How to pick a winner

Successful entrepreneur Luke Johnson acknowledges that researching the psychological make-up of entrepreneurs is difficult, but here he offers some tips on how to identify, and make the most of, potential

Entrepreneurs are a poorly understood breed. If academics, investors, civil servants and politicians were more familiar with the entrepreneur tribe, returns on capital would improve and industrial policy would be more effective. Founders are by nature individualistic and hard to analyse. Literature on the subject is neither extensive nor profound; given the importance of entrepreneurs to job and wealth creation, it is a costly omission. Academics have tried over the decades to categorise entrepreneurs to provide insight into their motivations and likelihood of success.

For example, Robert Hornaday proposed a simple division between ‘craftsmen’, ‘promoters’ and ‘professional managers’. The first type take great pride in the technical aspects of their products; the second are ‘wheeler dealers’ who concentrate on making money; the final sub-species have a structured approach to their trade, adopting many of the habits of large corporations. Craftsmen are passionate about quality, but often insufficiently ambitious. Promoters lack a long-term perspective. Professional managers can build scale, but may be too inflexible.

Orvis Collins predated this work, with a study in the early sixties. In Enterprising Man (Michigan State University Press, 1964), he and his colleague David Moore wrote about ‘trained’ entrepreneurs, who study MBAs; ‘like father, like son’ types, who inherit a family business; and ‘opportunistic’ entrepreneurs, who seize chances as they arise.

And in the work of researcher Douglas Gray we find an extensive set of typologies, including soloists, inventor-researchers, acquirers, speculators, lifestyle entrepreneurs and conglomerators. In all this work there is a degree of confusion between personality types and outcomes. For example, a ‘promoter’ might become a ‘conglomerator’, and a ‘professional manager’ might be an ‘acquirer’ or an ‘inventor-researcher’. It all seems rather academic, in every sense of the word.

Rule breakers

What interests me most are psychologies, backgrounds and spotting winners. Of course, actual people do not fit into theoretical definitions. By their nature, entrepreneurs are rule breakers who do not conform to sets of rules about their traits and what inspires them. If their magic could be simply identified, it would be a straightforward matter to recognise and back future business champions. Any venture capitalist will tell you how hard it is to know in advance which business prospects will turn into the big hits, and which will stumble and fail.

I like to think my judgment about prospective business partners is getting better, as it should after decades of trying. But there are no guarantees. The most impressive characters can suffer commercial disasters, and the most robust can have breakdowns. I read endless lists of what to look for and what to guard against. But that sort of perfection is impossible in the real world; we are all flawed and, anyway, many of the true stars would never tick all the boxes.

However, I do hold one firm view about entrepreneurs: strengths are more important than weaknesses. If you have one or two remarkable talents, they may carry you to the top in spite of many shortcomings. So, if you are a wonderful salesman, or a brilliant inventor, or a phenomenal picker of people – it might be enough, even if you are a poor general manager.

Entrepreneurs are not typically well-rounded human beings. Like artists, writers and other creative people, entrepreneurs have a mission and a skill they feel an overwhelming urge to pursue. In addition, drive and energy are necessary attributes, while luck and a special ingredient such as those listed above are also required. Even with a comprehensive databank that enabled an exhaustive examination of every living entrepreneur, no one could deliver sure-fire predictions. The sheer breadth of personalities who ascend to the summit shows that there is no single gene for success. I think we can all take comfort from that.

Should I Invest?

There are five questions I ask myself before investing.

1 How good is the management team? The quality of the management of a business is the acid test. If I do not like the people who run the show, forget it. I do not ignore instinct – if my gut feeling tells me the operators are useless, I walk away. Management must have achieved things in their careers. Do not back mad no-hopers who are always punting a crazy new idea. These types will lose you money. Look for winners who are obsessive about their business and who can demonstrate past performance.

Make sure the management team is honest. Working with crooks as partners is a gruesome experience. I recall putting a small amount of money into a tiny print company. Unfortunately, as soon as I invested the sales collapsed, although the business continued to use a constant amount of paper. The operator was doing business off the books, avoiding the taxman and me. I very quickly sold him my shares at a loss.

Managers must have high energy levels and be totally motivated. If they are sickly then the enterprise is doomed – no one who is ill can cope with the demands of building a profitable undertaking. Most importantly, the managers must have knowledge and experience of the trade: they must know the technology, customers, competitors and the best staff.

Finally, many of the best management have a large part of their wealth tied up in the enterprise. Most entrepreneurs are at least partly motivated by money, and to have cash at risk helps focus the mind and management’s interests with those of shareholders.

2 Is this company going to win big? Rather than dealing in and out of endless marginal situations, I look for investments that have the potential to grow substantially, where I can double, treble or quadruple my money. These are the investments that really make the difference to me.

Ideally, I want to see companies that can expand their sales, margins and their multiple. In other words, I pursue situations that will attract a higher P/E ratio over time, having demonstrated significant organic growth in sales and profits.

Generally, I ignore nice, safe little businesses with limited upside. An investment portfolio will only really perform once it’s found a few of the fabled ‘ten-baggers’ (stocks which rise tenfold). Such investments will allow you to end up with excellent returns despite several miserable performers.

Both Peter Lynch and Warren Buffett – two of the legendary investors of our time – agree that longer-term investing in outstanding companies produces above-average returns. The effective private investor focuses on a few sound businesses, running winners and dropping losers.

3 Have they found a solid niche? It’s unusual to find big new British companies growing rapidly. I am much more likely to identify opportunities with a vast upside among small, specialist companies. Such businesses should possess decent barriers to entry, be it a brand, patent, contracts, franchise or other proprietary situation. Ideally, the company should be unique, since it must compete against large competitors which will be better financed.

In the real world, such companies should have products or services that are evolutionary rather than revolutionary, since markets can take years to accept radical changes. Such drawn-out plays can produce low annualised returns that fail to match those produced by small companies delivering follow-on, adapted technology that is usually quicker to profit.

4 Is this firm making sales today, or hoping for sales in future? I want companies that have sales and can market. I tend to avoid entrepreneurs with marvellous gadgets with no proven commercial potential. The hardest thing in business is to build sales from scratch for a new business – so I prefer to support an entrepreneur who understands the marketplace and how to satisfy it.

I avoid research-and-development specialists who do not understand the importance of distribution and coping with the competition.

5 Do management understand the numbers? Do I understand them? I read all available information about the prospective project – be it an annual report, a prospectus, business plan, budget or management accounts. They need to clearly explain the key facts about the profitability, balance sheet and cash flow of the company.

They should identify any obviously scary items, and get me comfortable with them – or give up. There will always be another deal. If the transaction reveals itself as a stinker, I will walk away, no matter how much time and effort I have devoted to the proposal.

I must believe the numbers, and know how the funding and cash cycles and margins will work for the business in question. Only then can I make sensible valuation comparisons with other opportunities and make the right yes/no decision.

Bad business plans

I spend a lot of my time studying business plans from entrepreneurs who are looking for investment. Many are impressive, but some are ghastly. Among the worst offences are the following:

Aggressive confidentiality clauses and an over obsession about non-disclosure agreements. I find this sort of pushy legal stuff very off-putting, especially for startups. Often you are expected to sign-up to very rigid terms without even knowing anything about the proposition. In such circumstances, I just turn the deal down flat. If the entrepreneurs distrust me that much, they ought to seek backing elsewhere. Would-be restaurateurs are often the worst offenders – would I really bother stealing their idea?

Overly technical documents. Business plans should be written in layman’s terms and avoid all jargon and endless acronyms. They should be readable and accessible, not obscure. Inventors can get too wrapped up in their subject – they forget that there are always thousands of projects seeking money. And promoters often use long-winded gobbledegook to disguise a fundamentally bad idea. If I can’t understand the deal, then I don’t get involved.

Lack of focus. Plans that cover too much territory and companies that try to do too much at once don’t appeal to me. Successful concepts are mostly simple, and successful entrepreneurs generally concentrate on a finite market and product range.

Preposterous valuations. Obviously, things that are far too expensive go straight in the bin. Such plans usually work back from a daft conclusion based on wild future projections, or spurious comparisons. Instead, valuations should be based on sensible estimates of what investors would actually pay. Of course, this means you miss the odd Facebook, but I can live with that.

Biographies. These should be honest and full. They are perhaps the single most important part of the entire proposal. I want to really know the owners and individuals who will make the thing happen. Vague or brief CVs make me suspicious. The chief executive and finance director’s résumés are the ones that matter: big-name non-executives cannot compensate for weak executive management who are actually running the business.

The numbers. This is really critical. The funding requirement, the estimated returns, and the cash-flow projections – these must be attractive and sufficiently ambitious to be worthwhile. No one is going to put huge effort into a project that will never grow beyond ‘one man and his dog’. The figures should all be stated up-front in an uncomplicated format. Do not bury them at the back of the pack. Everyone knows whatever you budget will be wrong, but a target to aim for is better than nothing. The key calculation is your cash break-even point; once you hit this revenue and cost combination, you know you can survive – then you can build.

Details of the competition. All capable entrepreneurs know their competition well. If they say they have none they are fooling themselves. A solid business plan has plenty of specifics about their rivals, and why their particular proposition has a genuine competitive advantage.

Perfection. Every situation is flawed, and if you look for an opportunity with no drawbacks then you will never invest in anything. I quite like deals with a known problem, because then it can be addressed and the price can be adjusted to compensate.

Huge appendices and too many spreadsheets. These might be necessary for loan applications, but equity investors tend to decide based on a few key points. All the supportive evidence and background material can be supplied later if the proposal is of real interest. Don’t bury the hooks with padding.

Getting someone else to write it. It shows when advisers rather than principals author a plan – it lacks authenticity. By all means have experts critique your work but actually do the first draft yourself.

Make sure it can be emailed. Do not rely on the post, or present would-be backers with voluminous amounts of paper. Just get their email address and send them the core presentation online. Catch their attention early and it may lead to something.

Unbelievable margins, profits and returns. Plans that suggest your company will quickly achieve operating margins of 35%, returns on capital of 100% and so on are not credible. Be realistic and conservative and you are more likely to be taken seriously.

Writing a compelling business plan is an art. It should give a venture the best possible chance of securing finance and it is worth taking huge care over the task.

A list of don’ts

There are quite a few advisers out there helping start-up companies – banks, accountants, small-business agencies. Much of what they say is sensible enough, but few of these mentors have actually done it themselves. So allow me to present to you a handful of things entrepreneurs should not do when taking the plunge into self-employment.

Do not leave your job. Do not rent fancy commercial premises. Initially use your home or garage. And if you have to get space, make sure it’s short term, like serviced offices. In 1975, Bill Gates dropped out of Harvard and started Microsoft in an Albuquerque motel room. Do not be vain about such matters – low costs are everything.

Do not be put off by the prospect of a downturn. Many great companies are founded when times are tough, and often remarkable opportunities arise despite the economy struggling. I took control of Pizza Express in 1992 – when Britain was in recession – and it changed my career.

Do not spend money on advertising. Especially for fledgling enterprises; PR is a much better bet. There are so many media outlets now, thanks to the digital revolution, that any new product or service can get some editorial coverage if you try hard enough. And not only is PR much cheaper – editorial attention has much more impact.

Do not engage expensive advisers. Teach yourself the basics of commercial law, accountancy, property and so forth. All these professionals will charge substantial fees to tell you things you can discover easily online or in a beginner’s handbook. By gaining a solid understanding of these disciplines you will make better-informed decisions. For complex matters, such as a 120-page lease, you will need advice, but simple things like registering a company you can do yourself.

Do not take on partners in a rush. By all means work with others, but tread cautiously before actually setting up in business with someone. You need to know someone well – their motivation, their ambition, their honesty – before embarking on such a journey together. Running a company is often a demanding affair, and incompatibilities soon come out. Work initially on a trial basis as a partnership before making binding commitments.

Do not go ahead if your spouse or partner is against it. Make sure they are totally supportive of your plans. It is almost impossible to succeed in the challenging task of building a new business if you have huge domestic upheaval too.

Don’t be over ambitious. By all means dream of reaching the stars, but start on a realistic scale and grow. Develop a pilot, make it work, prove the concept, and then seize the day. There will always be unexpected problems and obstacles. Learn how to overcome them while operations are small.

Don’t be lazy or impatient about research and homework. Know your market intimately. Study your prospective customers and rivals obsessively. Learn everything you possibly can about your scheme: the costs, technical issues, staff needs, pricing, marketing and so on. Prepare a comprehensive business plan, even if you don’t need finance, simply as a discipline.

Luke Johnson is chairman of Risk Capital Partners Ltd

[email protected]

This is an edited extract from the book ‘Start it up: Why running your own business is easier than you think’, published by Portfolio Penguin, 2011.

 

Any venture capitalist will tell you how hard it is to know in advance which business prospects will turn into the big hits, and which will stumble and fail

 

The hardest thing in business is to build sales from scratch – so I prefer to support an entrepreneur who understands the marketplace and how to satisfy it Use PR. There are so many media outlets now, thanks to the digital revolution, that any new product or service can get some editorial coverage if you try hard enough