From the November 2009 issue of Investment Advisor • Subscribe!

November 1, 2009

The Private Venture Investment Process

One of the few commonalities among the thousands of VCs and angel investors is the consensus that the process of identifying an attractive private venture investment is "part art, part science." The art part speaks to the absence of certainty with respect to any venture's viability.

The science part? That's simply hindsight, which of course is an exact science. Of the many ways that I have become knowledgeable as a private venture investor, hindsight is the most expensive, the least merciful, and the most valuable.

When it comes to separating the wheat from the chaff, my primary screen is simple. For a private venture investment (PVI) to be worthy of the costly, time-consuming, bandwidth-bogarting process of evaluation, consideration, due diligence, and deal term negotiation, it must initially meet these four criteria:

o Criteria One: There is a large market for the firm's products or services. The size of the market must be material for a PVI to potentially achieve a high cash-flow or high-multiple outcome. The success of a category-killer app, product, or service in a small market lacks the potential of an exponential payoff and does not proportionately offset the risk of a loss.

Ideally, the market should not be merely mature, it should be a growing market as well. The market can be newly emerging (alternative energy, for example) or non-existent (Twitter) at the point of the venture's introduction of its product or service, but its potential must be measurable and meaningful.

The values set forth in the modern business classic Blue Ocean Strategy often come to mind. Blue oceans denote industries untainted by competition. In blue oceans, demand is created rather than fought over, and competition is irrelevant because the rules of the game are waiting to be set.

I am predisposed to the notion that the initially contemplated product, service, or business model rarely succeeds, and consequently ventures are frequently forced to adapt to new data points. This requires the room to maneuver that a large market provides.

o Criteria Two: The firm has a sustainable competitive advantage. The venture must have a sustainable edge to attract and retain its market share. The location or lease of a real estate development can be an edge. The celebrity chef in a restaurant, the IP portfolio of a technology or medical device company, or a strong distribution channel relationship can be a critical edge to a consumer product.

The more tangible, unique, defensible, and proprietary the edge (such as patents), the better. The competitive advantage should discourage competition and create a barrier to entry. The edge will vary according to the venture's industry. First-mover status is often meaningless (like many others I prefer second mover) and certainly not sustainable in a market of compelling size.

A sustainable edge to compete in a large market is critical to potential acquirers or public markets and the objective of realizing compelling multiples on an exit.

o Criteria Three: The management team has compelling expertise in the contemplated market. You must have a great execution team. Visionary founders may be inspiring but they alone cannot bring a great idea home. Get an experienced and accomplished operator in early.

In the past I failed to hone this rule to its proper endpoint. Naively, I believed that the serial entrepreneur with prior liquidity events was a proven winner and worthy of the wager. The first time that formula fell short I failed to make the proper connection, the second time I learned the lesson. There will not be a third time.

Successful entrepreneurs too often become deal junkies fueled by the fumes of their prior triumph. Some become self-anointed business "generalist" experts (contradictory, eh?) that no longer feel restricted by the limitations of their actual core competencies.

The founding partners and management team must include an accomplished C-level executive or highly accomplished operator with a track record of proven experience with the specific business model and target market. Moreover, the operator must have the authority and discretion to execute the business plan. Serial entrepreneurial ego in the absence of domain expertise is a formula for failure.

o Criteria Four: The deal terms are no less than fair and are, ideally, favorable. Valuation, investor rights, board representation, management discretion, and transparency with respect to material events, protective provisions, anti-dilution protection, liquidation preferences, and optionality issues must incentivize and respect the source of the capital. The investor's capital is the great enabler...the sine qua non for any venture.

Few things are as humbling as the successful venture that does not translate into a successful investment. I respect the often repeated axiom that a fair deal is one where both parties feel that they got a bad deal, but the end game should always be to negotiate favorable deal terms.

The probability of an attractive outcome is diminished if a private venture investment cannot meet these initial thresholds. In VC-speak you are nursing a newborn "zombie"...a walking dead venture...the ship is already sinking and it has not even left the port.

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