What People Ask
Here are some of the questions we receive most frequently from entrepreneurs looking for investment and potential Limited Partners.
Lateral Capital aims to fill the “growth gap” between Friends and Family (F&F) investors and the point the company takes in investments from institutions – generally strategic investors or Venture Capital. Based on what we have learned from entrepreneurs, this is the hardest money to raise. The companies we look for have used their F&F money to develop a product and get positive response from at least one customer. When Lateral invests, it is generally to help the company take the next step towards expanding its product, typically behind marketing and sales efforts in a targeted vertical market.
In some of our investments, this “next step” is still in a research and development context – with a “research” customer. For example, we invested in a company that makes an optical measurement device for evaluating brain injury. Their “first customers” were the IRB (Institutional Review Boards) at several hospitals. With the success of their prototype device in real world conditions, we were able to “tick the box” that the product actually worked.
Net, we bend over backwards to find investment opportunities which are “on strategy” from a timing perspective, even when the company doesn’t have traditional customers.
Lateral Capital V, LP was launched in October 2018. This fund is aimed at accredited individuals, college and university endowments and “Fund of Fund” investment groups looking for exposure to the Early Stage asset class. To receive information on the fund, send an email to:
John Lilly, Managing Member
Lateral Capital V, LP
Important Notice: The information contained in this document is intended only for accredited investors as defined by the Securities & Exchange Commission in Rule 501 of Regulation D. This document does not constitute an offer to sell or solicitation of an offer to buy any securities, nor does it constitute an offer to sell or solicitation of an offer to buy from any person in any state or other jurisdiction in which such an offer would be unlawful. This document does not constitute advertising or promotional materials with respect to any investment advisory services or any investment vehicle. The summary description included herein and any other materials provided are intended only for discussion purposes and convenient reference and are not intended to be complete. An offering of interests in any Lateral Capital investment vehicle will be made only by means of a confidential subscription booklet and only to qualified investors in jurisdictions where permitted by law. Please see the material titled Important Liability Disclaimer at the end of this presentation. (Updated 180803 KS)
We see Early Stage as significantly different from what most people call Angel Investing:
- We see Angel Investing as a hobby, a calling or a lifestyle. It is often focused on startups or on businesses which have a local or social value beyond the pure economics of being an investor. These can include:
- Artistic Investment – Theatre, music or artistic endeavoring; even Broadway shows.
- Lifestyle Businesses – Investments in restaurants, local service businesses, etc.
- Family Companies – Brother-in-law/sister-in-law/mother-in-law investments.
- By contrast we see Early Stage Investing as professional-quality investing in smaller companies which often have huge long-term potential.
- We see Early Stage as its own asset class.
- Being successful at it requires a long-term, disciplined commitment.
- It is not about investing in “startups” – these are Seed Stage investments.
Here’s our definition of a “professional” Early Stage investor:
Early Stage Investors are individuals
who have the experience, capacity and conviction
to invest in Early Stage companies
which they can help to make successful.
Research shows that to be successful over time, Early Stage investors have to make dozens of investments. But since our fund is relatively small, it is impossible to afford the big professional staffs which larger Venture Capital or Private Equity funds typically employ. This is where Angel groups come in.
While most Angel groups are composed of “volunteer investors,” they almost always include highly-skilled, very motivated members – many of them either past corporate executives or former entrepreneurs. Angel groups typically do 60-100 hours of due diligence on deals before they “report out” a decision. They tend to close only 1-5% of deals they see. So when we invest in a company “discovered” by an Angel group or fund, the company has already been through a rigorous due diligence process. We can talk to the members directly and see what they think about a business which is local to their members.
No. We are minority investors and we look to invest alongside Angel/Accelerator/Industry groups across the U.S. We look at the deal they have negotiated and either “take it or leave it.” We either invest in the LLC put together by the group as a way to “collect” multiple small investments or we invest on a stand-alone basis, on the same terms.
In most cases, we look to sign side letters with the company which gives us specific rights that may not be important for traditional Angel funds or other groups where we are affiliated. These could include issues which are not addressed in the investment agreement, including:
- The company’s commitment to provide information on company progress, on a quarterly basis.
- Follow-along or drag-along rights.
- Rights to “inspect” or audit the company’s books, should an issue occur.
? Lateral Capital’s definition of Early Stage Companies (ESCs) is neither precise nor “official.” We see an increasing number of groups using the term, and we’re not sure they know what they mean either!
We define ESCs as companies which fit to a particular space in the evolution path of companies with significant long-term potential. It is not a specific company age, investment stage (like Series A, etc.) or business status, like pre-revenue, Beta customer or pre-clinical. Rather, ESCs can be thought of as “late Angel to early Venture Capital.”
What we don’t do is “Angel investor,” at least not in the original sense of the words. The concept of Angel investor began on Broadway, where angels was meant to imply that to get your Broadway show off the ground, it had to come from the heavens with little expectations of a return. This is definitely not Lateral Capital. We expect a financial return and we clearly didn’t come from the heavens!
The LC model assumes that about half the companies we invest in initially will justify a follow-on investment (FOI) and that about half of those will receive a third round of investment. For Lateral Capital IV, each of these FOI rounds is modeled at $100,000; follow-on investment amounts are expected to increase in Lateral Capital V. The reasons to make a second or third investment in an Early Stage company are typically because the company:
- Needs additional capital to fund growth behind the current model. Generally, these are no-brainers: the company looks to raise more money because it has proven that the current product/market fit is well understood and that current customers want to buy more.
- Underestimated the amount of money they needed the first time. This is not ideal, as it often suggests that the company isn’t progressing at the rate promised, or that something has to be redone. But it’s not a signal that all is lost.
- The company needs to bridge to the next point of value inflection. This is often a subset of not raising enough money, but it could also be because research failure or something else unexpected. But if the company simply can’t raise more money at reasonable valuations before some new data is available, then we often (not always) step up.
- Is taking a down round. No one likes these situations, but they sometimes happen – even to companies that later become very successful. To protect our position, we often “join the group” of investors behind a strategic pivot.
- To make acquisitions. Merging/buying other companies is not always a great idea. It can distract the management on both sides of the transaction. But if it is the right kind of deal – to expand distribution channels or enter another country, for example – we are open to reinvesting.
In evaluating a follow-on opportunity, we look at the following:
- How much must we invest to offset the dilution caused by the new capital? Should we invest to hold our position? Or is this the time to expand our position?
- What new exit price is required to yield a 1.0X, 5.0X and 10.0X on our original and add-on investments? We look at these as separate decisions: the first investment requires a 5.0X potential return; should the second or third investment require only 3.0X? At what sales price?
- What happens to the company’s value position when the preference stack and option pool are considered? This includes the likely increases to “recharge” the options pool required to extend incentives to the management team.
- Are the strategic buyers we identified at the first investment still around? Is there still a commercial market for the company, or will the company now require Venture Capital to take us out?
- What’s the state of affairs for the books of the company? Records, IP filings, etc. Have they been good stewards of our money so far? Plus, the next-next investor is likely to be the buyer. Is the company ready internally for that line of inspection?
- What is the Board’s latest thought on selling the company? Is the minimum acceptable deal to the Board and CEO reasonable to us? Is it absurd? In other words, why would we invest more into a company which the controlling owners won’t sell at any reasonable price?
- If this really the “last money” the company needs before it sells? If not, how many tranches (really, really) are required before someone will buy it? Will the current investment take the company to Cash Flow Breakeven – so it can motor on for 2-3 years until buyers can be found?
Historically, we have not invested when:
- The lead investor negotiates terms which we are expected to match, but which make no sense for Lateral Capital. For example, we routinely pass on convertible notes which have valuation caps which are way out of the money or no caps at all. This is good for the company, perhaps, but this kind of note doesn’t compensate the investor for taking additional risk before a sale.
- The company is not on a path to cash flow breakeven (CFBE). We don’t insist that invested companies be at CFBE before we will invest again, but they have to be on a path to get there quickly and with confidence.
- The company loses key staff members before asking for more money. We invest because we believe the team in place can deliver the plan. But if the founders get into a fight or the CTO leaves for a competitor, we may not be willing to bet more again.
We would be remiss if we didn’t thank veteran investor John O. Huston for coming up with most of this. We particularly like his list of “Showstoppers” below.
- Any trust or honesty concerns.
- Outside directors not investing.
- Insufficient regular reporting on how the company is doing.
- New money goes to solve old problems – back taxes, payables, accrued salaries, etc.
- Very large round or valuation so the company has to deliver a $1Z (“a zillion dollars!”) valuation for us to get our money.
- The Board has “gone native,” to the point that the business plan has become delusional.
- The CEO can’t or won’t say what he or she has learned and what they will now do differently.
In Lateral Capital IV, our most recent fund, we look to invest up to $300,000 in each of 24 companies. We do this in steps and we start by investing $100,000 in every company. Combined with investments from the groups where we are affiliated, we are often part of a total
investment “pool” of $500,000 to $1,000,000.
Initial Lateral Capital investments are often followed by one or two additional rounds of $100,000 each, as circumstances warrant. This incremental approach recognizes that it is impossible to tell “upfront” whether a company can deliver on its plans or which company has the greatest chance of long-term success.
Lateral Capital invests principally alongside multiple Angel, Accelerator and Industry groups across the U.S.
We encourage companies looking for Early Stage investment from us to start with one of these Angel funds or groups. We occasionally invest in companies we meet directly, through trade shows or industry contacts. However, we usually refer them to one of our Angel group connections; depending on where they are located, etc. Remember, we have very limited capacity to consider companies directly and we make relatively small initial investments.
Each of the organizations below has 30-100 members who have broad-based experience and deep knowledge in one or more areas. Each of them has their own process for reviewing new companies. We follow what they do and indicate interest early in any company that fits our strategy.
|Band of Angels||Palo Alto||www.bandangels.com|
|Golden Seeds||New York||www.goldenseeds.com|
|Central Texas Angels||Austin||www.centraltexasangelnetwork.com|
|Tech Coast Angels||Los Angeles||www.techcoastangels.com|
|Biotechnology Innovation Organization||Washington||www.bio.org|
|Band of Angels||Palo Alto||www.bandangels.com|
|Queen City Angels||Cincinnati||www.qca.com|
We prefer priced rounds of Preferred Equity. We will consider Convertible Preferred Debt investments with discounts versus the next priced round and pre-discount caps in our valuation range. In other words, we would invest $100,000 in a Convertible Note with a 20% discount to the next round over $2MM, a 10% interest rate and a $3.5MM cap on conversion. We do not invest in common stock or SAFE notes. However, we will look at Royalty-Based Notes with equity-level IRRs (25-30%) and we are open to other kinds of venture debt, with warrants to deliver equity-type returns.
We get this question often. Early Stage companies typically think of patents and trademarks as cost items they can’t afford and can’t enforce. We get that. Our view, however, is that strong IP – trademarks, patents and copyrighted materials – are key investment considerations for Lateral Capital. Here’s why:
- Your claim to Intellectual Property tells others that you plan to practice your own technology. If you don’t put others on notice that you regard your IP as yours alone, you may wind up treading on the intellectual property of others because they don’t know you are there. In fact, the first value of patents is to ensure you can practice your own technology.
- Strong IP helps defend the company from competitors while the business grows. Even the words Patent Pending on your device or service will serve to make people think twice about invading your space. Are you going to sue them? Probably not. What you are really buying is time.
- Intellectual Property, particularly patents, is vitally important to large corporate buyers. Big companies who have the legal staff and financial resources to defend what you have invented. Where there’s a legal department, there’s a lawsuit!
Some key thoughts about Patents:
- Patents represent the right to exclude others from producing or selling a product exactly the same as yours. Not similar to yours; exactly like yours. The definition of “exactly” is found in the Patent Claims. That’s where you need to focus your attention and where your Patent Lawyer earns his or her salt.
- To get a patent, you have to disclose what you have invented. Once a patent is filed, you have agreed to tell the world exactly what you have invented and why it is better than other solutions to the same problem. Once the patent is filed, not necessarily received, it is public. It is also your stake is in the ground and you are free (but not required) to tell anyone about the patented invention.
- The first and most important benefit of having a patent is the right to practice your own technology. Many companies forget this. They say “I don’t want to disclose my invention – I’ll keep it secret.” This is fine until someone else invents the same thing – and patents it!
- Investors want to know what about your business is patented – or patentable. But they will also want to know whether your patent – or other aspects of your product of service – infringe on the patents of others. This is called “Freedom To Practice,” and is often abbreviated as an FTP opinion from a Patent Lawyer. This opinion can provide comfort to investors on your ability to practice what you have invented. The cost: typically $30,000-50,000, depending on the size of your patent estate. One reason this is so expensive: The insurance policy which backs up your law firm (and you) is very expensive.
- You can speed up your patent process by filing an Accelerated Application. Accelerated patent applications can be “bought” for an additional fee of about $5,000. This assumes your willingness to provide more information with the initial application on “prior art” in your area. Basically, you are helping the Patent Examiner more quickly review your file. Information on prior art which is close to yours is essential and helps the examiner to know why your “claims” are reasonable and why you should have freedom to operate. (Ask your lawyer for more details on how this works.)
Some key points about Copyrights:
- Copyright is established any time you put pen to paper, draw something, write software code, etc. By creating it, you are entitled to copyright protection.
- To remind people of this, you may put © and the year with your name or company name at the bottom of any page or website address where the copyrighted material is shown.
- There is no registration requirement – or even the opportunity to register copyrights. It is yours to own and defend. But copyrights can be very valuable. Just ask the Walt Disney Company. Their company has used copyright law to keep Mickey Mouse out of the pornography business for 50+ years.
- Your copyright lasts for a long time – 70 years past the death of the owner/author.
Some key points about Trademarks:
- In the United States, different from most other countries, federal trademark rights are established by using the mark to define your specific product or service. Registering your mark with the PTO – Patent and Trademark Office – simply tells the public who is claiming exclusive use of the words, illustrations, etc. and for what product classification.
- You can get a ® (meaning a Federally Registered Trademark) designation for your mark only after you have proven you are using the mark in interstate commerce. But if someone can prove they were using “your” trademark to describe something similar before you were, they can get your ® removed from the registry of marks. If they can prove that your mark is “confusingly similar” to theirs – usually based on simple research – they may be able to get a court to stop you from using the mark.
- No, spelling it differently doesn’t count: Kuik-E-Mart (“The Simpsons” spelling) and Quickee Mart would be confusingly similar. And speaking of confusing, The Simpsons could probably use the name Kuik-E-Mart without either registration or legal right under some combination of free speech, parody and “fair usage” statutes.
- Said another way, and even though it’s expensive, finding a good Trademark lawyer is very much worthwhile. We recommend John Parzych at Fredrikson & Byron (firstname.lastname@example.org).
|IMPORTANT DISCLAIMER – This material is for general background only. It is not legal advice. Readers are strongly encouraged to seek the advice of qualified legal counsel before acting on any information contained herein.|
No. This is broadly contrary to conventional wisdom which says, “You should invest in what you know.” But honestly, we haven’t seen this approach work very well for other Early Stage investors. We think this is why:
- What investors know is completely out-of-date – every Monday morning.
- Investors in what they know tend to be over-confident. They think about how it “used to be” – and assume that’s still the world.
- When you don’t know, you ask dumber, better questions. Perhaps Columbo would have been a good investor.
While we’re on the subject, we also work hard not to invest in “what’s hot” – segments which are the current equivalent of AI or cryptocurrencies. Hot categories have previously included home food delivery, “green energy” and LED lighting – all industries that turned out to be disappointing from an investment standpoint. One reason for this is that these so-called “hot” sectors tend to attract so much attention that price/value expectations make it difficult to achieve for a 2.6X return. Moreover, the concept of “picking the right industries” has proven less important over time than “picking the highest potential companies,” irrespective of industry. So we look for great businesses first, second and third.
We want Lateral Capital to play the role of mentor instead of governor. While we often look for “observer rights” in each company – primarily to judge the effectiveness of the Board process – we look to influence the CEO directly. We try to provide a steady stream of insights on how to best grow the enterprise; this based on both successes and failures in our past investments. Our experience is that “moving the company” in this way is much easier if we are not part of the Board. In fact, Lateral’s most successful influence tools have proven to be customer introductions and strategic insights, along with regularly scheduled CEO contact on everything from marketing ideas to patents.
Lateral Capital is a “hands in” investor, not a “hands on” investor. By this, we mean that we look to engage with management in the most helpful way possible, not to “run the company.” We have plenty of operating experience and we know that Boards have a very important role. But Lateral Capital’s “highest and best” value is to provide strategic insights, management advice and introductions to experienced resources in law, marketing, IP, distribution and, of course, potential customers. We are very open about all the mistakes we have made over our careers – hoping we can get our invested companies to “make new mistakes.”
We believe the best way to deliver on this objective is by not serving on Boards of Directors. Rather, we think the best way to successfully influence management is to coach the CEO from the side. We try to do several things for our invested companies – some of which Board members are unable to do because of their fiduciary responsibilities:
- Introductions, introductions, introductions (don’t forget introductions!).
- Gently reminding the CEO “Why” they are really in business – particularly on dark days. Sometimes the most important support we can provide is to remind the CEO that they got into this because they believed in something bigger than making money.
- Clear perspective on strategic planning using the Five Questions | One Page Success Plan™ approach. This includes advice on when to converge (do fewer things better) and when to diverge (look for new things that need doing).
- An endless stream of insights from around the world on topics of interest to Early Stage companies.
Our return objective is to deliver the “research average” for Angel investments on a continuing, sustainable basis. Based on a 2007 study of 450 companies (Wiltbank, Ph.D., Robert and Boeker, Ph.D., Warren, “Returns to Angels in Groups,” 2007), we target a gross return of 2.6X invested capital, with an imputed Internal Rate of Return of about 15-20%.
Importantly, this most recent research is the first in a series of studies, covering almost 1,000 Early Stage companies since 1997 – in the U.S. and the U.K. As shown below, the results are very similar across economic cycles:
“The consistent pattern of outcomes across multiple studies (which cover different time frames, economic cycles, geographies, and units of analysis) increases our confidence that these results are representative of outcomes to the U.S. group Angel investing.”
University of Willamette
The most recent 2016 study research, which included the Great Recession period of 2009 to 2011, is perhaps most remarkable. Without follow-on capital, 70% of companies went out of business versus an average of 54% of companies in the two previous studies. Still, the companies producing a 10X return or more were sufficiently successful to keep the average return at about 2.5X. A key to Lateral Capital success – actual and projected – has been our ability to have fewer “failed companies” than the industry typically experiences. As any investor will tell you, having “zeros” in your return average returns makes it very difficult to achieve target returns.
Stepping back, the key thing Early Stage investors have to remember is that Early Stage is an asset class, not a “one-at-a-time” business. Here is our perspective in a nutshell:
With 7-10% of Early Stage investments providing 80-90%
of total returns, diversification is essential. If investors
are not planning to invest in at least 10-15 companies,
they shouldn’t start.
We don’t serve on the Boards for any of our companies for several great and good reasons. But we do insist that our invested companies have them and that they improve them over time. Here are some of the parameters we recommend.
- Size/Composition – We look for five member Boards – two founders, two investors, and one independent Director. If neither of the founders are women, try to recruit them in one or more of the other roles. Companies with diversified thinking on their Boards do better. (If you don’t believe this, please let us know upfront so we can quickly decide not to invest!)
- Compensation – You get what you pay for and you won’t get great BOD members unless there’s something in it for them. We like to see the Board share 1.0-1.5% of the company, with the Board Chair to receive an extra 0.25%.
- Term of Service – Boards should rotate new members in and old members out on a three-year cycle, with three-year terms. The needs of the company will change over time, as will the skills of the BOD members needed. Plus, you will have much better luck getting great BOD members if they don’t see it as a lifetime sentence.
- Early Exits – If a BOD member decides not to invest in a financing authorized by the Board, he or she should step out and step off. It doesn’t have to be a huge check, as long as it is significant for the individual. What you don’t want are “professional watchers.”
In our view, the question of pre-money valuation gets more attention than it deserves. It is what most investors talk about most. This comes typically from investors who want to “make it on the buy” … investors who feel that their biggest chance of getting a return is to invest in the company at the lowest possible valuation. We are not saying that “buy low, sell high” has gone out of fashion. But this is not our only mantra. Rather, we look to “make it on the sell.” Our objective is to make our return by selling the company sold at a valuation higher than the one we came in at. In that context, the question we ask ourselves is not so much what the pre-money valuation is, but whether or not the company can be sold for at least 5X the price at which we invested. Here’s the logic.
A 5.0X multiple is about twice our target average return of 2.6X. Assuming that 50% of our investments will fail completely, the 5.0X translates to about 2.6X return, or thereabouts. Remember also that this only works because our first round investments are always the same at $100,000 per company. If we don’t believe the company can sell for 5X the price at which we invest, we don’t invest. It’s that simple.
In this context, all the published data around “pre-money valuation trends” is not all that helpful. Data services, including CB Insights, Halo and Prequin capture all kinds of data here, but so much detail underlies these averages that it’s like drowning in an average water depth of 2 inches. Rarely does this data show what percentage of these companies actually had revenue or what industry vertical they came from. For example, valuations on software-based companies are typically higher, but the chances of success are all over the map. MedTech valuations are higher as well, as the outcomes can be extraordinary. Adjusted for the risk and the timeline, however, it’s hard to know how meaningful the next Early Stage pharma valuation really is.
Likewise, we are not too concerned about regional variations. Median valuations for “Angel-Stage” companies (however that is defined) are often half in Texas what they are on the East Coast. This may reflect the fact that there is more money chasing fewer deals in one geography versus another. Or that the mix of investment types differs dramatically. As one example, Texas scores more investments in the Food and Beverage sector than any other Angel Investment market. Does this mean F&B deals are lower valued in general? Or that we should all rush to make investments in Texas? Probably not.
The net here for Lateral Capital is as follows: We try to invest in a valuation range between $3MM and $5MM on a pre-money basis. This is a range in which we can easily envision a sale at 5X our going in position. We typically cap valuations at $10MM since the number of companies which can sell for $50MM is very, very small. Remember that 90+% of Early Stage companies sell for less than $40MM. As we have said repeatedly, we are looking to get the “industry average” return in the Early Stage market: 2.6x our money on average … across groups of 15+ companies where about 50% of the companies will fail, 7-10% will produce a 10x return or more and most of the others will return 1-5x. To get to that average, every company we invest in has to have a 5X return potential.
Over the years, we have made more than a few mistakes; some more than once! Unfortunately, it’s not possible to say “never again,” as different facts and circumstances can disguise the next situation. More important, a decision to invest is always a function of the “weight of the evidence.” Sometimes we break rules, go off strategy and look past previous learning for what seems like a very good reason. But we do so with great care.
That said, here’s a summary of our biggest errors. The list doesn’t number 100 quite yet, but we expect to get there!!
- Investing when the benefit isn’t big enough to justify the price to the customer. We have sometimes been so dazzled by a product or service that we didn’t do enough work to figure out how the product or service would actually be priced – and then look again to see if there are enough customers to deliver that volume.
- Investing before the actual manufacturing costs are known. Prototypes are notoriously difficult to “bid.” Someone usually has to guess. We look to invest in companies who have identified a contract maker; someone who can actually say “with an order of this many, we will deliver it for this price.” This helps to understand what the pricing structure has to be and whether that’s reasonable for the target market.
- Investing when the company has underestimated their financial needs. The value of Early Stage companies tends to decline for the first 2-3 years, as the promise of new technology runs into the real world ups and downs of technology commercialization. More than once, we have participated in rounds where the company has raised less than they really needed – often in the name of preventing excess dilution. This actually turns out to deliver increased delays and even more equity dilution down the road – when they are forced to raise money during the “dip.” Going forward, we need to be sure we are part of an investment “package” big enough to get the company to the next set of measurable, positive outcomes – a basis for raising new money at a reasonable price.
- Investing in the wrong teams. We have invested several times in teams which turned out to be under-skilled for the work required. The reasons have been obvious in hindsight – except for ethical shortfalls which we have faced in only one very painful situation. The other situations have fallen into three different buckets:
- CEOs that were pig-headed and wouldn’t/couldn’t take counsel – from us or anyone else. These people are hard to spot, as they come across as very open/great listeners in Due Diligence. Once they have funding, however, a different person sometimes emerges.
- Teams who can’t sell their own product, usually because they couldn’t make it simple enough for mere mortals to understand. We can sometimes help on this, as an outsider tends to be much better at understanding what the benefit of the product really is and how to present it in compelling terms. But sometimes it’s so complicated that it literally can’t be sold.
- Businesses where the CEO has something to prove about themselves or to someone else, unrelated to making the company a success. This is also hard to spot. We have invested, for example, in a publicity hound who thought the company was about them personally and one company where the CEO was trying to prove his value to his in-laws.
- Investing in technology not yet productized. We are not startup investors. That is a different business – where the business is still a “technology” and not yet a product or service. Despite our best efforts to be sure the product is really “cooked” before we invest, we have several times found that either ingredients were missing, the process was not understood, the product was under-designed or even that the promised benefit was imaginary. We need to stick to the discipline of investing in products with customers, as even lead customers are easy to interview and harder to fool.
Remarkably, we have made few investments where the technology proved not to “work.” It almost always does what the entrepreneur says it can do. But we have made several investments in technology which had not yet – and may never – be converted into products customers will actually buy. The reason is usually because translating great concepts to actual, manufacturable products or software is very difficult. Just because it should scale doesn’t mean it will scale. As a result, we have learned not to invest unless there is a finished product and at least one customer who wants to buy more.
- Investing in health care. We should just stop, even though we probably won’t. As our long-time co-investor Tom Moore says, technology, “the first rise in the healthcare dough almost always deflates.” First efforts in new healthcare technologies rarely succeed because the human body isn’t understood well enough for that to happen without a lot of trial and error. This happens over a significant period of time, during which being an investor is interesting – if very painful. Devices are easier to produce and predict, and we have made several investments in this space.
- Investing in technology which requires ubiquity to succeed. If the only way for your business to be successful is to achieve ubiquity, to “own” the network effect of your innovation, then we would be crazy to invest in your company. The reason is that when ubiquity is required, there is usually only one ubiquitous player. Yes, Instagram reached ubiquity for whatever series of reasons (being first, raising huge amounts of money early on to drive awareness and trial), but there are very few sets of similar circumstances. One thing that is always required? POM. Plenty O’Money. We don’t have it; most Angels don’t either. These kinds of companies should be “reserved” for Venture Capital, where the mark of success is steadily increasing valuations, not a “quick sale” to a strategic buyer.
- Investing in companies with limited buyers. When companies, particularly in software, say their exit plan is to sell to Google or Facebook, this has mostly turned out to be a pipedream for several reasons:
- Large internet consolidators have their choice of dozens of other small companies to buy, none of which you have heard of and all of which have some product feature better than yours.
- You have no idea which of the features you have developed are important to these large players; either now or at the point you are ready to sell. The one thing you can be sure of is that by then, whenever then is, their interests will be different than they are when you invest.
- The willingness to acquire small companies goes in and out of favor with large companies, for reasons you cannot predict or even imagine.
Net: We have consistently failed to bring these big marquee players to the table, even when they are customers of our invested companies. You can’t depend on them to be your sole “way out.” You need to have more than a few big potential buyers; on a list you continually update.
- Investing in businesses where distribution is too hard to get – or maintain. As it turns out, every business is eventually a distribution business. When we came to Early Stage investing, our going in assumption was that products or services with great design, performance and price/value relationship would be pulled products into the market. This has turned out to be largely untrue, or at least, an inadequate understanding. Broadly speaking, the products we have invested in have “worked” pretty well. But after the product gets to completion, is manufactured at a reasonable cost, etc., the issue becomes distribution. In turn, distribution means push marketing – led by sales people who are very difficult and expensive to find and retain. This has not always been easy, as the examples below will show:
- One company we invested in is probably still sitting on 50,000 units of a product which a large distributor “guaranteed” to buy and then reneged on accepting. The product works very well; the distributor is a well-known player in the industry. And no, you can’t sue your customer to force them to buy things!
- We invested several times in a medical software company designed to meet the needs of physicians who practice away from their offices. It worked great. But none of the big hospital software providers would integrate the software into their products. Our company went out of business with one of the best products in the industry.
- Five successive rounds of sales people for an advertising technology company were unsuccessful at penetrating Google, Twitter or Facebook. This was despite the fact that each of these “super sales people” claimed to have sold products into these companies before. And the companies have said publicly, often more than once, that the product we were offering was exactly what they needed.
What we’ve concluded from all this is that people aren’t everything; they are the only thing. And distribution people, particularly those who can close a sale, are the people most scarce. Going forward, we have decided to rebalance our assessment of new investments based on their ability to both make and sell a solution to a really important problem. These days, we also look for investments that have “natural” distribution channels – perhaps online direct-to-consumer channels like Amazon or B2B channels through players like Grainger.
With only a small staff and a significant number of investments, we have to make quick decisions on investing in new companies. Since our investment levels don’t support much in the way of paid consultants, we have to rely on experience and the hard work of other Angels across the country – and our own advisors. So we are always open to a reason to say “no”; to put our pencils down and move on. Here are some of our show stoppers, greatly informed by the work of John O. Huston of Ohio Tech Angels.
- The idea is “new to the world” and not an improvement on existing products or services. We don’t have the money to invest in big, all new categories which require huge marketing investments. Rather, we want to get behind products and services which are so obviously superior to what’s out there that customers “buy” right away.
- The entrepreneur is only partly committed. We run from CEOs who are part-time, part-enthusiastic or part-hearted. Early Stage companies are for people who are crazy about being successful; who are in it for more than the money.
- When the idea is “borrowed” from someone else, particularly a previous employer, who is likely to be “not so happy” about someone running off with “their” idea. Defending lawsuits is not a good use of equity capital.
- The entrepreneur tells us even one small untruth – no matter how modest or inconsequential. Rather, we look for every contact with the company to build trust; not erode it.
- Founder / CEO / Management Team Issues
- The company expects Lateral to sign an NDA. We don’t sign NDAs. As stated at the bottom of every Lateral Capital e-mail, we specifically do not promise to keep anything given or shown to us as confidential. Simple reason: we see material from so many new companies, many of which are very similar, that we can’t promise to keep track of who said what to whom.
- The principals will not authorize a personal background check. This is standard these days and it rarely turns up anything significant. But it is simply good practice.
- The company won’t grant Lateral Capital observation rights if we ask for them. We don’t serve on Boards of Directors, but we want to know that the company is having them, when, and what is discussed. Key point for us: that every Board agenda includes a discussion of the plan to sell the company.
- The entrepreneur has no “skin in the game”,e., their investment is non-cash or conversion of a previous loan. This is particularly worrisome when the entrepreneur expects a salary from the company, but it signals that the leader really wants to be an employee, not an owner.
- The CEO lacks the “Passion, Presence and Conviction” to present well to other funding sources. If the CEO can’t sell the idea behind the company, but still expects to be CEO, something is awry.
- The Founder is in love with the idea of being CEO – this instead of doing what’s best for the company. What we don’t want is a CEO who would not allow their company’s fortunes to be optimized under someone else’s leadership. Often, finding a new CEO turns out to be what’s best for all shareholders – especially the founder!
- The Founder/CEO feels that receiving $10MM net proceeds is not enough. This kind of return from the sale of the company (i.e., from their share) in five years should be seen as a lucrative exit for the entrepreneurs we get behind. We can’t wait for a greedy CEO to drag out the sale process and $10MM or more is a great payday in anyone’s book.
- There is an un-coachable Founder/CEO; one who really isn’t open to the thoughts, guidance and challenges provided by people like us. We don’t expect the CEO to always agree with our input, but we do expect to be taken seriously. We want to see them step back, internalize our comments, do the appropriate homework and then respond. Our experience: CEOs who won’t listen to investors are unlikely to listen to their own customers.
- Capital Issues
- The company has an unwieldy Cap Table and/or complex shareholder issues. Key examples would include investors who are not accredited, many family members owning a significant position in the company or early investors that have too many preferences for return of capital ahead of new investors.
- Complicated contractual features from previous or senior investors, including liquidation preferences, put or call rights. Similarly, a structure with no lock-ups for key employees or co-sale requirements on the sale of the company is usually troublesome.
- Unacceptable legal structures. For example, Sub S corps can’t have LLCs as shareholders. We prefer C Corps and Preferred Stock.
- The company is already surviving “on fumes”. If the current burn rate has less than three month’s runway left, the company may be a victim of poor planning or slow fiscal decision-making. John O. Huston’s Rule:
|Job One of the Board is to be sure that the company never, ever runs out of cash.|
- When any shareholder has a “fixed and floating ownership percentage or other kind of “forever” arrangement. People who have the expectation that this will be honored by future investors are just not realistic. It will not.
- An unrealistic pre-money valuation for the capital being raised, so a later down-round is inevitable; particularly if that next investor is a VC/PE fund who knows very well what the real market is.
- Unrealistic valuation expectations in general. If the company expects pre-money valuations for a pre-revenue company above $2MM ($5MM if they have revenue), then the company is usually not a good candidate for investors as small as Lateral Capital. We go as high as $10MM for businesses with huge global potential and good data in hand, like our investments in human organ replacement, curing Alzheimer’s disease and “manufactured” rare earth magnets. But entrepreneurs need to remember that 90+% of Early Stage companies sell for less than $40MM. If Lateral Capital targets to deliver industry Average returns of 2.6X, investing in going in valuations above $10MM is daunting. It says that the company would have to be at the top of the curve, with a sale price of at least $26MM. Even this ignores the fact that 50-70% of Early Stage companies fail to return their capital – losses which have to be factored in to the average return.
- The CEO/Founder is unwilling to create a significant option pool to motivate current employees and recruit future employees. Greed kills.
- The company is using a fundraising agent which drains immediate cash from the financing. We like CEOs who raise their own capital. It’s the best way for a CEO to really learn whether the business resonates with strangers.
- The expectation that “new money” will be used to pay off old obligations, particularly debt extended by friends, family, employees or the entrepreneur. New equity money never pays off old debt or equity investors.
- Issues Around the Exit
- Too much capital is needed to get “From Here to Liquidity.” Generally (and not always), if more than $10MM is required, small investors like Lateral Capital will be diluted out … by investors we have yet to meet and who probably won’t care much about us.
- Pre-existing agreements which could complicate or depress the exit. For example, a strategic investor has a Right of First Refusal, a Founder has veto power regarding the exit, etc.
- Family members on the payroll. This typically dampens the enthusiasm for a sale of the company as strategic buyers won’t employ relatives in close connection. Oh, and blood is thicker than money.
- Unsettling body language from the CEO and team when “Exit” or “Liquidity Event” is mentioned. For example, unwillingness to accept redemption triggers from the investor; a feature which protects the investor if the venture starts turning into a “Build To Keep” or “Lifestyle” company.
- Miscellaneous Issues
- Pending litigation. Product warranty or product return problems of any kind make us nervous.
- Markets that are too small. We have made this mistake more than once, even in markets we liked because we thought they were “protectable niches.” Generally, if 100% market share is less than $100MM of annual revenues, the market is too small for Lateral Capital to invest in.
- When the Founder/Inventor refuses to contribute their IP to the company outright, we walk. This is another version of an entrepreneur who is not “all in.”
- Insufficient time remaining until patents expire. Generally, this means less than 10 years.
- Strategies that are unlikely to ever bring the company to net profitability, for whatever reason. This is usually because the business model has some significant shortcoming. Or worse, the company is a research lab (“We’re almost there – just a little more work”) for an entrepreneur who is a testaholoic.
- The current investors/founders already have the capital needed to fund the company, but are still seeking outside capital. Often, this is a sign that they are simply “shopping” the deal so as to set a valuation for themselves; wasting our time in the process. Worse, these are often founders who are not as convinced about the company’s prospects as they would be if they were using other people’s money! Our question is usually this: “If this is such a great idea, why don’t you put in more of your own money?”
- The entrepreneur has a reputation for being litigious, or worse, a PITA. One of the first things we do with a company is to check out the Founder/CEO; to check their reputation in the market. When the people who have worked with the CEO before have nothing enthusiastic to say, we get an instant picture of what it would be like to invest behind him or her.
- The co-investors are inexperienced or lack significant “dry powder”,e., other investors who have not “experienced” Early Stage losses, or invested in follow-on rounds – some of which may be down rounds. These people often turn out to be prisoners of their own regret.
Source: This material is informed by similar lists from several Early Stage investors, but we are particularly indebted to John O. Huston, who provided the backbone of this list.
Like any other financial tool, Royalty-Based Financing (RBF) of Early Stage Companies (ESC) has strengths and drawbacks. The advantages can be compelling. As we have learned from a couple of these deals, however, there are also some downsides. Both investors and entrepreneurs should take them into consideration. Remember, our thoughts here are no substitute for professional advice. You should not rely on anything we offer as legal or accounting advice.
What is RBF? In a nutshell, the investor advances money against a revenue stream which the company is relatively certain to receive. Basically, the ESC pledges that revenue to the investor, with or without guaranteeing it with money from other sources. In return, the investor receives a fixed rate of return on their money; one which is about equivalent to an equity return. The rate is negotiable, but investors would typically look for a 25-30% IRR.
A simple example of this structure would be a pledge of payments from a licensee, where the Early Stage company has agreed to out-license some of its intellectual property. Typically, these licenses have minimum payments attached to them which are paid annually to the ESC licensor. If the licensee is financially strong, and the license contract is well written, the investor would be pretty certain of seeing their money returned, with an “assured” return, over time.
Why Is This Attractive to Both Parties? Royalty Financing can be a “safer” way for investors to get a return they will be happy with. Sometimes, they don’t even care what else the company does, so long as there is relative certainty that the payment stream they are relying on will come in the door and be forwarded to them. For a steady stream of license revenue, or even a shipment-based security (“You pay me $1.00 per unit you ship … from now until I get a 30% IRR on the money I advance to you”), this may be quite a comfortable proposition. And it can be done without extensive due diligence or painful arguing about the company’s valuation. For the entrepreneur, RBF has one huge upside: it brings much needed cash in the door without giving up equity.
Downsides For Investors
- Capped Returns – Investors who are used to “swinging for the fences” may cringe at a more certain, but fully capped return. If the payout is capped at the IRR you agree to upfront, and then the company ends up to be the next Sales force, the investor may not be very happy.
- Uncertain Period – If payments are from product sales, investors are at the mercy of the market and no one can know for sure how long it will take to receive their full return. This is why stable, predictable revenue streams are typically one of the investment criteria for the Royalty-based approach.
- Tax Status – From the standpoint of taxing authorities, Royalty based financing could be seen as a loan. This may disqualify angel investors from claiming angel tax credits, because you can’t claim tax credits on a loan. Also, royalty payments would typically not be taxed as capital gains, but at regular income tax rates.
Downsides For Early Stage Companies:
- Growth Impediment – Instead of investing all of its cash in future growth and R&D, the company has to use some of the cash to make regular royalty payments. This may be fine if the company is using the money to fund marketing and sales activity – say if the product is shipping and the Royalty cash is being used to support more sales people. But if the company needs every dime? Perhaps going after more equity is a better approach.
- Non-Committed Capital – Opponents of RBF agreements stress that some royalty payments are based on a percentage of revenues, say 10% of net sales for three years. In this case, the company has to make royalty payments even if it’s not profitable. This ends up eating into operating capital.
- More Liabilities – At its core, royalty-based financing is a loan. This means that instead of what would otherwise be an equity investment, investors have rights that are similar to those of traditional creditors. If there’s a change of control, for example, investors may want their unpaid return off the top – with an early payment penalty which delivers their total projected return.
- Risk of Default – Unlike traditional equity financing in which returns are based on capital appreciation, Royalty-Based Financing is a loan that relies on repayment of a debt-like instrument. If the company defaults on repayments, it might be forced to liquidate assets in order to repay the entire advance.
- Lower Valuation – Royalty contracts are recorded as debt in the financials, which will lower the company’s valuation should it decide to raise additional money to grow or survive. So if the company doesn’t have the money to make regular Royalty payments, it might have no choice but to sell equity at a lower valuation.
Like everything else in Early Stage investing, there is no right or wrong. It all depends.
|IMPORTANT DISCLAIMER – This material is for general background only. It is not legal or accounting advice. Readers are strongly encouraged to seek the advice of qualified legal and/or accounting counsel before acting on any information contained herein.|
When we meet a new investment candidate, we lead with enthusiasm! We are a “yes” from minute one. Then, we start asking questions in an orderly process which yields a decision, ideally at the end of 4 weeks.
The first questions we think about are whether the product or service is something people will actually want to buy. This sounds obvious, but remember that the leading cause of failure for Early Stage companies is “no identifiable market!” Then we take a quick measure of the people: Do they have a clear view of “Why” they are investing so much of their time, money and passion into the business? Are they likely to fit to our target entrepreneur profile of “paranoid optimists of impeccable character”? Only if we can tick these boxes do we start thinking about the return potential. In a nutshell, we ask whether the company in question has the potential to return 5.0X our money in five years. Here’s the logic for this approach:
- A 5.0X is about twice the 2.6X average gross return we look to deliver for Lateral Capital Funds. This is basically the “industry average” return from a study of 450 Early Stage companies in 2007 and 245 additional companies in 2016.
- With research showing that about 50% of our investments will fail, a 5.0X return on half the companies would theoretically produce about a 2.6X average gross return.
- If Lateral Capital can produce a consistent average gross return of 2.6X for our Limited Partners, we should be able to attract a portion of the investable assets from an increasing number of investors over time. In turn, this will allow us to make more investments in Early Stage companies.
- If we can continue to increase the number of Lateral Capital funds we can launch, and deliver steady 2.6X returns, we can achieve our own “Why.”
Our mission is to become
the vehicle of choice for investors
who want to add Early Stage companies
to their investment portfolios.
And while Internal Rates of Return (IRR) are not the primary way we measure Lateral Capital success, this “5.0X for 2.6X” approach gives entrepreneurs a simple way to think about the competitive nature of capital markets. As shown below, there is a clear relationship between time and the return multiples necessary to deliver specific IRRs. For example, if an Early Stage company delivers 5.0X the investor’s money in 5 years, they will deliver a 38% IRR:
Said another way, this chart shows how much our invested companies have to “give back” in order to deliver a specific multiple. For example, if Lateral Capital targets to earn a 5.0X return on a $100,000 investment at the end of 5 years, we would need to receive $500,000 back. Pretty simple. Unfortunately, we know that only about half our invested companies can be expected to return much of anything! So the average return from half the companies is what we depend on to reward our Limited Partners. Hence, the “5.0X for 2.6X” model.
One other point. If we can’t decide whether or not to invest, we pass. For practical purposes, there are an infinite number of investment opportunities out there. Early Stage investing is, after all, an asset class. So if we don’t feel better and better with everything we learn about a potential investment, we pass. This doesn’t mean we won’t regret it. We have lived through dozens of coulda, woulda, shoulda situations. But the next investment is just around the corner and we try not to look back.
There are two reasons. First, investing in startups is a different business – and it is not well suited to small investment funds. Here’s how we know.
The investment data platform CB Insights looked at a cohort of tech companies headquarters in the U.S. that raised the first round of seed funding in 2008, 2009, or 2010. They followed them through to February 28, 2017. Given the timeframe, these companies have had a substantial amount of time to obtain follow-on funding or to exit.
Of the 1,098 tech companies they tracked, less than half, or 46%, managed to raise a second round of funding. Every round saw fewer companies advance toward new infusions of capital. For example, only 14% of companies went on to raise a fourth round of funding, which typically corresponds to a Series C round.
This incredible fall-off rate means that startup investors (like 500 Startups) have to invest in hundreds of companies to achieve a rate of return. That requires capital we don’t have. Some of CBI’s other conclusions:
- Only 306 (28%) of companies that raised a seed round in 2008-2010 exited through an M&A or IPO within 7 rounds of funding with all that time and money, 2/3rds of the companies still failed.
- Less than 1% (10) companies from the CBI seed cohort ended up becoming unicorns, e.g., companies valued at $1B or more. Some of these companies are the most-hyped tech companies of the decade, including Uber, Airbnb and Slack. This compares to 7-10% of companies in Early Stage which would up as “winners” – albeit at a much lower return.
- About 70% of companies ended up either dead or became self-sustaining. “Self-sustaining” means cash flow breakeven, which may be great for the companies and their founders: It’s a great job! But this is not great for investors who need an exit to see a return. Perhaps worse, some companies often stumble on as Zombies for years before calling it quits. The death of the company? This generally happens without any official announcement.
Second, we don’t have the skills. To be a startup investor in technology, you have to understand technology in great depth – or at least enough to know if what you are seeing is really new and if it has a chance of success ten steps down the road. This means that successful startup investors typically have deep technology expertise and focus on one industry vertical where they know what they are looking at. We’re not smart enough in any area, so we invest in a wide range of verticals and we rely on customers to tell us whether the product is new, different or better.
There is no doubt that technology developed by Early Stage companies has the best chance of fixing society’s problems: Indeed, “saving the world a little bit at a time.” Big companies, like the ones we worked for, are just not going to get us there. They are rewarded for having a very short-term profit focus and thus very bad at taking longer-term risks.
The question is whether Lateral should invest with a larger purpose in mind; whether “saving the world” should be an investment criteria. We have considered this from several perspectives, including the idea that we should invest against a double bottom line: Doing well and doing good. In the end, we concluded we can’t do both at once.
Investors can’t have more than one master. That master has to be the potential for the investment to return a profit in excess of cost of capital. If the company does well by doing good, even better. But every time we have looked at an investment which lacks economic viability on its own merits, no matter how good the “cause,” we have concluded that it won’t succeed long-term. Said differently, if you want to save the world, the world will have to pay investors – and the companies they invest in – to do the saving.
So how do we ensure we don’t invest in the wrong things? Companies that might be unbelievably profitable, but which deliver no particular redeeming social benefit. We all know what we are talking about: Vapor cigarettes, computer games, online gambling, the next great dating site – or the next great strip mine. The rule we have adopted is this:
If our children wouldn’t be proud to tell their friends
about a Lateral Capital investment, we don’t invest.
In strategic terms, we have defined this as the fifth of our five core investing criteria: The invested company has to contribute to the greater good. This is amorphous and not specific. But it is a standard all of our Limited Partners support. Plus, we all know it when we see it.
In 2010, Ben Horowitz of Andreessen Horowitz (AH) wrote a blog post on the difference between Angel investors and Venture Capital (VC), http://blog.pmarca.com/2010/03/02/angels-vs-venture-capitalists-1/. He made the point that VCs and Angels are not two different kinds of people, but two different styles of investment. The Andreessen Horowitz fund invests at all stages, from startups to Late Stage Venture, so they have a good basis to make a comparison.
Horowitz’s comments are largely repeated below, updated by us to reflect the current investing environment. In a nutshell, how Lateral Capital invests today is in many ways similar to the way Andreessen Horowitz approaches investing – but only when they are making investments in Early Stage companies.
“In the early days of technology, venture capital, great firms like Arthur Rock and Kleiner Perkins funded companies like Digital Equipment Corporation (DEC) and Tandem. In those days, building the initial product required a great deal more than a high quality software team. Companies like Tandem had to manufacture their own products. As a result, getting into the market with the first idea meant, among other things, building a factory. Beyond that, almost all technology products required a direct sales force, field engineers and professional services. A startup might easily employ 50-100 people prior to signing their first customer.
Based on these challenges, startups developed specific requirements for venture capital partners:
- Access to large amounts of money to fund the many complex activities.
- Access to very senior executives such as an experienced head of manufacturing.
- Access to early-adopter customers.
- Intense, hands-on expert help from the very beginning of the company to avoid serious mistakes.
In order to both meet these requirements and build profitable businesses themselves, venture capitalists developed an operating model which is still broadly used today:
- Raise a large amount of capital from institutional investors.
- Assemble a set of experienced partners who can provide hands-on expertise in building the product and then the company.
- Evaluate each deal very carefully with extensive due diligence and broad partner consensus.
- Employ strong governance to protect the large amount of capital deployed in each deal. This includes requisite board seats and complex deal terms including the ability to control subsequent financings.
- Manage own resources effectively by calculating the amount of capital/number of partners/maximum number of board seats per partner to derive the minimum amount of capital that must be invested in each deal.
It turns out that building a company has changed quite a bit since the early days of venture-backed technology companies. Building a company like Twitter or Facebook is quite different from building Tandem. Specifically, the risk and cost of building the initial product is dramatically lower. I emphasize product to distinguish it from building the company. Building modern companies is not low risk or low cost: Facebook, for example, faced plenty of competitive and market risks and has raised hundreds of millions of dollars to build their business. But building the initial Facebook product cost well under $1 Mand did not entail hiring a head of manufacturing or building a factory.
As a result, for a modern startup, funding the initial product can be incompatible with the traditional venture capital model in the following ways:
- Lengthy diligence process. Venture capitalists take too long to decide whether or not they want to invest because they are set up to take large risks and have complex processes to evaluate those risks.
- Too much capital. Venture capitalists need to put too much capital to work – often a VC will want to invest a minimum of $3M. If you only need 4 people to build the product and get it into market, this likely won’t make sense for your business.
- Board seat. Venture capitalists often require a board seat and, for that matter, a board of directors be formed. If 100% of the company is building the product and the team knows how to do that, then a board of directors may be overkill. In addition, it may be too early to decide who you want to be on the board.”
Unlike Venture Capital investors, Lateral Capital has none of the VC constraints described above: we don’t go on Boards, we don’t look to be the lead investor; we prefer dead simple terms and we understand that Early Stage companies don’t know everything, yet.
So, can VCs invest in Early Stage companies? Is it “safe” to have them participate? The answer turns out to be “if and only if they behave like Early Stage investors. To quote Horowitz, once again:
“They have to:
- Be comfortable investing a small amount of money, e.g., $100,000.
- Be able to make an investment decision quickly, e.g., in one or two meetings.
- Be able to invest without taking a board seat.
- Not require control of subsequent funding rounds.
- Not impose complex terms.
If the VC wants to be in the early round, but refuses to behave like Early Stage [investors], then entrepreneur beware. Having a VC who behaves like a VC in the early round can jeopardize subsequent financings. Horowitz invests in both venture rounds and Angel [Early Stage] rounds. When we invest early, we behave like Angels – literally and figuratively. As Angel investors, we invest as little as $50,000, we do not take board seats, and we do not require control.”
The investing philosophy of Lateral Capital is modeled on the thinking of Edward de Bono, one of the foremost modern-day experts on conceptual thinking. de Bono is credited with developing the concept of “Lateral Thinking”:
“Vertical thinking is selective, while lateral thinking is generative.
Rightness is what matters in vertical thinking.
Richness is what matters in lateral thinking.
Vertical thinking selects a pathway by excluding other pathways.
Lateral thinking does not select, but seeks to open up other pathways.”
The use of Lateral Thinking underlies our approach to Early Stage investing. We believe that:
- Transferring technology solutions from one industry to another can result in extraordinary outcomes.
- Mistakes made in one investment can be avoided in others – if you are open about sharing them.
- New problems can be solved by old solutions – if the problem can be reduced to its’ essence.
Over time, de Bono’s insights have also taught us how to think about managing a significant number of very different investments at the same time – by using de Bono’s definition of “expertise”:
“An expert is someone who has succeeded
in making decisions and judgements simpler
through knowing what to pay attention to
and what to ignore.”
In short, we believe Lateral Thinking leads to a differentiated view of which businesses are most likely to succeed and how we can be helpful to them.
There is no straight line from learning about a new company to a decision to invest. Different issues have priority in individual evaluations. The key is this: We generally decide to invest in the first five minutes of learning about the company. This is because we know right away whether the company fits to our strategic criteria. And it’s typically obvious whether the product or service has a market or not. If it doesn’t fit, we try to say so right away. The rest of the decision process is Due Diligence – trying to uncover potholes into which the company could fall or “critical flaws” in the business model.
If enough issues crop up, our assessment declines and we decline. The list of questions below will help prospective companies answer our typical Due Diligence questions for themselves. By the way, this list is not original to us. We borrowed big chucks of it from fellow investor, John O. Huston, then added our thoughts!
Business Plan and Vision
- Can the company answer The Five Questions with relative confidence?
- “Why” does the organization really exist?
- “Where” is the organization headed long-term?
- “What” will the organization achieve in the next 3 years?
- “How” will these goals be achieved?
- “Which” work will the organization NOT do?
- Does the company operate according to some kind of simple strategic plan which everyone in the organization understands? Is there a clear process for changing the plan when needed?
- Are all the required inventions, resources and financial milestones spelled out in the plan? Does the plan balance costs and customers to give a realistic forecast of growth?
- Does the projected growth rate make sense? Does it seem like customers can be added at the rate proposed? Are selling skills and resources in place?
- Does everyone in the organization operate according to a formal schedule of who needs to do what by when?
- Is there a process in place to govern spending and hiring so as to assure progress against the plan in a way which honors the budget?
- Does the CEO possess the level of intelligence, energy, ethics and determination required to drive the company?
- Has the CEO previously demonstrated management, team-building and leadership abilities in a resource-constrained environment? Has the CEO succeeded before on a “do-it-yourself” basis?
- Can the CEO recruit (help select and then sell) great, critical hires?
- Can the CEO attract capital, board members, key customers, and strategic corporate partners?
- Does the CEO have a “partner” in the company; someone with complementary strengths and offsetting skills? Do they get along really well?
- Does the company have a fundamental, defensible, and measurably superior technology?
- Does the product have well-defined features and functions? Will they be seen as benefits by the customer, not just nice to have?
- Does the company have the development/engineering talent to support the initial product? Can they keep evolving the product in response to customer needs or the competitive market? Can the current team build the next generation of follow-on products?
- Is the product benefit promise big enough to support the price the company intends to charge? Does it match what the market will pay? Can customers who buy the company’s product or service get a cash-on-cash payout in under 12 months?
- Does the company have a well-defined process for producing products at the cost, quality and on the schedule required by its customers? Can it scale up its product manufacturing or service delivery process rapidly? Do they have product and process specifications which outside contractors can understand?
- Is the top-level team composed of individuals of impeccable character? Do they have measurable, relevant experience and expertise?
- Are they capable of attracting Grade-A staff as well as leading and managing their respective functions?
- Is the team “do” oriented rather than “management” oriented? Or will they confuse activity with accomplishment?
- Can each of the members “play” several positions on his or her team as opposed to just managing a team of players?
- Do the members behave collectively as an integrated team as opposed to operating as a collection of individuals?
- Does the company have a good understanding of what it will take to sell the product – together with a sales leader who can implement it?
- Does the sales group and its leader have an understanding of what it takes to sell to this class of customers? Does the sales leader have a clear understanding of what the product does and doesn’t do for the customer?
- Is there a clear view of the most likely group of buyers are and how they can be reached efficiently?
- How will the product or service be delivered and installed? Are there any missing components needed to deliver a complete product to the buyer?
- What will the buyer tell him/herself is the rationale for issuing a Purchase Order for the company’s product – in terms of features, functions, and (most important) benefits?
- How will the product get to the customer and at what cost? What are the distribution channels?
- Does the company have a driven sales leader?
Board of Directors
- Is the Board composed of individuals whose experience and expertise enhance the company’s competence? Or are they just placeholders? “Great guys” from the world of “used to be” who happen to have money to invest?
- Can the Board shepherd the company for the period of our investment?
- Are all of them also investors, with skin in the game?
- Do Board members act as reviewers, counselors, and company missionaries for sales and finance? Do they understand their role; that they are not running the company?
- Is the Board reviewing the firm’s strategic plans and direction as well as providing the CEO with advice about current operations?
- Is the Board focused continuously on selling the company; when and for how much?
- Does the company have enough cash to complete the current stage according to plan … with a 20% safety margin? Can it “live” to see the following stage while it secures the next round of financing?
- Can the company name multiple investors they believe will be willing to contribute to the next stage of the company’s growth? With whom have they spoken to get that feedback? Based on the product and market outlook for the firm in the context of their feelings about the economy and the market sector?
One problem with being an Early Stage investor is that you rarely get negative feedback from the companies you invest in. After all, you wired them money! So we have only collected the positive comments below – which you should take with a healthy amount of pink Himalayan salt! But still, companies don’t seem to mind having us as investors.
“You have been a great mentor to me over the past five years and I am pleased that things will conclude well for all those that supported the company.”
CEO Invested Company
“You’re a phenomenal teacher. Often we’ll bring around mentors and they’ll drop lingo like everyone knows it. You took the time to explain the basics.”
COO Invested Company
“Too many investors have a God-like complex where they have to be the smartest guy in the room by many standard deviations. You give off a vibe in which you’re OK admitting you don’t have all the answers.”
COO Invested Company
“Every single one of the people at the meeting commented on how much they enjoyed their time with you.”
COO Technology Accelerator
“I didn’t want you to think for a minute that you were just another talking head. Those 90 minutes had a big impact on all of those entrepreneurs. Thanks for that.”
Managing Director Startup Investment Fund
“I think you’re one of the few visionaries with enough insight (and cojones) to be able to see the tremendous opportunity in what I’m doing and help us get to the next stage.”
CEO Early Stage Company
“Thanks so much for your time yesterday and thoughts on [a new business investment]. You gave us some great ideas and insight as to whether this is worth pursuing and if so, how.”
Early Stage Investor
“We just got the signed contracts. You are the best at customer referrals. Can’t tell you how much I appreciate your support!
CEO Early Stage Company
“Again, thanks for your advice — it really made a substantial difference in our outcome.”
CEO Early Stage Company
We see Early Stage as significantly different from what most people call Angel Investing: ● We see Angel Investing as a hobby, a calling or a lifestyle. It is often focused on startups or on businesses which have a local or social value beyond the pure economics of being an investor. These can include: – Artistic Investment – Theatre, music or artistic endeavoring; even Broadway shows. – Lifestyle Businesses – Investments in restaurants, local service businesses, etc. – Family Companies – Brother-in-law/sister-in-law/mother-in-law investments. ● By contrast we see Early Stage Investing as professional-quality investing in smaller companies which often have huge long-term potential. – We see Early Stage as its own asset class. – Being successful at it requires a long-term, disciplined commitment. – It is not about investing in “startups” – these are Seed Stage investments. Here’s our definition of a “professional” Early Stage investor:
Early Stage Investors are individuals who have the experience, capacity and conviction to invest in Early Stage companies which they can help to make successful.
What’s the Lateral Capital Strategic Plan? One of the success “habits” we encourage all our invested companies to adopt is to answer five simple questions about their business. Together, these form a Five Questions │One Page® Success Plan. There’s nothing very new here. These questions map pretty well to the traditional strategic planning definitions of Mission, Vision, Objectives and Strategies, making this a very simple way to collect all your most important thoughts in one place. To help us stay on track, we have added a fifth question: Which work will we not do? This is what our One Page Solutions colleague Harry Kangis has dubbed The Won’t Do List®. Here’s how we answer these five questions for Lateral Capital:
1. “Why” does the organization really exist? – We are here to prove that over time, systematic investment in pools of Early Stage companies can be financially rewarding and benefit the Common Good.
2. “Where” is the organization headed long-term? – At the end of 25 years (2027), our plan is to have in place a sustainable investing system which can produce continuous long-term success for hundreds of investors.
3. “What” will the organization achieve? – We will prove that Lateral Capital can over-deliver the industry research average financial returns of 2.6X invested capital.
4. “How” will success be achieved? – These are the choices about the work needed to deliver the “What.” We have picked five strategies: a. Keep the funnel full with new investment opportunities – always more deals than we can do.
b. Invest against consistent investment criteria – which we will improve as we learn.
c. Help our invested companies to successful sales – with our perspective on how to succeed.
d. Learn from other investors – at every opportunity. e. Capture and share – what we have learned about achieving success, while acknowledging and understanding the causes of failure.
5. “Which” work will we not do? – We will not: ● Stop learning about what works in Early Stage investing. ● Lose our humility or sense of humor. ● Forget that our objective is to build a sustainable long-term system.