The following is an interview with Gregg Smith, Founder, Evolution Corporate Advisors, for my Advanced Entrepreneurial Finance graduate course. Gregg and I have known each other since about 2010. We discuss entrepreneurial investment from an investor’s perspective
Q. Tell me little about yourself and Evolution Corporate Advisors as it may relate to or support the financing of entrepreneurial ventures and small businesses.
A. I spent ~20 years on Wall Street as an investment banker, with most of my career spent helping growth stage companies execute private placements. I have completed over 120 private placement transactions for clients in the healthcare, technology, consumer & retail, energy and other sectors. I have also (conservatively) reviewed more than 1,000 business plans and met with 100s of management teams and entrepreneurs. I have seen many success stories of small companies I financed that were sold for >$10 billion, and many I financed that failed.
Q. When considering an investment, which is more valuable to an investor, experience in an industry vs. experience as an entrepreneur? Why?
A. Many outsiders have come to existing, “old world” antiquated industries and completely disrupted the norm—all with no prior in-depth industry experience. I would rather back a highly successful entrepreneur who has succeed elsewhere in a new industry, than back an industry insider who does not have any meaningful record of success. Also, many outsiders have a fresh perspective on things that don’t live with every day and may innovate and/or solve a problem that is not obvious to the industry insider.
Q. In your experience, which is more important in early state financing, the fit with the entrepreneur, the apparent accuracy of the pro forma assumptions, or the expected potential of the business? Why?
A. In the more than 120 transactions I completed, I have only had one client meet their first quarter projections after closing a deal. Things are very difficult to predict, and everything in life ends up costing more and taking more time than one anticipates. The same holds true with even the most sophisticated management teams using their best judgment to project where their business will be in one-quarter or one year. It is hard. I am more interested in understanding the drivers of a business and the assumptions used to project where growth will come from and anticipated costs. With this being said, for someone that is backing an early stage business, the “fit” with the entrepreneur is paramount. You will live and die at the hand of this individual, and you must understand their strengths and weaknesses. If you have confidence in the leader, then it is easier to understand the potential of the business and how and if it will be achieved.
Q. What are the top three things you look for when considering an investment partnership with an entrepreneur? Why are these three things the most important to you?
A. When evaluating a new [early stage] investment opportunity I first look at the business. Does it excite me? Will it disrupt the norm? Can it scale and scale fast? What are the barriers to entry? Next, I look at the individual and the team. Is this a team that can do it and have they had previous “wins”? Do I have confidence in them and do I want to be partners with these folks—thru good and bad? Lastly, I look at what is required to execute the plan in terms of resources and funding requirements and what is my potential exit for this investment. If invest today, what expectation should I have and how am I going to exit this investment and get a return on my capital? Will it be an IPO or a sale to another company?
Q. How important is a formalized business plan for a venture when considering an investment? What are those things you look for in a plan?
A. Formal “business plans” were popular until sometime within the last ten years. In the 1990s, I got long business plans sent to me almost daily that were mostly comprised of pages and pages of text and some financial statements. Today, most of what you see is a “deck,” some type of PowerPoint presentation on the company and opportunity that tells you everything you want to know in a more graphically, storytelling manner. Ultimately, I like seeing a deck and a working “model,” which would be an Excel file with quarterly projections and use of funds and, most importantly, assumptions that I can change and toggle if I want to evaluate my own assumptions.
Q. What are the three most important financial measures (statements, ratios, etc.) when reviewing a pro forma or a later stage investment?
A. This depends on the business. A retailer or manufacturer of a consumer product will have different metrics to review and understand than a biotech company. As it pertains to a financing, there is always risk involved when investing in a company and an investor always seeks to minimize the risks they take. Hence, I want always to understand “How far will this capital last the company?” when I am investing, and I want to try to reduce my “financing risk.” If a company tells me they need $2MM to execute their plan and get to a meaningful milestone, I don’t want to invest if they can only raise $1MM, because this would leave me exposed that they may not be able to raise the next $1MM to meet such critical milestone.
Q. How often would you, for example, use ratios to identify potential problem areas in a venture’s performance when compared to an industry sector? Which ratios are most important and why?
A. The most relevant ratios or measures I may look at today would include “customer acquisition cost” and gross margins and cost of goods. I want to understand how profitable a business is before you add in their overhead and as it relates to many online or product or service companies, how much are they spending to acquire a customer.
Q. How might seed investment requirements of an entrepreneurial venture differ from early-stage or late-stage requirements?
A. When investing in a company at the “seed stage” or start-up stage, there is a lot of risk because the company’s model may not have been proven out. In fact, a seed stage company may not even have a demonstrable product, customers or working prototype or website. In contrast, an “early stage” investment should have at least proof of concept or a working model as well as customers and customer references.
Q. What advice would you offer an entrepreneur seeking start-up or early-stage financing?
A. Finding money is almost as much about finding a partner that believes in you and your business, so there has to be some chemistry between the investor and entrepreneur. Try to find an investor that will also help accelerate the growth of the business in other ways than just providing money. Develop a pitch deck that clearly outlines what product or service you are offering, [for example] why it is better than existing solutions on the market today, how you will generate revenue and your growth strategy, why you are the strong candidate to lead this venture, how much capital you need (to do what with?), and how long it will last you till you hit milestones that will increase your valuation and lead you to raise more capital.
Rachael Harper, owner of Vida Calma Wellness and former owner of On Track Yoga shares her thoughts on entrepreneurship for my Entrepreneurial Marketing graduate course. Rachael and I discuss what it’s like to start a business, grassroots marketing, the importance of creating a business built for community and social good, and many other things.
The following is an interview with Kim Stewart, SVP, Working Capital Solutions Advisor, BB&T for my Entrepreneurial Feasibility Analysis graduate course. Kim and I became acquainted in 2016. We discuss entrepreneurial financing.
Q. What is your role in banking as it relates to “investment” in small business?
A. I work in an area of the bank that provides various solutions to companies that need working capital financing to support their on-going business activity or growth.
Q. What role do you now or have you in the past played in determining financing support for an entrepreneurial venture?
A. I have in the past worked in a banking environment where we would provide working capital lines of credit down to a minimum of $1MM, which may likely be too high of a minimum for many entrepreneurs that are “start-up” ventures, but I was still able to work with many entrepreneurial companies. I am involved in working with the customers on the front end in determining what their financing need is and how best to structure a financing solution.
Q. How is bank “investment” in small business different than, say angel investment? Does a bank often provide seed or startup investment?
A. It is inaccurate to say that banks invest in small business in the normal course of their operations. Providing financing is not investing, and for that reason, banks have to be stringent about identifying the risks and appropriately mitigating those risks. Traditional banks are paid a reasonable rate of interest for the use of funds as opposed to having an opportunity to participate in the upside of a business venture. There are ways that banks can work through the Small Business Association (SBA) to provide funding for a start-up investment, and there may be banks that are willing to take more risks on start-up ventures, but they would generally be interested in opportunities where the entrepreneur had a track record of successful ventures and had some capital to invest in the venture.
Q. How might bank financing requirements of an entrepreneurial venture differ from an angel investor?
A. Both are going to underwrite the risk of success or failure of the venture and the likelihood of being repaid in the event the venture fails, but an angel investor is not bound by regulation regarding the amount of interest and fees that they can charge and will often require some percentage of ownership of the company as a part of the investment, therefore they have the ability to get compensated for taking a higher level of risk.
Underwriting the risk involved in providing credit to a business will include considering primary and secondary sources of repayment. The primary source of repayment is generally cash flow generated by the operations of the company and to underwrite this involves a complete knowledge and understanding of the company’s operations, the industry in which they operate, the capital required to operate the business, financial analysis of historical operations, management strengths, ownership structure, etc. The secondary sources of repayment are generally liquidation of collateral and financial support provided by guarantors. These sources would also need to be fully reviewed to assess how much support they are capable of providing in the event the primary source is inadequate.
Q. What are the top three things you look for when considering an “investment” partnership with an entrepreneur? Why are these three things the most important to you?
A. I am going to reword to say that when I am reviewing an opportunity to provide financing to an entrepreneur, the three things that I am most focused on are going to be the strength of management in regards to knowledge of their industry and ability to execute as borne out by historical success, the amount of equity that the entrepreneur is able to put into the venture, and the strength of the sources of repayment.
Q. How important is a formalized business plan for a venture when a bank is considering an “investment?”
A. I can’t overstate how important a formalized detailed business plan that included realistic forecasts would be in obtaining a serious audience with a financial institution.
Q. What are the three most important financial measures (statements, ratios, etc.)?
A. There has to be confidence that management can produce accurate and timely financial information, not only to the lender but also that they are paying attention to the business factors that will indicate that they are successfully executing on the business plan. It is not uncommon for a start-up venture to take some time to be profitable, therefore it is critical that you understand their sources of capital and how long their horizon is to reach profitability. Generally, even those ventures that turn out very successful take longer to get there than was estimated by the owner/entrepreneur.
Financial performance and attention to the statements is important, but it has to be combined with a boots-on-the-ground familiarity with management and the company.
Q. How does a bank, for example, use ratios to identify potential problem areas of a borrower’s performance when compared to an industry sector? Which ratios are most important and why?
A. The most common financial ratios that are watched in a traditional commercial bank environment are balance sheet leverage, cash flow or fixed charge coverage and cash flow leverage. Balance sheet leverage measures how much equity the company has versus how much debt they have (for every dollar the owner invests, how much does he borrow). Some industries will naturally have higher leverage than others if they are capital intensive and have to invest heavily in equipment or infrastructure to operate. Cash flow coverage, debt service coverage, and fixed charge coverage all are measurements of whether the operations of the company can generate adequate cash to satisfy all of the demands on that cash. Cash flow leverage is similar to balance sheet leverage but can be used as an indicator when you have a young or rapidly growing company that doesn’t have a lot of equity built up yet, but has demonstrated the ability to generate adequate cash flow to consistent meet their obligations.
Q. What advice would your offer an entrepreneur seeking start-up or early stage financing?
A. Be prepared with your business plan, knowledge of the industry, and distinctive competencies that you bring, and identify the risks and the steps that you are taking not only to mitigate those risks but also to mitigate the loss in the event the risks are realized.
Be realistic in your expectations and understand that you are seeking risky capital and it is likely going to be more expensive and more cumbersome than traditional bank lending.