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Life in the George H. W. Bush Administration was very different from today’s Washington. I was fortunate to have been chosen by the elder Bush to serve at the U.S. Treasury Department tackling the subject I was most passionate about: American competitiveness.
President Bush surrounded himself with people he trusted, but he did not choose sycophants. He encouraged us to work with the “other side of the aisle” to develop policy that served America, with no pride of authorship. He never pointed at himself after a goal had been scored.
Ethics were not relative, they were absolute. Before I could occupy my office at 1500 Pennsylvania Avenue, the Secret Service and IRS scrutinized everything about my past. They even went through three years of checkbooks asking where every deposit came from.
Because I was director of corporate finance policy, I was called on by many financial industry lobbyists, including Trump’s current chief economic advisor Larry Kudlow, who was a lobbyist for Bear Stearns at the time. One Christmas I received a bottle of wine from a Solomon Brothers executive. I was instructed to send it back.
I will never forget a strategy meeting we had in Bush’s living room at the Naval Observatory when he was vice president and running for president. His amazingly strong but humble wife Barbara was needlepointing silently the entire time, while a bunch of self-important men debated their campaign ideas.
When we were about to wrap it up, Barbara made a comment that made it clear she had listened to every word of our conversation. And George Bush listened attentively to her. She was his most trusted adviser.
My bosses at Treasury were not political animals. In fact, none of them were political at all. Reporting to Secretary Nicholas Brady, a former Wall Street CEO and Bush’s Yale baseball teammate, were two Harvard Business School finance professors. When one of them left to become vice chairman of the Federal Reserve Board, Jay Powell, the current chairman of the Fed, left Dillon Read to become my boss, with no political chops.
Bush was a one-term president because he lacked “the vision thing.” It is true that compared to his predecessor Ronald Reagan, Bush was not a big-picture guy.
He had so much experience in government that he considered it his job to tackle the myriad challenges that faced our country. One year, in drafting his State of the Union message, he solicited input from every agency. It was, as you might expect, a laundry list of unrelated priorities.
Rather than his words, his life was his message. Bush loved God and family first. He loved his country as much as any man who ever occupied the Oval Office. He did not make decisions based on how they would make him look. All he cared about was doing “the right thing.” What a great mentor and boss! I will miss him.
Although I am not a medical professional, I have taken the same number of nutrition classes as the vast majority of doctors—zero. That’s right. Most medical doctors know next to nothing about how what we put into our mouths every day effects our bodies.
My saga with gluten is illustrative. There are 18 million Americans who suffer from gluten sensitivity, an exponential increase in recent years. Yet only about 3 million actually suffer from a true gluten allergy. So, what is behind this explosion in gluten problems?
There are a number of theories. One possibility is a surge in foodies who derive pleasure from badgering waiters about the ingredients in every menu item before ordering a meal. Another possibility is that the human body suddenly and radically evolved to reject gluten, after thousands of years of tolerating it.
However, there is a more plausible explanation: our food has changed.
Nearly a decade ago I started having joint aches and neuropathy (shooting nerve pains). I went to a series of doctors, including a top neurologist at a well-known academic hospital, who offered no explanation whatsoever, just a smorgasbord of pharmaceuticals to treat symptoms, not problems.
After listening to me vent about my team of clueless physicians, a friend of mine who is one of UNC’s leading neuroscientists suggested that I stop eating gluten. After a quick Google search to find out what exactly gluten was, I omitted it from my diet, and within weeks my years of pain vanished.
But it turns out gluten wasn’t the problem after all. Every year, I take my family to France or Italy for a couple weeks where I gorge on bread, pasta and pizza daily, with no discernible effect whatsoever. My problem is with American gluten.
Did you ever wonder why a baguette purchased in France develops mold after a few days, while your American bread lasts a month? American food companies use additives to preserve the shelf life of processed products that cause damaging inflammation in our joints, intestines and stomach (which contains 100 million neurons).
Some people blame the pesticides used on U.S. farms for the toxicity of wheat products, while others blame the genetic modification of domestic wheat. My research indicates the preservatives infused into wheat-based products are a contributing factor.
The vegetable oils used in breads to prevent them from hardening are bleached, deodorized and refined so that bugs, bacteria and other microbes won’t eat them. Inconveniently, most human cells are microbes, and our stomachs are a bacteria convention.
Those tortilla wraps that retain their soft and supple features for weeks contain glycerol, which is a compound used to manufacture anti-freeze and nitroglycerin. Our bodies were not designed to seamlessly absorb these chemicals.
Moreover, studies show that processed or refined wheat leads to greater incidences of Type 2 diabetes, Irritable Bowel Syndrome, obesity, and cognitive decline, in addition to pain from inflammation. But rather than instructing us to eliminate the cause of the problem, most doctors prescribe some chemical to offset the problems caused by other chemicals in our diet.
Millions of people who suffer from unexplained digestive maladies and joint pains may well be sensitive to the food products they consume daily, but just don’t realize it.
One possible solution would be to demand that Blue Cross/Blue Shield, or the government, underwrite annual trips to Tuscany or Bordeaux for gluten sufferers. However, a less expensive alternative would be to stop granting medical degrees to people who have never taken a nutrition class.
A “liberal education” does not mean you studied under Elizabeth Warren. According to the Association of American Colleges and Universities:
“Liberal Education is an approach to learning that empowers individuals and prepares them to deal with complexity, diversity, and change. It provides students with broad knowledge of the wider world (e.g. science, culture, and society).”
The goal of most American universities is to provide students a liberal education, as defined above. But many are failing miserably. You cannot prepare young minds to deal with “complexity, diversity and change” without exposing them to diverse ways of thinking. A school cannot impart “broad knowledge of the wider world” without professors who are familiar with the wider world that exists beyond major cities and college towns.
If a school has a faculty comprised of every nationality, race, and gender identity possible, teaching the same world view, you have no academic diversity whatsoever. You simply have different flavors of Kool-Aid.
UNC-Chapel Hill ranks ahead of liberal stalwarts Harvard, Yale, Stanford, Dartmouth, Duke, and UC-Berkeley in one category: the percentage of liberal arts faculty registered as Democrats.
In 1970, Democrat voter registration among university faculty across the country outnumbered Republicans by 3.5 to one. Nationally, that disparity has soared to 11 to 1. At UNC, there are 23 registered Democrats for every Republican in the departments that address political and social issues, according to Econ Journal Watch.
Many academic departments have a toxic culture that equates conservative thought with ignorance. After I suggested in a previous opinion piece that there was a debilitating lack of political diversity at UNC, one professor queried a mutual friend: “Doesn’t he understand that academics are liberal because that is the way intelligent people think?”
Such hubris is reminiscent of Hillary’s “deplorable” comment. Surely there are more brilliant conservatives working in the technology, health care and financial industries than all the college professors combined. Perhaps the toxic academic culture doesn’t appeal to them.
I received a call last year from a former UNC chancellor. He asked if I would participate in a debate following a video to be shown to retired faculty where I would defend the “conservative” perspective. I chuckled and asked him: “Do you mean to tell me that among the thousands of UNC faculty, the best you can do to find a conservative perspective is a part-time business school professor?” He confessed that, “Yes, we do have a diversity problem.”
That ranks as one of the greatest understatements I have heard. But at least he recognized it as a problem. Apparently, the faculty doesn’t see it that way. They are doing nothing to address the disparity. Academics embrace all underrepresented minorities on campus — except conservatives.
One of the nation’s leading conservative scholars, Robby George, who occupies the chair at Princeton once held by Woodrow Wilson, was recently invited to address the UNC Board of Governors. At dinner the night before, Professor George explained to us why there have been none of the disruptions at Princeton we witness at Middlebury, Berkeley and other campuses involving violent protests, shouting down and censoring conservative speakers. He said, “When students have an opportunity to engage in civil discourse, they don’t feel compelled to engage in uncivil discourse.”
Until UNC can demonstrate that it employs a critical mass of nationally-recognized conservative scholars, like most other leading universities, it cannot pretend to offer a “liberal education.” Fortunately, there are a few thought leaders on campus who recognize this. Let’s pray (not in the classroom) that they will be effective change agents.
Community columnist Michael Jacobs is CEO of Jacobs Capital and on the faculty of UNC’s Kenan-Flagler Business School.
In a world where the new normal is the extreme, I detest extremes.
I am a Republican who doesn’t watch Fox News. I try to figure out how people on the other side of the aisle think, so I read the New York Times and Washington Post daily.
I don’t understand why black people consistently vote for liberals in overwhelming numbers while they flee the state’s most liberal towns, Chapel Hill and Asheville, the only two North Carolina communities that lost black population the last decade.
It doesn’t make sense that UNC-Chapel Hill professors, who are supposed to prepare our youth to think independently, complain about our state’s political system being rigged by gerrymandering, yet select a social sciences faculty whose party affiliation is 23 to 1 in favor of Democrats.
I don’t understand how Google maintains 1,000 data points on every American, yet our government can’t fully inform gun dealers of people’s criminal records.
Nor do I see the logic in why taking guns away from everyone except criminals will make the world a safer place.
It makes no sense to me why the president is so obsessed with the Russian investigation if nothing happened.
I don’t get how lowering corporate taxes constitutes a war on the middle class when such a large percentage of the shares of corporations are owned by pension funds and individual accounts that fund the retirement of the middle class.
I am totally bewildered how people can say with a straight face that freedom of speech is a valid principle only when they agree with what is being said.
It escapes me why progressives care more about the size of a chicken’s house than the cost of a poor person’s food.
It doesn’t register how CEOs of public companies with shareholders and customers of every political stripe feel their job is a platform to pontificate about their personal agendas.
Admittedly, modern politics is confusing. But why did the Democrats nominate a white woman for president who lost 52% of the white women vote?
It perplexes me why we apply a tax to companies when they hire a human but give a tax deduction to those which purchase robots.
I can’t comprehend why a monetary system where you can lose your entire net worth if you forget your password is the wave of the future.
I don’t understand how an academic institution can consistently admit 60 percent of its students from one gender yet teach that all gender bias harms that same gender.
I still believe men and women are different. How passé!
I’ve been around too long to understand why educated people embrace socialism when it has never worked anywhere…ever.
I don’t care what happens to a statue for a different reason than everyone else cares what does happen to it. I proposed to my first wife next to Silent Sam, and the marriage did not work out.
I still hang on to the old-fashioned notion that academic freedom gives you the right to attack ideas, not people.
And I will never understand why the book that has had the most profound impact on modern history is banished in most classrooms.
Finally, I can’t figure out why our nation enjoys being polarized. I worked for a moderate president, George H.W. Bush, and was recruited to senior positions by both Presidents Obama and Trump.
Clearly, I am out of touch with modern thinking, so don’t ask why The News & Observer would request that I write a monthly column. I have no idea.
This suggestion will lead to concerns that there will be more children claiming the dog ate their homework, but the idea of using dogs to protect our schools is deadly serious. Rather than asking 72-year old kindergarten teacher Miss Mildred to pack heat, we need to place explosive and weapon detection dogs in our children’s schools.
The United States military spent billions of dollars trying to develop technology to detect the improvised explosive devices that maimed and murdered our soldiers overseas. But none of the equipment the Defense Department has produced compares to the effectiveness of the dogs that were deployed.
A dog’s nose is 1000 times more sensitive than a human’s. According to a report by Auburn University, “U.S. Customs and Border Protection has more than 800 canine teams that work with the U.S. Department of Homeland Security to combat terrorist threats, stop the flow of illegal narcotics, and detect unreported currency, concealed humans, or smuggled agriculture products.”
Today explosive and weapons detection canines are being used by the NFL, Kentucky Derby, and Masters golf tournament. Southern Pines-based K2 Solutions was the leading supplier of bomb detection dogs to the Marines in Iraq and Afghanistan.
Today, K2 dogs protect you at concerts and Hurricanes games at the PNC Center. Dogs from Southern Pines were deployed at this year’s Country Music Awards in Nashville, the Denver presentation of “Hamilton” and the Super Bowl. One of the world’s most famous musical performers is in the process of contracting with K2 to have its dogs patrol every one of her concerts, regardless of where they are held.
The State Department is in the process of placing detection dogs at every “high-threat” U.S. embassy across the globe. Dogs found Osama bin Laden. Some of the applications being developed at K2 are mind boggling.
If you place a properly trained dog in a room and pump in air sucked out of a cargo container, the dog can tell you if there is an explosive in the container. This approach is more effective and far more efficient than manually inspecting the cargo.
With all these proven applications, it is unconscionable that we don’t have state or national programs for the use of dogs to protect our most valuable asset, our children.
Weapons detection dogs come in many sizes and breeds. Some are docile and playful, such as Labradors who have followed people with concealed weapons around football stadiums and laid at their feet when they sat down so that security officers could frisk the offender.
Others, such as German Shepherds, can be taught to attack anyone on command who is carrying a weapon or explosive device. Belgian Malinois and several mixed breeds are also used.
Consider where within the airport the devastating bomb attacks occurred in Brussels and Ankara—in the lobby before passing through security. Dogs could have identified these threats and saved countless lives.
A weapons detection dog supervised by a trained person can screen 150 students per minute. Not many schools have that much foot traffic. They can be placed in high-traffic choke points during class changes, and search lockers between classes. Simply the presence of a detection dog would be a meaningful deterrent.
The breed deployed can be tailored to the threat risk of the school. For example, an elementary school might choose a friendly breed, which the students would come to know and love, while a suburban high school might opt for a more aggressive canine.
Dogs alone are not a silver bullet to ensure 100 percent safety. We still need people in law enforcement who actually do something when a teenager posts on Facebook that he plans to shoot up his school. And we need security officers who have the courage to enter the school when a terrorist opens fire on innocent children. But detection dogs would certainly be a huge step in the right direction.
If we can use dogs to protect our soldiers, concert goers, football fans and overseas diplomats, why can’t we use them to protect our children?
Michael Jacobs serves on the board of K2 Solutions, which provides threat mitigation and canine detection services.
What is the proper amount of debt for your company to borrow?
The correct answer is c. In fact, for every company, there is an optimal amount of leverage that results in the highest return on the shareholders’ investment. The trick is to figure out what your company’s appropriate capital structure.
To determine how much your company should borrow, it is imperative to understand an esoteric financial concept known as the cost of equity. We all recognize the cost of debt, which is the interest rate. But contrary to popular belief, equity capital is not without cost.
Understanding this concept can have an enormous impact on the returns a business owner achieves. Roberto Goizueta increased the stock price of Coca-Cola over tenfold during his tenure as CEO, and much of this appreciation can be attributed to the fact that he understood the financial merits of appropriate leverage.
In layman’s terms, the cost of equity for your company is the return that you would demand from an “arms-length” investment in another company with a similar risk profile. From an academic standpoint, you can estimate your company’s cost of equity as follows:
Begin with the return that is available on a long-term, risk-free security. The best proxy for this is a long-term Treasury bond, which currently is yielding about five percent.
Then, add the premium over long-term Treasuries that has historically been required to invest in stocks, which is approximately eight percent. If your industry is more cyclical or volatile than average, this premium will be higher, say 10 percent to 12 percent.
Finally, academic studies show that small companies are inherently riskier than larger companies, and that businesses with revenues less than $100 million require an additional premium of four percent to attract investors.
The sum of the above factors in today’s market approaches 20 percent. But that is the return rational investors would require on a marketable interest in the equity of a small company. If your company is privately owned, its stock is probably not readily marketable. When you add an appropriate premium for lack of marketability, the cost of equity in a typical private company is somewhere in the range of 25 percent. Clearly, equity is a lot more expensive form of capital than borrowing from the bank.
If a rational investor would require a 25 percent return to invest in your company, why shouldn’t you? One possible answer is that you are not rational. Or, more likely, until now you were not cognizant of the return you should expect from your investment in your business.
Computing your return on capital
The performance measure that approximates the cash flow that a business generates which is available to shareholders and lenders, is earnings before interest and taxes, or EBIT. This assumes that you have to reinvest an amount in capital expenditures to maintain your current competitive position that is roughly equivalent to the current amount of depreciation and amortization, which are non-cash charges to your profits. It also assumes that you add back to earnings any monies paid to the owners in compensation, perks or otherwise that are in excess of what you would pay a nonowner to perform the same duties with the same proficiency.
To quantify the return on capital your company produces, a back-of-the-envelope approach is achieved by dividing EBIT by the amount of equity in your company plus interest-bearing debt. If your return on capital is below your cost of capital, then continuing to own stock in your company is not a prudent investment unless you take some action to either increase the cash flow the company produces or to lower your cost of capital. I have valued and sold dozens of companies that routinely failed to produce adequate returns on capital, so it is not unusual, just unfortunate. In truth, very few business owners have ever performed this analysis; therefore, they don’t realize whether ownership in their business is a good investment or not.
The key to increasing profitability depends on your company’s specific situation and is beyond the scope of this article. But an equally valid, yet often overlooked way to increase the shareholders’ return, is to lower your cost of capital through the prudent use of leverage. If your cost of debt is seven percent and your cost of equity is 25 percent, a company with no debt must achieve a return on capital of 25 percent. Similarly, a company with an equal amount of debt and equity capital must earn a return of only 16 percent (50 percent of capital at seven percent plus 50 percent at 25 percent) for it to be producing a market return to the owners.
Using this logic with no caveats leads to excessive leverage when pursuing the goal of driving up the returns to shareholders, which is what we experienced during the leveraged buyout bubble of the late 1980s. What happens in reality is that as you increase the leverage of your company, you increase the risk of defaulting on your loans and reduce your financial flexibility, both of which drive up your cost of equity because your stock becomes a riskier investment. So the use of debt only makes sense when the benefit derived from lowering your cost of capital exceeds the incremental risk of the associated leverage.
Each company has an optimal capital structure that is unique to that company. This occurs when low-cost debt is used to capitalize your business up to the point where the company can comfortably repay its borrowings without compromising its strategy.
Business owners who have never computed their own cost of capital or evaluated their optimal capital structure are “leaving money on the table” by not capitalizing their business in a manner to achieve the highest return on investment. One excuse I hear often is that if the owner sold his or her business, he or she would put the money in T-bills at a return of three percent or four percent, so their hurdle rate for a return on equity is minimal. This is highly flawed logic, though, because it compares apples and oranges. An investment in T-bills is quite a bit safer and more liquid than an investment in a non-marketable private company’s stock. Just because you have had many consecutive years of growth does not mean your company will grow forever or that owning its stock is without risk.
If you own a business that consistently produces a return on capital in excess of 25 percent, you have the luxury of ignoring this issue altogether. You can operate with no debt simply as a matter of principal and still rest assured that you are achieving a fair return on your investment, which is how I run my business.
I like knowing I owe nothing, even if it is not the most financially rational position to take. However, you can get away with this attitude only as long as you are not accountable to any other shareholders. Otherwise, you need to run a few numbers to see if you are fulfilling your fiduciary responsibilities.
I recently discussed with my client Keith, the CEO and 50 percent owner of a recycling company, the options for buying out his partner, Bob, who owns the other half of the company. Bob, who put up the initial capital to start the company about 15 years ago, has never been actively involved in the business and views it simply as an investment.
Now that Bob is spending most of his time on his boat in Florida, he wants to cash in on his investments in operating businesses and invest the proceeds into real estate so all he has to worry about is tornados and whether or not the fish are biting. Keith is agreeable to Bob cashing out, particularly as he sees some opportunities to grow the business, which he can’t pursue as long as he has a partner who insists that all available cash be distributed each year.
I explained that the most efficient way to achieve both parties’ objectives would be to raise mezzanine financing, but neither of the owners was familiar with the concept.
In a nutshell, mezzanine debt is a form of capital that is between equity and debt, as its name implies. Mezzanine debt has some of the qualities of debt (it has to be repaid and it carries an interest charge) and certain qualities of equity (generally options or warrants to purchase stock are granted to the lender.) Mezzanine debt is an appropriate financing option when a company has borrowed all the traditional debt that banks will lend and they still need additional capital to expand their operations, make acquisitions or cash out a partner.
I valued Keith and Bob’s company at about $10 million; therefore, Keith would need to come up with $5 million to buy out his partner. The company generates about $2 million in cash flow each year, which means that in today’s tight credit markets it could only borrow about $4 million from a bank and it already had about $1 million in operating debt. Consequently, Keith needed to come up with an additional $2 million. When I explained to Keith that he would not be able to borrow the entire $5 million needed from his bank, he responded: “Then we will have to go to another bank to get the difference.” Unfortunately, it doesn’t work that way.
While banks come in many shapes and sizes, they all generally approach lending from one of two perspectives. The amount they will lend is either: 1.) a percentage of the hard assets you own, or 2.) a multiple of your annual cash flow. In today’s market, cash flow lenders (which have become virtually extinct since 2001) are generally extending credit equal to about two times annual cash flow. In the headier days of the stock market bubble, that multiple was nearly twice what it is today.
So, if you want to borrow more than twice your annual cash flow now, you most likely will have to turn to a mezzanine lender.
The benefit of using mezzanine debt is that it allows you to raise capital beyond what banks will lend, without relinquishing the same percentage of ownership you would have to if you simply sold stock in your company. However, it comes at a price; the interest rate is substantially higher than bank debt. According to Brent Burgess, of Triangle Capital Partners, the interest rate associated with mezzanine debt generally ranges from 10 percent to 14 percent; plus the lender generally retains an ownership interest after the debt is repaid.
Typically, according to Burgess, the lender will receive warrants to purchase stock in the company, for virtually nothing, that they can exercise from the time the loan is repaid until up to 10 years from the initial funding. For example, in the case of my client looking to cash out his partner, if he had to sell stock to raise $2 million to bridge the gap between what he could borrow and the price he had to pay for his partner’s interest, he would have to give up about 20 percent of the company. If he instead borrowed mezzanine debt, he might give up only 5 percent of the stock.
Mezzanine debt is typically paid back over a five- to seven-year period. If it is paid back more quickly, the number of options or warrants is typically reduced and, if it takes longer to pay it back, the number of shares the lender can purchase are increased.
With traditional banks tightening the reins on lending, more and more companies have considered mezzanine financing for the first time in recent years. Not surprisingly, a lot of capital has poured into the mezzanine market since 2001, attracting some of the major players on a national basis who had never before focused on this market, such as Goldman Sachs and The Carlyle Group.
One fund that has been active in Atlanta is CapitalSouth Partners out of Charlotte, NC. Joe Alala, president of Capital South, says he visits Atlanta monthly and views it as one of the most attractive markets in the south. CapitalSouth invested $1 million to help the management team from Alpharetta-based Staircase and Millwork acquire the company from its prior owner. Alala’s fund also invested $5 million to help fund the buyout of Atlanta-based Canterbury Engineering, a supplier of engineered plastic parts.
Capital South is looking to invest about $100 million in chunks of $3 million to $8 million. Locally, a new mezzanine fund, Chatham Capital, has recently been formed in Atlanta.The reason the rates on mezzanine debt are so high is that the risk associated with subordinated debt are much greater than for traditional senior bank debt, which is often secured by the assets of the company.
According to Burgess, for investments in companies with annual cash flow less than $5 million, a mezzanine investor is looking for a total return of about 20 percent to 25 percent a year. because most companies can’t handle an interest burden that onerous, the lenders achieve their returns by attaching options or warrants to the loan.
While most business owners recoil at the notion of paying this level of return, the cost of mezzanine debt is still less than what venture capitalists or private equity investors seek — typically in the 30 percent to 40 percent range. Equity investors who strictly buy stock may not charge a current yield on the funds they invest, which reduces the burden on cash flow; however, they get their returns by taking a larger chunk of the company and demanding greater rights to control the business.
With the reduced availability of private equity and bank financing in recent years, mezzanine lenders have evolved from fringe players in the capital markets to mainstream sources of capital. Of course, whenever that happens, as Burgess notes, a lot more money gets poured into the sector and it becomes much more competitive. Moreover, both private equity and bank financing are starting to flow a bit more freely these days, all of which bodes well for the business owner seeking to grow or transition the ownership of their business.
The first step is research. Which firms are a good match for your type of business and the stage of financing you are looking for? According to Melissa Lassiter, an investment manager with Parish Capital in Research Triangle Park, NC, early stage capital is increasingly available only through the small venture funds. Many of these are spin-offs of larger funds, where a successful individual or two from an established VC fund goes out to start a fund of their own.
Today, the larger, better-known funds are focusing primarily on sizable “growth capital” rounds for established, profitable businesses. So before you call the top funds in town seeking to raise $1 million to get a new business going, do a little research to identify the smaller guys with whom you have a legitimate shot at securing some capital. For a list of venture capital funds and their target markets, check out www.vfinance.com, www.entrepreneur.com OR www.nvca.org. Yahoo also has an extensive list.
In selecting the funds to approach, be sure to visit each firm’s web site to see if your business is a fit for their strategy. Pay particular attention to who their portfolio companies are, as this will give you better insight into their true appetite than the general parameters they list on their home- page. VC funds that have invested in the same or a related industry sector are often the most receptive, and if not, at least they are less likely to waste your time if there is not a fit.
Kathy Harris, with Atlanta’s largest venture capital fund Noro-Moseley, says the best way to approach a venture firm is through someone who has done a deal with them in the past. This might be a management team member or board member from one of their portfolio companies or even an attorney who has previously done business with the fund.
If you have a good meeting with a fund that decides not to invest in your business, ask them who they think would be a good fit, and ask if they will make an introduction. According to Bill Henagan, chairman of Atlanta Technology Angels, relying on an agent to promote an early stage deal is “the kiss of death” because early-stage investors don’t like to see a meaningful chunk of their investment going to pay fees. It also shows a lack of resourcefulness on the part of the entrepreneur; it is not difficult to identify whom to call in the close-knit venture capital community.
But before you pick up the phone and start dialing for dollars, you need to be sure you have the type of business that professional investors will look at and that you have the information they will be asking for written down on paper.
There are countless great business ideas out there and many ways to make money. A good business model, however, may not be sufficient to attract venture capital. VC firms are looking for a business concept that can become a very large company, i.e., more than $100 million in revenues, if the enterprise is successful. The market you are going after must be sufficiently large to accommodate a new entrant that will grow to that size.
I have reviewed many well-written plans in which the company would have to capture a 100 percent market share to achieve any meaningful size. Define your market and quantify how large it is before even contemplating approaching a VC fund.
Also on the checklist for VC funds is a valid “use of proceeds.” Be sure that you can explain exactly why you need someone else’s money and what you are going to do with it. I have never met a business owner that didn’t believe that they could grow much faster if they had more capital. By definition that is usually the case. However, you need to show that rapid growth and scale are required to succeed in your business and that internally generated funds are inadequate to finance that growth. In other words, there needs to be a window of opportunity that will close if you do not secure greater financial resources.
What else do professional investors look for? Paramount is evidence that the management team is up to the task. You need to have not just the potential but also to have demonstrated the capacity to build a company in the sector you are in. This experience is referred to by VCs as “domain expertise.”
Having run a similar business unit for another company or possessing a track record of building successful businesses from scratch are the best ways to demonstrate that you can accomplish what you have put on paper. Of course, the same VCs that preach the importance of “management” today all threw millions at baby-faced Internet wizards a few years ago. Because most of the VC funds got burned abandoning their number one principle, they say that they really mean it this time.
Absent a track record, you will have to deliver a proprietary advantage in the form of technology or relationships that will get your business to the stage at which you can bring in the appropriate management team to take the company to the next level. But even a great new technology is not adequate to attract venture money. There are countless inspiring technologies in search of a market.
No matter how great the idea is, you have to be able to explain your “financial model.” A financial model is an articulation of how your concept will produce profits. That means you need to know how much it will cost to produce the product or service — on a fixed and variable basis — and how much you can charge for it given the dynamics of the market you are going after.
Over the years, I have probably seen a dozen business plans from entrepreneurs who claim to be able to turn trash into energy. While that is a noble concept, unless you can demonstrate that the cost of converting the trash to energy is low enough and the amount of energy created is high enough to compete with existing energy alternatives, you don’t have a commercially viable technology. The price point for your product or service needs to be low enough to capture the market share indicated by your financial projections, yet high enough to generate an attractive return for professional investors.
The return VC firms look for depends on the size of their fund and the stage of company in which they are investing. Generally, it is in the 30 percent to 40 percent range. That means if you achieve what they believe to be a reasonable level of success, and they cash in their investment in five to seven years, they can expect a compounded annual return on that investment in the 30 percent to 40 percent range.
While this may sound high to an aspiring entrepreneur, their required return reflects the amount of risk they are taking. Out of every 10 investments, a professional venture capitalist expects to hit one or two home runs (quadrupling their money or better); a couple of doubles, a few singles and to strike out three or four times. Starting with an expected return of greater than 30 percent for every deal provides them the discipline to avoid business models that lack the potential to be an extra-base hit. In fact, the reality is that over long periods of time, venture capital funds in the aggregate have an abysmal track record. So even targeting returns of 30+ percent does not often result in achieving them.
While Harris says that Noro-Moseley seldom fails to close a deal because of a difference with the owner in price expectations, before you approach a VC fund, you should run the numbers to see what percentage of your company you can expect to give up for the amount of capital you are seeking and still provide the investor a return in their desired range.
Finally, when you are ready to send off your proposal to VC funds, be sure to send an appropriate document. Because the partners in these funds have an inbox dozens deep on any given day, they do not have time to read that 50-page treatise you wrote on the company. A one-page overview won’t do either. You should prepare a five- to 10-page executive summary that addresses all of the above issues, plus a brief analysis of the competition and why you have something to offer that other companies don’t or can’t.
As mentioned, the best entrée to a venture capital fund is an introduction from someone the VC firm respects, but the reality is that most first-time entrepreneurs do not have such connections. If that is the case, make sure you have a powerful executive summary, and mail it to the VC firms that are a fit. They are used to receiving proposals over the transom and they will eventually give it a look and get back to you.
Your chances of receiving a prompt and favorable reply, though, are greatly enhanced if you carefully select which funds to approach and send them a document that articulates answers to all the obvious questions they will ask prior to reaching for their checkbooks.