Everyone works hard to ensure that investment deals get completed once they're agreed in principle - but a surprising number don't. What are the most common problems, and how can you head them off?
If you're worried about going through due diligence, spare a thought for some of the world's less mature entrepreneurial environments. A staggering 70 per cent of deals in emerging markets fall through after investors have conducted background checks, according to a survey of foreign investment executives by Deloitte - often, it seems, because company founders lack the necessary 'integrity' for their investment. In the UK, start-ups tend to feature more reputable management teams, but - depending on whose figures you believe - anywhere up to a third of deals can fall apart after the initial terms sheet has been issued.
It's the last thing anyone wants to happen after all the hard work that's put into pitching for deals, but the final negotiations in any investment can be a fraught time. Either side can get cold feet when they're confronted with the reality of the deal. So what are the most common causes of deals falling down after they've been agreed in principle?
The first cause is when due diligence turns up something unexpected. 'In our experience of working with one of the early-stage investment funds, one in four deals have fallen through in the past two years,' says John Foundling, head of corporate finance at chartered accountancy firm Morley and Scott. 'But our whole approach to due diligence on behalf of investors is about driving into any issues that emerge as soon as possible, getting prompt responses and feedback and suggesting how we believe a potential risk area can be mitigated against in some way.'
This approach is reflected in the due diligence report it produces, which the investee company may be shown and asked to vouchsafe as to its factual accuracy. Foundling says it's like an 'exception report', drilling into any potential issues that may arise.
Foundling gives the example of financial projections, which can cause problems but are usually not a deal breaker. 'We look at the mechanics and the structure, the assumptions behind them and check all the basics, and if we find a problem, in conjunction with the investor we may ask for a new set of projections.' Problems usually revolve around technical issues - such as a creditor or debtor not being factored in correctly, or some other discrepancy between the cash flow and the balance sheet. Morley and Scott may even recommend that a new management accounting system be introduced - it's that practical.
It will also look at the credibility of projections, running what Foundling calls a 'sensitivity test', and will flag up if they seem over-optimistic, although the ultimate say on believability rests with the investment manager themselves. A set of projections was highlighted in a recent deal because they appeared to be too linear, for example. 'That's not necessarily a problem, but it implies a simplistic approach. It depends how bullish they've been as to whether it's an issue or not.'
More likely to emerge as a problem in due diligence is the issue of Intellectual Property (IP) ownership, according to Ted Dewhurst, an associate at legal firm Nabarro. 'The area where most early-stage high-tech companies encounter problems is to do with IP, and the most common thing we find is they don't own their technology. If it's owned by the founders, that's quite simple to sort out. But if it's licensed from somebody else that can be a problem.'
Dewhurst says once you look into the licence, alarm bells start ringing if it's capable of being revoked at short notice, or if it's non-exclusive or ambiguous. 'If the business is built on licensed software you want that licence to be perpetual and irrevocable. If it can be terminated or it's not exclusive, then that's not good news.'
A third reason for a deal falling through - and probably the most common - is that the two parties fail to agree a price, or the entrepreneur has a better offer, otherwise known as gazumping. Dewhurst says this was more common last year and the year before when there were a lot of funds looking to invest in a relatively small pool of investment-ready companies.
It's not necessarily a bad strategy for a start-up to get to an advanced stage with a couple of investors - in fact, it can help push a deal through if you let it be known that another investor is waiting to step in. But the investment community is relatively small and deals that are done on trust can be soured if you don't play the game with a straight bat. 'We always assume that having got that far, the investee company will complete the deal,' says Dewhurst. 'But over the last two years there has been sufficient competition for good deals for gazumping to happen.'
Time, of course, is of the essence, and advisors are all too aware of the need for speed. Dewhurst says Nabarro is typically asked to have its draft assessment documents with the client within 48 hours and to complete the assessment in two to three weeks. Foundling, however, points out that for smaller deals, early-stage investors will be unlikely to want to expend too much time on a complex due diligence, given the associated opportunity costs. 'I would say that investors tend to be relatively risk averse,' he adds, 'by which I mean that if by waiting a few more weeks the risk in the investment becomes clearer, then they will wait. It's much easier to wait for the circumstances to change than decline an investment or rush forward with an investment they're not comfortable with.'
Which helps explain the next reason - a downturn in the company's fortunes. 'Poor results in terms of the current trading falling short of projections is a reason deals fall through,' says Dewhurst. 'It could be that trading has taken a turn for the worse or perhaps it's never picked up in the way they were projecting.'
The final reason is perhaps the hardest to guard against - the human factor. Dewhurst says that if an entrepreneur isn't used to dealing with VCs, they can be intimidated by the documents when they first see them. 'When they start talking to investors it's all very friendly, but when they see what they're asked to give in the way of warrants and assurances, restrictions on employment, service contracts, share transfers, putting in place share option schemes - they sometimes think it's outrageous. We can usually calm them down and it won't throw the deal.
'When VCs invest millions in a company, it's their duty to protect their clients' investment and they really have no power other than what's in the investment document.'
Foundling, whose firm also acts as a lead advisor to companies seeking investment, adds that it's important to think about the deal in the round from the very start. 'At the beginning, the focus in nine out of ten cases is on the percentage [of equity they are giving away]. It's only later, as they take legal advice and tie up the legal documents, that they understand the warranties they have to give - that the business plan is accurate and complete and not misleading, for example. What I try to impress on companies as a lead advisor is that they shouldn't be afraid to give warranties, because if they're asked to give a warranty they're not happy about, then there's already a potential problem between them and the investor.'
He concludes: 'At the end of the day it's about the convergence of interests between the investee and the investor. It's important that you choose the right investor, and what the deal means for you is often hidden in the terms and conditions and the details.'
By David Longworth, Webster Buchanan Research
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Saturday, February 24, 2007
Saturday, February 10, 2007
Entrepreneurs & Technology
Most technology entrepreneurs are creative by nature - but they don't always know how to hire the other innovators they need. Management guru Dr John Sullivan has strong views on how to get that right
Dr John Sullivan isn't known for holding back on his opinions. A professor at San Francisco State University and a well-known authority on people management issues, he's a frequent fixture at conferences and in the media expounding his views on how poorly most companies handle their employees. And talking to him a couple of weeks ago, one thing that's particularly irking him today is how companies mismanage their innovators.
While some of his views will be largely academic to smaller companies - his complaints about the inadequacies of many HR professionals make for entertaining reading, for example, but don't really matter if your workforce isn't big enough to hire one - much of his agenda drives to the heart of what makes a business succeed. Firstly, like a growing number of experts in the people management arena, Dr Sullivan believes recruitment is a sales and marketing activity rather than an HR discipline (see 'Candidate or Customer?' [TECHNICAL; 220035]). Good quality people are in high demand, and you need to adopt the same techniques to sign them up as you apply to winning a customer. While old school recruitment philosophy says candidates need to convince you to hire them, securing good people today is as much about convincing them that you're the best place for them to work.
So how exactly do you do that? To begin with, argues Dr Sullivan, you need to find out what factors they'll take into account when they decide on a job - what he calls their acceptance criteria. You can ask them direct when they put in an application or during the job interview - or you can be a little more circumspect and simply ask them to describe their dream job. Either way, it's unlikely that their goal is going to correspond exactly with the role you've created, so you need to adjust your sales pitch to hone in on areas where the two do cross over. In fact, if you've found a really good candidate, you might even change the role you'd mapped out - better to have a great person in a slightly different job than a mediocre operator who ticks all the boxes.
Secondly, you need to stand out from the rest of the people fighting for talent - so you've got to have what Dr Sullivan calls the 'wow' factor. In the technology field, companies like Google and Genentech have long attracted applicants by doing things differently. Google in particular has ripped up much of the employee rule book, famously shipping its Bay Area employees into work in limousine shuttles and providing free gourmet food at its campus restaurants. It also encourages engineers to work on their own projects one day a week, a policy that has helped spawn a huge number of its inventions. Likewise, biotech giant Genentech owes much of the success of one of its most successful therapies, Herceptin, to the 'underground' research culture it fostered, where scientists were encouraged to research their own projects. Breaking the rules to foster creativity creates a buzz and gets people talking.
Of course, 'wow recruiting' is easier to pull off when it's backed by the resource of an industry giant like Google, but that's not to say Dr Sullivan's philosophy can't be adopted by entrepreneurs. One advantage smaller businesses have, in fact, is that they can rewrite job roles much more easily than their large counterparts, which have to steer through internal politics and adapt complex hierarchies. Another is that, by their very nature, entrepreneurs tend to be trying something different - so if you're looking for an experienced software engineer, your ground-breaking technology concept could be the thing that woos them. The flipside, of course, is that new ideas don't do it for everybody - a great salesperson won't be excited by new technology, they'll be excited by new technology that looks like it will generate big dollars.
Thirdly, if you're going to 'wow' people, you need to target the right ones, and be clear about how to handle them. Dr Sullivan argues that companies need to distinguish between high performers, who've traditionally been the target for recruiters, and innovators, who are more likely to be the people driving today's companies forward. 'In a world that changes so fast, you have to innovate consistently,' he says. 'You've got top performers and innovators - the innovators are the critical ones. The top performer will make the wired phone better - the innovator will say 'Let's not have the wire'.'
The challenge with innovators, however, is that they're not just unconventional in their thinking - they also tend to be unconventional in their work habits. So you'll probably need to reciprocate by being flexible about your working practices. The reason Google offers employees breakfast, lunch and dinner on campus isn't just to keep them in the office for longer - it also knows that creative people work odd hours. In fact, some innovators won't want to be tied down to an office at all. Innovation has never been a nine-to-five job - so if you want to tap into someone's creativity, you might need to grab it wherever you can get it.
By Keith Rodgers, Webster Buchanan Research
Dr John Sullivan isn't known for holding back on his opinions. A professor at San Francisco State University and a well-known authority on people management issues, he's a frequent fixture at conferences and in the media expounding his views on how poorly most companies handle their employees. And talking to him a couple of weeks ago, one thing that's particularly irking him today is how companies mismanage their innovators.
While some of his views will be largely academic to smaller companies - his complaints about the inadequacies of many HR professionals make for entertaining reading, for example, but don't really matter if your workforce isn't big enough to hire one - much of his agenda drives to the heart of what makes a business succeed. Firstly, like a growing number of experts in the people management arena, Dr Sullivan believes recruitment is a sales and marketing activity rather than an HR discipline (see 'Candidate or Customer?' [TECHNICAL; 220035]). Good quality people are in high demand, and you need to adopt the same techniques to sign them up as you apply to winning a customer. While old school recruitment philosophy says candidates need to convince you to hire them, securing good people today is as much about convincing them that you're the best place for them to work.
So how exactly do you do that? To begin with, argues Dr Sullivan, you need to find out what factors they'll take into account when they decide on a job - what he calls their acceptance criteria. You can ask them direct when they put in an application or during the job interview - or you can be a little more circumspect and simply ask them to describe their dream job. Either way, it's unlikely that their goal is going to correspond exactly with the role you've created, so you need to adjust your sales pitch to hone in on areas where the two do cross over. In fact, if you've found a really good candidate, you might even change the role you'd mapped out - better to have a great person in a slightly different job than a mediocre operator who ticks all the boxes.
Secondly, you need to stand out from the rest of the people fighting for talent - so you've got to have what Dr Sullivan calls the 'wow' factor. In the technology field, companies like Google and Genentech have long attracted applicants by doing things differently. Google in particular has ripped up much of the employee rule book, famously shipping its Bay Area employees into work in limousine shuttles and providing free gourmet food at its campus restaurants. It also encourages engineers to work on their own projects one day a week, a policy that has helped spawn a huge number of its inventions. Likewise, biotech giant Genentech owes much of the success of one of its most successful therapies, Herceptin, to the 'underground' research culture it fostered, where scientists were encouraged to research their own projects. Breaking the rules to foster creativity creates a buzz and gets people talking.
Of course, 'wow recruiting' is easier to pull off when it's backed by the resource of an industry giant like Google, but that's not to say Dr Sullivan's philosophy can't be adopted by entrepreneurs. One advantage smaller businesses have, in fact, is that they can rewrite job roles much more easily than their large counterparts, which have to steer through internal politics and adapt complex hierarchies. Another is that, by their very nature, entrepreneurs tend to be trying something different - so if you're looking for an experienced software engineer, your ground-breaking technology concept could be the thing that woos them. The flipside, of course, is that new ideas don't do it for everybody - a great salesperson won't be excited by new technology, they'll be excited by new technology that looks like it will generate big dollars.
Thirdly, if you're going to 'wow' people, you need to target the right ones, and be clear about how to handle them. Dr Sullivan argues that companies need to distinguish between high performers, who've traditionally been the target for recruiters, and innovators, who are more likely to be the people driving today's companies forward. 'In a world that changes so fast, you have to innovate consistently,' he says. 'You've got top performers and innovators - the innovators are the critical ones. The top performer will make the wired phone better - the innovator will say 'Let's not have the wire'.'
The challenge with innovators, however, is that they're not just unconventional in their thinking - they also tend to be unconventional in their work habits. So you'll probably need to reciprocate by being flexible about your working practices. The reason Google offers employees breakfast, lunch and dinner on campus isn't just to keep them in the office for longer - it also knows that creative people work odd hours. In fact, some innovators won't want to be tied down to an office at all. Innovation has never been a nine-to-five job - so if you want to tap into someone's creativity, you might need to grab it wherever you can get it.
By Keith Rodgers, Webster Buchanan Research
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