I got tired of performing “entrepreneur CPR,” a fund manager confessed to me over dinner one evening. We’d been discussing his latest fund offering mezzanine debt, and I’d asked why he no longer invested in seed-stage companies.
I certainly understood his complaint. For while so much has been said and written about how we’re living in an “Age of the Entrepreneur,” and how technology has enabled founders to launch startups so easily that investors should need to compete to offer up capital, here’s an uncomfortable truth: Most so-called entrepreneurs can’t run a business. Not “can’t run a high-growth, disruptive technology, hope-to-be-a-Silicon-Valley-unicorn-deal-business.” I mean, can’t run a basic, profit-making business.
If that sounds harsh, take a moment to consider what quality should define a true entrepreneur: above all things, a willingness to defer gratification. Not for three months, or for six months. Not while startup founders are practicing their funding pitches as part of some accelerator program cohort. Not just while “living the dream,” drinking the organic coffee provided at a hip coworking space. True entrepreneurs are business builders who display an obsessiveness with managing their company’s limited resources against the risk of loss and failure for a period of years. Entrepreneurs should go into business expecting to defer personal reward for many years, until their business becomes more than minimally self-sustaining.
Note to investors: When considering an entrepreneur’s pitch, look carefully at the pro-forma cash flow statement and hiring plan. Look at the company’s budget. Do salaries suggest that an entrepreneur is expecting a fast reward? Does the company’s hiring plan show headcount growth matching or exceeding the growth rate for net operating income? If so, investor, beware!
True entrepreneurs display neuroticism as one of their higher-order personality factors. More prone to negative traits such as anger, depression, and anxiety, people with a high level of neuroticism are particularly sensitive to experiences of pain and loss. Such people live with higher-than-average baseline levels of stress hormones that prepare their bodies for the fight-or-flight response. If an entrepreneur is perceived as being downright hostile to taking on additional expenses (such as staff, office space, travel expenses, and equipment costs), it may be a good sign. Of at least a sign that a would-be entrepreneur is willing to control spending until a new business starts generating free cash.
After having worked with or performed due diligence on hundreds of entrepreneurs and their businesses, I feel confident in saying that most founders are not neurotic enough when it comes to facing risks to their business. Which means to an investor that most are not adequately concerned for their investors’ capital. No investor should feel “lucky” just because they were able to get a piece of a deal in this or that early-stage company. But investors should count themselves as lucky when they’ve placed their capital with an entrepreneur who is suitably interested in growing balance sheet value before expanding a company’s cost structure. This fact sounds obvious; however, lack of fiscal discipline is the number one reason that entrepreneurs are unable to build a business. Not bad luck, or poor timing, or difficult market competition…. It’s a basic failure to match expenses to revenues that dooms most new businesses. A suitably neurotic business founder plans for severe cash constraints and executes their business according to such a plan.
Note to investors: You say the entrepreneur doesn’t have a written business plan? It’s because in the Age of the Entrepreneur they’re supposed to “fail fast”? So quickly that a “nimble” entrepreneur can’t be expected to organize and commit to paper what their technique will be for making a profit? Such thinking is nonsense. While not every new business requires a 30+ page formal business plan, every business that expects to receive outside investors’ money must be able to demonstrate the critical thinking that went into their proposal for funding.
As a rule, I decline to meet with an entrepreneur or to receive their pitch until after I’ve had a chance to review their business plan. I’ve found that there’s little I can’t learn about an entrepreneur’s intended method for generating a profit from reading a well-composed business plan. By holding off on meeting entrepreneurs until after I’ve analyzed their plans, I frustrate their designs to “sell me” on their scheme based on an emotional versus rational response. Once I am satisfied by the soundness of their business plan, then I’m content to meet or take a phone meeting in which the entrepreneur can pitch to me. I use in-person meetings to judge how effective the entrepreneur will be in creating a demand for their own company and product or service, and for trying to judge the character of the person who’ll be taking investors’ money.
Note to investors: Because someone is a good salesperson doesn’t mean they’ll turn out to be a good businessperson. Conversely, because someone can create a good plan on paper for making money doesn’t guarantee that they’ll be effective at selling their value proposition, either to other investors or (most importantly) to paying customers.
Entrepreneur CPR is most often required when investors discover that: a) the entrepreneur lacks a technique for creating demand for their product or service, and mistakenly depends on outsiders (independent sales reps, distributors, marketing consultants…) to solve their growth problem, or b) the entrepreneur turns out to be the “vision guy” or “vision gal,” and fails to appreciate that business is—fundamentally—a financial exercise. This sort will rely on someone else to maintain the company’s books, without accepting financial controls to be put on his- or herself and the business. In both cases, investors must step in as activists to preserve their investment, resulting in their needing to spend a great deal of time sorting out the entrepreneur’s company—if that’s even possible. It’s the classic case that every investor dreads: having to work (in someone else’s business) for their money, rather than having their money work for them.
See that I didn’t point to isolated technical failure as being one of the main reasons investors are called to perform entrepreneur CPR. It does happen that a research or product development effort goes off course, and sometimes, a professionally knowledgeable or industry-connected investor can steer a startup’s technical effort back toward success. Also, sometimes it happens that gaining traction in the marketplace can be accelerated by an investor’s bringing in a seasoned adviser to help with marketing, branding, and advertising. But those problems tend to be fixed by adjustments, and not business resuscitations. Entrepreneur CPR is what happens when a startup goes into cardiac arrest. “Tweaks” and “pivots” to an otherwise sound business model won’t be enough to help investors receive a return of their capital, let alone a return on their capital. When entrepreneur CPR is needed, the investor will be intervening using whatever control terms were provided by their funding deal—quite often to restructure and restart an otherwise dying company.
Note to investors: Make certain that you pay attention to the control terms in every deal, as well as to the financial terms. You may come to rely on that voting or observer seat on a company’s board of directors, or on information rights, or protective provisions to help save your investment.
I shouldn’t wonder why my venture capitalist friend got out of the business of funding seed-stage companies. In truth, I ought to wonder why I still do it, except that I hope after working as many deals as I have, I’ve learned enough hard lessons. The lessons that have been discerned for Angel Capital Group, in paying closer attention to companies after funding and in performing better due diligence ahead of investment, we trust will cut down on the need to perform entrepreneur CPR.
Copyright Scott Ewing 2018
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