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Tuesday, February 8, 2011

Taking stock of your potential investment

One of the pitfalls in VC financing is erroneous perceptions that investors develop when analyzing entrepreneurs. Not completely erroneous, of course, but rather vague and ungrounded.

Unfortunately, sticking labels on people has always been a tendency. Those labels are a ‘summary’ of what a person has done and still does, and others tend to build upon those their ‘forecasts’ about how the person will act in future. Assuming that an entrepreneur’s past flaws will not necessarily repeat in future is routinely ignored. Analyzers simply take an occurrence and develop their long-term perceptions of other people based on that occurrence.

Sticking an ‘honesty’ label is a classic, I think. We use our prior observations to say if a person is honest or dishonest, thus alleging that the person will be such in all of his future moves.

It’s not so easy to determine whether or not an entrepreneur will act honestly; each step could be interpreted differently, depending on what circumstances preceded it. An investor looks into the past and analyzes how an entrepreneur was evaluated before, but in most instances the investor lacks current data to see if the entrepreneur is honest enough now.

Even with the data aplenty, you can’t fully rely on their truthfulness. According to much research, there’s a major flaw in testing people for honesty, as all of us have at least once done something, for which we can be called dishonest, but does that mean we all want to do other dishonest things in future?

Such traits as perseverance, aggressiveness, inclination to dependence or submission and others are as hard to determine as honesty. While some other traits of an entrepreneur’s character may be just irrelevant.

So, how to take stock of an entrepreneur?

When we assess a person, we set for him standards that we expect from him or adhere to ourselves.

We develop ideas we expect people to act upon, based on prior experience.

When assessing we do not weigh all pros and cons in everything a person does. We respond spontaneously and are oftentimes dependent on our intuition. Intuition is a skill that can hardly be studied and which we typically use unconsciously. We always tend to subconsciously weigh up other people’s doings as ‘correct’ or ‘incorrect,’ and we do not ask ourselves what our assumption is based on.

There are two major approaches to evaluating an entrepreneur that are still valid: analytical and psychological.

The analytical approach is used when an investor completes his study of an entrepreneur (recommendations received, credit reports scrutinized, etc.), and comes down to the investor getting answers to the below questions:

• How will the entrepreneur treat the investor and his company?
• Does the entrepreneur have the traits of character that one should have in this particular business field to achieve success?
• Do the entrepreneur’s traits match those that ensure a successful business?

The psychological approach provides no answers to why people act in a certain manner and not otherwise. The approach helps figure what a person is capable of. With this approach an analyzer purposes to frame a ‘pared-down model’ of the person under scrutiny to predict his reactions in various situations rather than reasons for the person’s action.

You may request the person to undergo some tests (not the best option, I believe), or you may ask him to tell you his life story. Encourage him, and he will eagerly give you an account of his family, achievements, business experience or what he thinks of important aspects of life. It takes asking open questions and be able to listen. A good listener will hear many things he’s interested in reveal themselves unsolicited in a conversation. What questions are worth asking?

First of all, about intellectual efficiency. An investor should try to compare this manager with others he has ever met to see if this new one is part of the investor’s top list (5% of the best). Can the person learn fast? Can he think in conceptual terms? Can he work with numbers fast and accurately? Is he equally skilled in expressing ideas verbally and in writing? Can he make impromptu decisions or does he only stick to plan?

Secondly, about his business approaches and styles. Can he prioritize things or doesn’t know what to start from? Is he impetuous or prudent in decision-making? What strategy does he prefer? Is he reserved or quick-tempered? Sure-footed or easy to stray with the wind? How does he react to force-majeure? Are his goals realistic?

And thirdly, about his personal relationships. What type of relationship does he prefer with his bosses? Is he sincere, stubborn, loyal, responsible? How does he prefer to build relationships with inferiors? Does he feel his responsibility?

A VC investor doesn’t have to have a psychologist on staff to be able to screen an entrepreneur’s personal qualities. Learning some psychological techniques and applying them in work would do.

What do VC investors expect from entrepreneurs?

Personal characteristics:
• High efficiency
• High risk assessment capabilities
• Ability to convince
• Detail-oriented performance
• Psychological compatibility

Entrepreneurial experience:
• Knowledge of the market
• Business records
• Leadership
• Reputation

I recommend that as you analyze an entrepreneur you put down five things you liked and another five things you didn’t like. If a ‘like’ list is shorter than that of “dislike’—do not invest in such a person. When you detect negative traits think how you would act in his shoes. Sometimes, when interacting with your entrepreneur, you might come across things that may prima facie seem negative. If you do not delve deeper and make a no-investment decision, it might turn out that you have missed a terrific investment opportunity.

As an investor you have to consider everything. And make the right decision.


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