital you need to get to break even or better.
• Determine at what point in the company’s growth it will require a second investment.
• Determine whether the company should do an IPO or be purchased.

Fundamental Benefits of Australian and US VCs

Australian VCs

• Geographically close to Australian investments.
• Willing to undertake early-stage companies.
• Recognise early-stage company management requirements
• Understand early-stage companies
• Primary and secondary investments always part of investment plan.
• Understand Australian businesses.
• Well connected in Australian business network.
• Tight focus on few investment sectors.
• Relatively low hurdles to undertake an IPO exit.
• Relatively small business market for acquisition exit.

An Australian venture capital firm’s greatest contribution to an investee company is being able to pass onto management the knowledge of the business sector the company is in. But as in every partnership, it is important to keep the playing field level between investor and owner/management.

The experience (as distinct from “knowledge”) an Australian venture firm can bring has significant value to the company’s growth and helps reduce or eliminate unnecessary business exercises as it moves from early stage to growth stage. Fundamentals such as how to stimulate channel sales; outsourcing sources that are proven in quality and reliability; instituting quality control in R&D; timeliness, value and objectives of public relations.

US VCs

• Prefer later-stage companies.
• Expect experienced management team.
• Expect large market.
• Expect scalable businesses.
• Primary and secondary investments always part of investment plan.
• Prefer US-based company management.
• Well connected in specific US business networks.
• Focused on preferred investment sectors where knowledge and experience exists.
• Experienced management resource network.
• Deep connections in US investment banking (IPO).
• Experienced and knowledgeable in acquisition transactions.

On the subject of management experience, one leading US venture firm states that what it looks for begins with the “capabilities and charisma of the founding team”. The larger VCs frequently have on staff an executive recruiter to find people with the qualities that are missing in a portfolio company. The adage among US VCs is that they would rather invest in an A management team with a B business, than vice versa. That doesn’t mean that the reverse doesn’t happen.

There are exceptions, and most of the exceptions have been hugely successful (Bill Gates at Microsoft, Michael Dell at Dell Computers and Larry Page and Sergey Brin of Google are well recognised examples of exceptions).

A leading factor for the importance of this one element has been documented in surveys conducted by US magazine Inc. In one of their surveys, only 12 percent of the founders said that the success of their company was due to having a paradigm-shifting product or idea. Eighty-eight percent attributed the success of their company to excellent execution of an ordinary idea.

It’s a risky business betting on emerging companies. So VCs hedge the bet on quality management and strong products that do make a recognisable difference to customers all by themselves.

Steve Anderson started as a journalist, working first at The New York Times and the next 30 years interpreting business to investors. He is now Managing Partner, Marquis Advisory Group (San Francisco and Sydney).

Photo: PDR

It’s Venture Capital Month at Anthill. Click the image below to attend the event!

Holy Grail

In 2008, US venture capitalists invested $28.3 billion in 3,800 deals – a down year for the first time since “post-bubble” 2003, but still a lot of capital looking for potentially great companies.

Is this an opportunity for Australian or New Zealand companies seeking a US venture capital cash infusion?

Yes! However, there are barriers to entry. If a company has the right stuff, the barriers go down. And then, success requires serious preparation for that opportunity.

The benefits do not begin with the money. The money matters, of course, but the benefits of having the right venture capital firm invest in a company have more to do with business execution. Execution is the engine. The money is the fuel.

Choosing the right venture firms to invest in a company is the most important decision. It is Darwinian in this respect. The venture capital partner with the best characteristics (their DNA) for a company results in a much higher probability of success.

Specifically, the right venture firm will have partners that know everything about your business and key people in the industry. They will provide knowledge gained from experience and will open access to businesses that will contribute to success and customers.

Given the degree of difficulty, why undertake pursuing US venture investment?

1.    There are more VCs in the US than any other country in the world.

2.    They invest more money in a year than any other country’s VCs.

3.    The US VC investment exit objective is 3-5 years.

It is extremely important to look at your company from the VC’s perspective right from the start. They only want to make an investment that will significantly increase in value.

Holy Hell

Australian and New Zealand companies make mistakes in entering the US marketplace for investment capital and for business in general. That can be Holy Hell. The mistakes are primarily due to assuming that what worked in Australia and New Zealand works in the US.

The belief that the US is as homogeneous as Australia or New Zealand is a significant misperception from both a personal and business point of view. Significant differences exist that, if missed, can be costly and painful to the business.

Preparing to seek US venture capital, in the current economic environment, begins with making sure that the business has proven commercially that customers will buy it for any of the possible reasons, and the more reasons there are the better. The best (but not only) proof of that is two years of continuous, significant revenue growth.

The company needs to have nailed down, in place and working, business policies that enable management to focus on building the business and not be distracted by hourly decision-making about fundamentals.

Next is the preparation of the “Due Diligence” files, or what will become known as the Due Diligence Package. This consists of a long list of audited documents that cover every aspect of the business, its management and its pre-venture investors. This is your business laundry. It better be clean. Put it on a secure website.

Research all the venture capital firms to determine those that invest in the company’s sector, have partners that understand the business and that have sufficient funds to invest. All VCs have websites, but the website describes only how they see themselves. Talking to their portfolio companies is important on a founder to founder level and provides invaluable insight into how the venture firm really works.

The initial presentation is a short (10 frames), compelling PowerPoint that explains:

• what the product or service does
• how it makes a difference to customers
• how the business model works
• who the customers are
• revenue history
• capital amount requested and what it will be used for
• the management team that will execute.

Be prepared to be on the road pitching the company over and over, seeking the second meeting with the venture firm of your choice. Sound like Holy Hell yet?

Setting a valuation on the company is a mistake. The market will decide what the valuation should be. Having more than one interested venture firm with investment offerings enables the company to have at least two metrics to rely on for valuation.

Keeping a level playing field between the company and the venture capitalist firm is very important. Keep in mind that if the company is as good as it needs to be to obtain an investment, the venture firm needs the company as much as the company needs in capital.

Negotiating the “deal” is best done by someone other than the principals of the company. A US lawyer who has negotiated a lot of deals with venture firms is able to read the agreement and recognise elements that are not in the best interests of the founders.

All of this is positioning the company for either another round of capital investment within the next 18-24 months and starting this process all over again, usually with the original venture firm, or the sale of the company to a strategic buyer.

Oh, yes, and plan to move the company to the United States, close to the customers and the venture investors.

Steve Anderson started as a journalist, working first at The New York Times and the next 30 years interpreting business to investors. He is now Managing Partner, Marquis Advisory Group (San Francisco and Sydney).

Photo: PDR

It’s Venture Capital Month at Anthill. Click the image below to attend the event!

Here are the top 13 things you “must do” prior to taking the plunge and doing business in the US.

1. Select the best and most experienced business manager in the company to move to the US and be responsible for US deployment.
2. Prepare a 24-36 month operating budget that will have US operations self-supporting after year one… and add 30 percent more to cost of operations.
3. Establish your primary office in a US state located near your target market/customers. And research what local (city or town), state or federal tax benefits you might be eligible for in the state you are selecting.
4. Develop US-compliant commercial documents for customer contracts, employee contracts, licensing agreements, product warrantees, whatever documents that are necessary for you to do business with customers.
5. Incorporate your business in the US – customers, bankers, etc., will require it.
6. Establish a relationship with a law firm that has experience with businesses like yours, and with US Visas.
7. Establish commercial banking relationship with a bank best suited to and most knowledgeable of your business. This is not necessarily the largest bank.
8. Obtain corporate insurance through a knowledgeable agent that covers your product liability, US employee accident coverage, etc.
9. Obtain healthcare insurance for US-based employees, (Australian healthcare does not cover employees, even Australian citizens, working in the US)
10. Establish relationship with an appropriately sized accounting firm that is familiar with your business and will address all quarterly and annual commercial and employee tax payments in the states in which you operate your business and/or have employees.
11. Make the selection process of US employees a top priority of management, with the objective of selecting the best. It will save money and accelerate growth. Be cognisant of state and federal regulations on what is legal and what is illegal in hiring and “sacking” employees.
12. Establish a network outside of your business relationships through association with business organisations such as the Association for Corporate Growth.
13. Plan to revise your business plan and financial operations plan after six months of operating in the US.

Doing business in a market as large and vibrant as the US can be extremely lucrative. Plan it well and the odds will be stacked in your favour.

Steve Anderson started as a journalist, working first at The New York Times and the next 30 years interpreting business to investors. He is now Managing Partner, Marquis Advisory Group (San Francisco and Sydney).

Photo: PDR