Just What Are Investors Looking For Anyway?
So much time is devoted to coaching business plan writers on what NOT to do (reference Common Reasons Business Plans Get Rejected), we thought it would be helpful to allocate a few paragraphs to some of the aspects that investors are looking for.
Experience tells us that sophisticated investors are, by nature, a rather finicky lot. Over the course of the last 20-plus years, we have run into all sorts of personalities and varying levels of sophistication. But the one common denominator amongst all potential investors is that they want to make money. They are seeking a return on invested capital (ROIC), and they want to do so with the least amount of risk for a given level or return. This concept has its roots tied to Harry Markowitz’s Modern Portfolio Theory (MPT).
After the financial crisis of 2008 and for a couple of years that followed, the traditional risk-reward paradigm went out the door. During normal market environments (i.e., pre-2008), riskier assets generally garner higher rates of return, but do so with less certainty. The increased uncertainty necessitates a higher rate of return as compensation. The opposite can be said of lower risk assets – they carry greater certainty (less uncertainty) and, therefore, lower rates of return.
The stresses caused by the Great Recession forced many governing bodies and agencies to temporarily alter the risk-reward paradigm by forgiving, extending, or covering many poorly conceived assets. Had it not done so, a significant portion of financial obligations would have been insolvent or, at a minimum, be reclassified as nonperforming assets. The net result would have surely driven the economy and financial markets into even greater turmoil and distress. Through the process of manipulating risky assets, they became divorced from their traditional constructs.
We offer this admittedly rudimentary discussion as a way of underscoring the fact that now, more than ever, investors are focused not only on the return ON invested capital, but also the probability for the return OF invested capital.
Now that we have discussed how an investor thinks (in a relatively broad and generic scope), it is time to consider some of the elements they ponder while perusing a business plan. Ignoring for a moment the fact that the overarching objective for an investor is to earn an acceptable ROIC, we consider many of the questions that will play through their minds when reading your report. Having read and listened to thousands of business plans and pitches, and having poured over a mountain of critical feedback, we can tell you that these are the questions swimming in their minds most often. If you as a business plan writer do not come to the table equipped to answer them, the odds of rejection increase greatly.
What is the underlying problem/opportunity, and the corresponding solution?
This is the most basic element of a business plan – presenting the opportunity and how you intend to address it. If you are struggling at identifying either, it may be that the opportunity is not that great or the solution not that significant. This does not imply that every business solution needs to be a revolutionary concept.
Efficient and highly competitive markets typically lack differentiation. For instance, the decision to open up a new coffee shop may be an effort to attract customers in a new housing area, or it may be an attempt to capture consumers in a high traffic neighborhood. Either way, there is nothing exceptional about the idea of opening a coffee shop. However, being a first-mover or identifying an untapped market opportunity may be notable.
Who are your competitors? How are they different? How will you compete?
Identifying the breadth of a market is vital in determining top-down and bottom-up economics. A potential investor wants to know that the addressable market has enough bandwidth to support the underlying financial assumptions. In some instances, particularly in the case of highly competitive markets (like coffee shops), they may need to see a thorough real estate analysis to validate the need and justify the financials. Such a study might include a survey of traffic patterns, signage locations, and an understanding of which of the surrounding businesses may serve as potential complements or substitutes. In this manner, opening a coffee shop involves much more than creating a logo, purchasing tables and chairs, and deciding on where to place the condiment stand.
How are sales sourced, and what is the latent demand?
Investors always want to know more about sales – the lifeblood of any company. They need to understand not only the strategy in growing units, but also any nuances surrounding sales. Without question, long sale cycles tend to concern savvy investors; the steeper the trajectory to a sale, the greater its uncertainty. Whether public or private, markets typically penalize concepts and actions that clarity.
Potential investors may be curious about the forces surrounding the demand equation. Businesses predicated on one-time sales are treated much differently from those involving a captive customer base from which recurring sales are possible. This typically impacts the underlying valuation multiples that a company can expect.
How is the product manufactured and distributed?
Investors are sticklers for details. When it comes to products they want to know the throughput and capacity of manufacturing, as well as the inventory turns across any given cycle. Moreover, they need to understand the dynamics surrounding distribution. They leave no stone unturned in understanding any delays that may impact the cash cycle and create an unwarranted cash crisis.
How accurately does the financial model portray reality?
Outside of the Executive Summary, the financial component of a business plan is generally regarded as the most critical. It is also the area of a report that draws the most questions and analysis. We devoted an entire narrative to The Art and Science of Financial Modeling in an effort to underscore its role in the composition of an effective business plan.
At any point in time, an investor has a multitude of financial-oriented questions on their mind. Below are but a few questions that we recommend business plan writers become intimately familiar with:
- Are the financial assumptions reasonable?
- What is the cash burn (and burn rate) of the business?
- When will you become profitable?
What is the probability that the business will require another round of funding?
This question is partly related to the financial component of the plan, but we believe it should be addressed separately because of its monumental importance. Investors are wary of the fact that the businesses they fund could face a cash crisis. Underestimating the capital necessary to reach profitability is a real risk that keeps investors up at night. This fear is directly tied to the options at hand, none of which are all that attractive.
- An investor may not be prepared to invest more capital into a concept that has failed to evolve as expected.
- Bringing in additional investors could dilute the ownership of the original stakeholder(s).
- A cash crunch could point to an ineffective management team (discussed later in this piece), and that group may need to be replaced.
What are the risks to your business? How might they be addressed?
Sophisticated investors are absolute pros when it comes to identifying risks in your business plan. Going back to our opening thoughts regarding the risk-reward paradigm, investors are often calculating the sum of these risks. When they collectively outweigh the potential return, the business concept is abandoned.
The best way to overcome some of these concerns is to address them in the narrative and discuss how you plan to conquer these risks. Many times the fact that you identified these risks and offer some viable solutions is enough to quell some the concern. We have devoted an entire narrative to this topic (reference Identifying and Responding to Business Risks).
Who is managing the business, and are they the right person/team?
We see it frequently in the public markets (less often in private markets), executives are replaced due to less than optimal performance. Even the best idea can result in a poor outcome if it is managed improperly. Consider this basic schematic of possible outcomes for a business idea and the corresponding performance of the management team.
While relatively elementary in concept, it brings home the point that investors are faced with one outcome that will maximize their investment dollars – investing in a good idea that is executed by a capable management team. In other words, is the management team able to carry out the vision presented in the business plan? If, as the business plan owner, you are uncertain, then it might be worthwhile to stimulate the management ranks before soliciting investors. Leaving a seat in the management ranks vacant rarely counts against you, unless it is the CEO position.
What is my exit strategy?
This question is a bit of double-edge sword. The investor sitting across the table will be thinking about how they will eventually exit the investment. This could happen either in a buyout, or possibly during a later round of funding. The exit strategy may become your problem, however, when it is not clear to an investor.
We have seen many good ideas and business plans get held up by the lack of visibility surrounding an exit strategy. This can be overcome when the underlying business is highly profitable and is throwing off huge cash flow. In this instance, an investor assumes (and rightly so) that an acquisition will eventually take them out.
Such a scenario segues to the next logical question, who might acquire your company? As noted earlier, this is not something you generally need to worry about with respect to inclusion in your business plan. But it does warrant some consideration offline and before meeting with potential investors. They just might ask either to judge your answer or see if your vision of the business encompasses such an eventuality.