Practices and Patterns of Informal Investors

Key Parameters of the Investment Process

Essential Factors Prompting Investors to Make Investments

Investors across Canada in all discussion groups were very consistent in identifying and discussing three critical factors that prompt their investment in a project. The 3 critical factors are:

1. people,
2. the product and/or technology potential,
3. the non financial value that the investor sees he can bring to a project.

The majority of investors note that the people involved in a potential investment opportunity are the most critical factor in their decision to make an investment. Many investors note that they would be spending considerable time with these people, so it is important that the people be the right ones for the job and be individuals with whom the investor would like to spend some time. The importance of people is best stated by the investors:

"I invest in jockeys not horses. Good jockeys will ride good horses. I am not capable of identifying which technologies will become new 'platform' or winning technologies and products".

"For me, I only want to invest in entrepreneurs who are going to maintain control of their company, I'm investing in the person, I want them making the decisions."

"Il faut tenir compte autant de la capacité de l'entreprise dans son produit, dans la capacité de gérer et aussi de mettre en marché le produit."

"I didn't always feel this way, but there's only one thing that makes the world go round and that's who are sitting around this table – people, and if you have people with the wrong expectations, then you are in trouble to start with. If you can get the right kind of people with the right tools that you want to work with, then that can make a whole lot of difference."

The investors noted that they look for people who:

• are honest;

  "I want somebody who is honest - if everybody is honest, you usually make money. If something happens, its not because they have screwed you, it could be bad luck or economic conditions."

  "Il faut s'impliquer directement avec l'entrepreneur pour analyser les potentiels d'investissement, faire la pré-analyse, faire le montage financier. Il est aussi important avant de rencontrer le promoteur et de pouvoir faire enquête sur la crédibilité et la solvabilité de ce dernier."

• exhibit a strong work ethic;

  "A big thing is work ethic – are they willing to put in 60–70–80 hours a week to build the business."

  "Make sure the entrepreneur understands he gets paid a salary for working really hard – that's his job and they better understand that in 10 years time if the shares are worth 2 million dollars, my shares are worth the same as his on a per share basis".

• understand what it takes to make the business succeed;

  "I look that somebody in the company has all the different knowledge needed – you don't mortgage the building to fund cash flow."

  "Whether the entrepreneur acknowledges he is missing key ingredients and step 2 is on what basis is he willing to try and acquire that expertise"

  "The investments I've made have been structured pretty well as far as accounting, paper work and paper trail. When I was starting out in my business, I thought why would I bother doing all this 5 year forecasting stuff, I have no idea what my sales are going to be in year 2, I'm just starting out from scratch. But now that I've gone through it myself, you can see that the people who've at least taken the time to think about it - whether its right or wrong - tend to have a better chance of success."

• have invested in their own business;

  "The most critical thing there is, if I'm investing in somebody's company, if they don't have money in it, I'm not interested. They have to have something in it – not just sweat equity; sweat equity doesn't mean a lot. If I'm standing there holding all the paper...there is a reason the banks like personal guarantees, they [the entrepreneurs] need to suffer if they are going to walk away from the business."

• and, have a realistic notion of how to value the business.

  "What's important to me is that the entrepreneur have an understanding of the relative value of the contributions of the necessary cogs of the wheel to make the idea work. If you work that way, you avoid some of the problems of the absolutes in valuation and you just say my contribution as the production manager is a 10% value of the ultimate success of this business. Whether its 10% of 100 million or 200 million I don't know and some investment banker can tell us that in 3-4 years when we are about to go public...but its that relative value."

Not surprisingly, the market potential for the product or technology is also a key factor in determining whether Canadian private investors make an investment. For a minority of investors, the product or technology is even more key than the people. Investors who express this point of view believe that they can always change or add to the people necessary to make a business successful, but what they really want is an extremely promising technology or product. These investors are often seeking new breakthrough technologies and their approach is to seek these opportunities and if necessary change the people involved in the venture.

"Beyond that if you are looking at something that is coming to you across your desk I would tend to look more for a technology that is what you would call "a platform", like something that has really great potential...something that is exciting. After that a very key thing are the people involved."

"Il faut comme investisseur être capable de visualiser comment l'entreprise pourrait se développer. Cette aptitude vient avec l'expérience."

"What we look at are people, people and people, the other significant one is the magnitude of the market for the product... We like at least North America or global markets  – that is the upside potential, you've got to look at the upside potential in my opinion."

"I look for management and the markets that they are looking to penetrate, are they looking just for the just the New Brunswick region, Atlantic, North America, these are key things... Once you look at what they are trying to achieve, does management have the ability to do that – do they have the proper skill sets? Can they execute?"

A third major criteria mentioned by a majority of Canadian private investors is the value added that the investor judges he or she can bring to a given project. Virtually all investors believe that equally as important as the money they provide to a project is the mentoring, experience, contacts, and other forms of value they add to the projects with which they invest. (The nature of these non-financial contributions is discussed in a separate report entitled "Value Added by Informal Investors: A Preliminary Study").

The following statement by an investor provides an excellent summary of much of the discussion:

"Provided the business opportunity contemplated meets the first criteria [in this case, an acceptable fit with the investor's personal priority for sustainable development] then second level considerations come into play. These are grouped as follows:

Prior to investing I am guided by the three P's: People, their character, background and personality. I am influenced too by their network – by their other champions and mentors and whether their advisers think as I do? Patents – strength of and who filed them? Products – competition and their products place in the market.

Prior to investment I also look for the 3Cs: Confidence – is the entrepreneur outgoing and well able to communicate; Character – is the entrepreneur really driven to succeed- and is this his overriding passion and is that passion driven by money, greed or ego? Is he honest? Do others speak well of him. I would not care if his only asset was a fine reputation; Common sense – is the entrepreneur a realist and does he or she posses a practical down-to-earth attitude? Can he or she think on their feet? Are they flexible?

I am also influenced by the 3E's: Experience – background-breath of knowledge and a history of success. Ego – and temperament-drive and openness. I must know that an individual is a net contributor to his community – a giver not a taker. Eccentricities – these sometimes take years to unearth."

Investors' Experience with Level of Preparedness of SMEs

The investors are very consistent in their views that entrepreneurs and small business owners who are seeking investment are not well prepared to attract private investment. From the private investor viewpoint, there are a number of common ways in which potential entrepreneurs and small business owners are not well prepared. These include:

• business plans not well developed;
• expectations that large investments from outside investors would occur with little interference from those outside investors;
• unwillingness to relinquish control;
• poorly developed ideas about markets and revenue streams; and,
• an inability to recognize the need to acquire the multitude of skills needed to develop their businesses.

Overall, these shortcomings can be characterized as:

1. the inability of most potential entrepreneurs to manage the commercialization process; and,
2. inappropriate views by entrepreneurs (in the opinion of the investors) regarding the value of the firm as a whole and, within the firm, the value of an idea compared to the overall value of a business. Most investors note that potential entrepreneurs overvalue the idea and undervalue the contributions (both financial and non-financial) that are required to grow and develop a business.

Quotes that illustrate these investor views include:

"To get to your question about whether businesses are at a stage where they can properly use financing, in my experience, about 95% are not. The business plans are not well thought through and often there is no pragmatism for the approach... There is a lack of entrepreneurial culture, which means that people who have an idea – which I generally refer to as a widget – 'I've got the widget, I've got the widget' – give very little thought towards growing the business. Once they have the idea they move to asking 'Now where's my money for my business?' They give very little thought towards business planning or cash flow – it's a very high percentage that are not ready for cash, but are ready for assistance."

"Il y a un manque de vision à long-terme puisqu'on peut toujours se réadapter."

"Manque de préparation dans les plans d'affaires."

"... a lot of times they have a great idea, but have no idea about how the cash is going to come in. I can think of cases where my first question is 'How is this idea going to pay your bills?' They say 'Well, I don't know'. I say 'Well it's a great hobby then'. It's not a business until they can answer some of these questions."

"I think the biggest challenge is the recognition that the entrepreneur does not have the necessary skill set to be successful... they are probably really good at one item like developing software or whatever, but they are lousy at marketing or management. Our biggest problem is do they recognize that and get the help they need – sometimes it takes a long time to convince them..."

"There is a misunderstanding of the value of an idea compared to the value of a business. We can sit around this table and generate good ideas that would be quite executable, but its the execution and the preparedness to take risk with it that makes a difference. If you have management that not only don't see what their own limitations are, but at the same time, they place the value of their idea at 95% of the enterprise value. They are not willing to slice the equity value of the business in a way that reflects the important contribution of those 4-5 components that are needed for business to succeed – be it to attract the right talent or financing. Most entrepreneurs are unrealistic, are likely to overvalue the idea and if they do that, they won't get the talent or the equity that they need."

"Souvent le promoteur aimerait avoir l'investissement en comptant, sans avoir aucune autre forme de support ou de participation de l'investisseur. Le promoteur a peur de perdre le contrôle de son entreprise."

"I have seen opportunities where 30% of the company was represented by $300,000 or $400,000 and 70% was represented by less than $1,000 and they wanted to look at raising more money."

"I think it is the entrepreneur that doesn't want to let go, doesn't want to let go of control"