Wednesday, July 2, 2008/
Want to establish credibility in the mind of the investor? Let me explain that investor’s psychology. DORON BEN-MEIR
By Doron Ben-Meir
I’ve never seen a funding proposal that doesn’t present an impressive J-curve (that is, a steep ramp-up of revenues and profits) in the context of a “conservative” set of revenue forecasts.
Given that VCs will utilise revenue and profit projections as inputs toward establishing a pre-money valuation – surely it makes sense to oversell rather than under sell the opportunity.
As we noted in a previous article, valuation is both art and science so it’s important to understand how the psychology of an investor works.
First, every investor will assume that the numbers presented are at least somewhat optimistic if not completely improbable. Again superficially this supports shooting high on the basis that the numbers are going to be discounted anyway so why start from a low base?
Next is the question of inherent credibility…
If your numbers have been derived top down – survey of the addressable market (often through the use of available market research reports from such firms as Gartner etc) against which a percentage penetration is assumed – then the credibility of the proposition is very low.
Among several flaws in this approach, such analyses are a sign of entrepreneurial laziness in that they demonstrate (on a business maturity scale of 1-100) how a business might transition from 20 to 50, but don’t address how it will move from 0 to 1, 1 to 5 and 5 to 20.
The lower you are on the business maturity scale, the harder it is to get traction and so the more evidence one must bring to be convincing. The real skill of an entrepreneur is how they transition those early numbers – moving from 20 to 50 is less challenging from an entrepreneurial perspective and is typically where management and operational skills are more acutely tested.
So back to our J-curve…
If you can systematically build your numbers from the bottom up with real client engagements and bona fide pipeline, then the inherent credibility of the overall proposition increases and so the discount applied to your projections will reduce.
Finally, a VC worth his salt will spend considerable time in due diligence validating the bottom up analysis to satisfy himself that the projections are grounded in fact. If the findings of this work suggest that the projections are outrageously optimistic, then it reflects badly on the entrepreneur and substantially reduces the probability that the VC will determine that the entrepreneur really knows what he’s doing and can be trusted to operate the business post investment.
In short, there is nothing more important in securing investment than establishing a high degree of credibility in the eyes of the investor. Every aspect of your pitch should bear this in mind and when it comes to your numbers, the J-curve, and your accompanying evidence – demonstrate quickly whether you are a serious prospect or a dreamer.
Read more about venture capitalists
Doron Ben-Meir has been an active venture capital manager for the last eight years. He founded Prescient Venture Capital and prior to that was a consulting investment director of Momentum Funds Management. He was a serial entrepreneur over a 12 year period, co-founding five new technology based businesses.
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