I generally try to avoid too much controversy on this blog. Admittedly, I might occasionally pen a provocative opinion piece, but by and large, I try to stick to informative articles. Earlier this week, I took a call from now investor who really, really wasn’t ready for an investment in his business. That might sound like a contřroversial claim, but I thought it might make interesting reading – particularly if you’re seeking investment yourself.
A significant portion of the deals I review are rejected. With some, this is because I don’t feel confident about the finer details of the business and the market it operates in. With others, I feel the opportunity poses too much risk. But with many, it’s simply because the person pitching hasn’t taken time to try and understand my perspective and requirements.
Missing the point when seeking investment
There can often be a broad misunderstanding between a small business owner and investor. Failure to address this often increases as an investor looks outside their immediate circle of acquaintances.
I wouldn’t consider myself a skilled expert in the world of property. I understand that prices rise in line with demand, but I don’t have an in-depth knowledge of plumbing requirements or interior design. I couldn’t hold an intelligent conversation about the future of installing kitchen cabinets. I don’t have connections with skilled contractors or plumbers. I am not an expert.
By extension, an aspiring real estate entrepreneur is generally not a corporate finance professional. They may not know the difference between a convertible note, general agreement or promissory note. They might be the world’s greatest developer of luxury properties, but their finance knowledge might not extend beyond asking “how much will you charge?”. They might be able to answer basic investment questions, but would be unlikely to hold their own against a seasoned fund manager.
At the end of the day, an investment is a contract; a legal agreement which lays out the terms and conditions agreed upon in exchange for money. A good contract can protect an investor from loss and unnecessary risk, but a bad contract can turn a great investment into a horrible mistake. It’s here that those seeking capital often fall down.
“If you just give me…”
It doesn’t happen often, but occasionally I’ll be faced with a pitch that goes “Henry. If you invest £50,000 into this house, we’ll split the profits 50/50.”. This is usually accompanied by a few flimsy pages of inconsequential pictures, numbers and if I’m lucky, some local market statistics.
What the entrepreneur has failed to spot here is that the investment will be into a legal entity, like a corporation or limited partnership, which will then go on to acquire the property on our behalf. I would either purchase shares in, or extend a loan to this legal entity. Not the entrepreneur, and not the asset. If the entrepreneur were aware of this fact, the pitch would sound more like this;
“Henry. If you invest £50,000 into this venture, we’ll split the profit equally. A corporation, Property Management Ltd. will be formed, in which you will own 50% of the common stock. I will own the other half in exchange for the work I do on the property. The corporation will be used to buy the property. After the fees for maintaining the property are paid, the corporation will distribute 100% of the real estate earnings to the shareholders.”
Why the structure of the deal matters
Unwitting investors are often burned because a deals structure is disadvantageous to their interests. The underlying asset may perform well, but certain terms in the contract may exclude the investor from receiving a fair share of the profits. For example, some investment opportunities have a main shareholder who receives the major share of any profits, or perhaps a portion of profits is withheld for future reinvestment. The entrepreneur might issue separate class of stock with fewer rights, and an unsophisticated investor is at risk of blindly signing a contract without understanding the fine print which ultimately determines how that investment will perform.
Knowing that, any savvy investor will take care to read the fine print and gain an in-depth understanding of the investment and how it should work. They recognise that while the headline story has to be a compelling one, the contract has to be equally compelling.
When reviewing investment opportunities, I look for detail and plenty of material on which I can carry out due diligence. I want to see information about the asset/s I’m investing in, the structure of the investment and how cash will flow from those assets, into the structure and then to me. I’ve written before about the importance of due diligence, and have a helpful article here. I’ve also written about what to looking for in investor literature, which is another important read for those keen on protecting their money.
To expand beyond investments from friends and family, entrepreneurs must take their pitch to a whole new level. There are far more good deals out there than capital, and if an investor doesn’t like what they’re presented with, they’ll rarely offer a second chance. Many business owners are fantastic at what they do, but approaching investors requires an entirely new skillset: the ability to raise capital and seek investment from professionals.
Finally, don’t forget the most obvious part of seeking investment. Once on-board, you have an entirely new master in the former of your investor. You’ve formed a legal obligation to your client, and now have to take regular phone calls and emails with questions and even consult with them before making decisions. If you’re serious about making the deal work, you’ll handle this new partner, but if you don’t think you’ve got the legs to get to the finish line, don’t get in the race.