First Comes Due Diligence, Then Comes Marriage

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Accepting venture capital can be an exciting yet unnerving experience for first-time entrepreneurs. We spoke to three veterans separately about what it takes to work smoothly with private equity investors.

Entrepreneurs are notably bold, visionary and ambitious. They possess the desire to assess and initiate opportunities independently. These same characteristics can cause many to bristle at the idea of working with outsiders, which is generally a requirement for receiving private equity financing. For this edition of the Journal of EDM Finance, we caught up with three men who have traversed three separate paths to achieve what many recognize as entrepreneurial greatness.

Moctesuma Esparza, Ralph Clark and Donn Clendenon — each possesses the vision, energy, and self-direction that are characteristic of great entrepreneurs. Their knowledge, patience and diligence make them good private equity partners. Over the years, each has led multiple, private equity-backed businesses.

In this article, they share their views about what makes for a successful marriage between investor and entrepreneur.

Moctesuma Esparza loves bringing entertainment to people and is entertained by life. At his core, the producer of feature films “The Milagro Beanfield War” and “Selena,” and executive producer of the 2005 HBO film “Walkout,” considers himself a storyteller.

“I am a storyteller. And because of storytelling, all I do is in pursuit of my goals,” he says.

Esparza considers the word “no” an opportunity to learn. He has a long history of learning about private equity investment and has received private equity financing eight times over the course of his career. His first entrepreneurial venture was an educational film distribution company, with a customer base of schools and libraries focused on Latino and general education.

It was through that venture that he made his first foray into a relationship with private equity investors.

“I made a personal investment and raised the other capital through friends and other interested parties,” he says. While this initial reliance upon his own resources and the support of friends and family allowed him to get the company going, Esparza soon found that he needed access to more capital than his early backers were willing and able to put at risk.

“It was a question of availability of risk capital,” he says. “Beyond start-up, you need a professional investor and risk assessors and support. Professional investors are willing to invest and take risk without the emotional factors that may make individuals lose perspective. A tremendous strength is assessing what is an appropriate risk.” Esparza says that the trouble he faced is not uncommon for entrepreneurs of color. “In the minority space, we need deeper pockets.”

Esparza’s first company folded, largely because its clients were public education institutions that suffered under the passage of California’s Proposition 13, which capped property taxes used to fund the state’s schools, changing the amount of resources schools had at their disposal.

“Instead of categorical financing, which my company depended on, the financing was suddenly exclusively done by the federal government with block grants,” he says. “When that happened, the market Converged to severely constrict the industry. Small players didn’t have enough market-share to survive.” As difficult as it was to see his first business fail, Esparza says it taught him the drawbacks of building a business that was solely dependent on government agencies as clients.

“There must be diversification of income sources. Overdependence [on any one source] means your risk is high.” In 1979, Esparza’s third company Buenavision entered into a private equity relationship with the then new SYNCOM Capital Corporation.

“SYNCOM was a tremendous asset, with both resources and human capital unavailable anywhere else as a minority entrepreneur,” he says. “They provided tremendous management support. But SYNCOM, as a new firm with a small capital base in the early eighties, could not financially support the follow-on growth capital needs of media properties.” Looking back over his years as an entrepreneur who has worked with private equity investors, Esparza is convinced that the decision to seek outside investment was essential to the growth and success of his companies. He admits, however, that initially he was not at all prepared for what his investors would require of him. Nor were his initial expectations of what the investors would bring to the table completely accurate.

“As a young graduate, with a masters in fine arts from UCLA, trying to build a production and distribution company, I was not prepared for how investors raised money from other funds, had their own set of reports and responsibilities, and how that impacted me …Within the context of expectations of an entrepreneur, there must be an acceptance and understanding of the internal rate of return targets that are tied to the risk profile of an investment,” he says.

In time, Esparza came to understand that investors were accountable to their own investors.

“There were disciplines I had to master to be responsive to investors. I did not give the same importance to some things, initially. Giving proper weight to reporting financial results, accounting, measurements and metrics is as important as the day-to-day operations. [For example], a sole proprietor might manage [his/her] business out of a check register, which is something I was guilty of for years. It doesn’t take into account ROI and IRR, or call for balance sheet assets and liabilities. This is a discipline an entrepreneur is compelled to master to be able to communicate with private equity investors to properly trend growth and profitability.” Esparza says another challenge he faced was making the transition from viewing his business as an extension of himself.

“[You have] to understand that the future of the business is distinct from your future. Private equity investors view a business as achieving economic and, hopefully, social goals.

Businesses need to be bought and sold to achieve liquidity and achieve returns. [For entrepreneurs] there is a danger of over identification with their businesses. This is a process, a journey.” Esparza offers a few suggestions to entrepreneurs who are new to private equity investment arrangements.

“Certainly they should seek out events [sponsored by organizations such as NAIC, The Marathon Club, The Executive Leadership Roundtable and the New America Alliance] to meet attorneys, CPAs, consultants and private equity investors to educate themselves to become investment-ready.” Esparza also urges entrepreneurs to conduct their own due diligence. “First-time entrepreneurs may not know how demanding the process is.

[They] may not know on what terms a private equity investor will invest. It is a process to learn to be ready to receive money. A private equity investor’s initial decision that an operation looks promising is merely the first step in what could be a prolonged and intensive due diligence process,one which could take up to 18 months (perhaps longer). There is a long list of detailed information that is required for due diligence.”

Finally, Esparza says entrepreneurs should prepare for the process to take time. “Be prepared to survive while in pursuit of investment,” he says.

“First time entrepreneurs are blessed with tremendous vision, dreams and energy. From a venture capitalist’s perspective, the asset is the entrepreneurs because they bring the dream forward and execute it. Entrepreneurs need support from an operations point of view. An investor has to make an assessment as to whether the success [of a business] is based on the individual, to then support the individual with a team, and provide education and information about expectations and needs.

Ralph Clark is passionate about technology and discovering new things. He’s a voracious reader, and devoted husband and father of four children. As a three-time entrepreneur with Altos Ventures, this NAIC member and Harvard Business School graduate is well equipped to handle the intricacies of private equity partnerships. He encourages firsttime private equity recipients to be passionate about the opportunity for growth. With regard to control and ownership of resources, he says, “I always read and understand the fine print.”

Clark’s first relationship with a private equity investor as an entrepreneur came during the early years of a technology firm he joined: Evolve Software, which specialized in ERP (enterprise resource planning) software.

“There were three or four rounds of financing, but the initial investment was $1 million,” he recalls. “[It came from] Altos Ventures. This was actually the first investment for Altos Ventures.”

Clark says he became open to the idea of private equity investment when he realized it might boost his company’s credibility.

“We wanted to establish credibility. In fact, we believed our only option was to pursue and establish an association with an institutional investor. Others would look at that and want to hitch up.”

“Credibility opens doors. One of the rounds of financing secured a relationship with Bill Hambrecht [Hambrecht and Quist]. That relationship led us to David Yoffie, a Harvard Business School professor who was also on the board of Intel. Governance assistance is also an important piece in accepting private capital. Milestones should be staged out to show progress.” Clark admits he was concerned about the dilution effect of taking on a private equity partner, but says he thought Evolve could reduce the net effect by building value in recruiting, developing, and retaining the most talented people.

“You also have to be careful about the partner you select,” he says. “You and the venture capital partner should have a shared worldview.

Clark considers himself lucky to have hooked up with Altos when the firm was just getting started. “We chose Altos Ventures because they are smart guys who were just starting, energetic, passionate and committed to making an impact. [They] helped us recruit and retain board members and managers. They helped open doors. From a consultative aspect, it was good to have someone passionate about the industry.”

For many entrepreneurs, the accountability that comes with private equity investment takes getting used to. Clark advises that in pursuing private equity investment one should just accept the accountability piece as part of the process.

“As an entrepreneur accepting outside capital, you have to embrace accountability. The challenge in [any] relationship is about managing expectations. There is also a challenge in making sure you don’t have mismatched capital. Your sources of Capital need to match your operation. A long-term player wants long-term capital and resources tied to long-term capital. For example, a semi-conductor operation doesn’t want to align itself with a consumer software firm.” Clark also suggests that entrepreneurs be flexible.

“Sometimes what you end up doing isn’t always what you start out doing. You want patient capital that can be constructive during that process of the journey.” In order to avoid mismatched expectations, Clark says entrepreneurs should take care to always be honest and up front about their own expectations.

“There will be disappointments and setbacks — maybe a wrong hire, and things always take longer than expected — but relationships can survive if you have a shared fundamental worldview.” Evolve eventually went public in August 2000.

Clark says he has no regrets about pursuing private equity investment for the firm. He is currently working with Altos for a third time and urges entrepreneurs who are considering working with private equity investors for the first time to get out and start talking with other entrepreneurs who have some experience.

“Networking is an important aspect of the job.

It puts entrepreneurs in touch with other entrepreneurs to share and provide insight. Altos Ventures hosts events for entrepreneurs. They invite marketing Vps and others to talk about specific subjects.

An outside facilitator is also invited. These events provide opportunities for first-time entrepreneurs to expand and refine their own worldview.” Before entering into any investor relationship, Clark also says do your research and don’t be afraid to be true to yourself.

“Know the person you’re going to marry.

Practice your own due diligence. Know the other deals your prospective [investor] has been involved with. Have your own perspective, and make them aware. Be honest. You want to be able to raise enough capital to reach the next appropriate milestone to show progress and reduce the risk.

“Investors don’t want (or shouldn’t want) to run the company. The optimal relationship is for the investor to provide money and governance while the entrepreneur defines the strategy and executes the tactics. You don’t want a fundamental disconnect with your partner(s). You almost need a Vulcan mind meld with your financing partner.” Perhaps defying the entrepreneurial archetype, Donn Clendenon is someone who is content to work behind the scenes. His tendency toward humility is something he learned from his father. His stepfather, meanwhile, taught him that money “is to be spent and enjoyed.” As CEO of Heatwave Interactive, Clendenon stays true to form for minimizing the risks associated with venture capital projects. He founded Heatwave Interactive, an entertainment gaming software company, along with partner Anthony Castoro, Heatwave’s chief creative officer. Together they have developed a business model that blends the creative talent of the best designers and developers from the games industry with business practices that resemble those of the multi-media, creative powerhouse, Pixar. It is a process they believe will attract additional investors and other strategic partners while allowing for free flowing creativity.

The work environment that he is creating is one Clendenon describes as “conducive to creativity but focused on the bottom line. “[We like to] massage business sensibilities into our creative process,” he says.

World Gaming Corporation was the first Clendenon-founded company for which he raised private equity capital completely on his own. He had worked with private equity investors prior to that, but never for his own company. In 1995, World Gaming was conceptualized to be the world’s first [Web-based] casino. In 1999, it ended up as the Web’s fastest-growing group of non-gambling gaming sites, growing from zero users to more than 500,000 in six months.

“The World Gaming story is not sexy,” Clendenon says. “We raised $327,000 through a 504 private placement, launched the service in November of 1998 and sold the company to in December of 1999 for just north of $10 million.”

He describes the experience as clean and simple. Not nearly so interesting as his next venturebacked business: iSun Networks, which he founded in September 1999.

“iSun was started with the vision of becoming a privately brandable, online social networking application to be paired up with MTV or other major brands that had a large audience and no interactive online presence. It was a way to truly aggregate a user base and maintain a persistent connection, allowing the brands to monetize the service in any number of ways,” he says.

At launch, with a new business model aimed at colleges and universities, Clendenon and his CTO invested $2.1 million, which Clendenon says was necessary “to mobilize and lay the foundation for the technology we required to build this Web-based, AOL-like service.” In an effort to be taken more seriously by the higher education market, Clendenon was also motivated to pursue private equity financing.

“We felt that it would help us accelerate our ability to execute on our core vision and plan as well as help [make the] transition to a longer sales cycle commonly experienced when selling services to the college and university market.” Clendenon says one advantage to having a venture- backed company is that it is more likely to succeed because of the clear access to capital.

Private equity investment, he says, also helps boost a company’s industry perception.

“We felt having professional money behind us would get us taken more seriously by the higher education market than if we were only self-funded.

A private equity partnership should bring capital as well as credibility.

Clendenon didn’t have to search long for a private equity investor. His success with World Gaming Corporation made him the subject of an article featured in the Philadelphia Business Journal. Within five days of that article’s publication, a venture capital firm was sitting in his office.

“It was a foreign experience having a venture capital firm pursuing us, offering more capital than we actually needed at the time,” he says.

Clendenon and his colleagues decided to pursue the opportunity that was before them, not fully understanding what to expect.

The due diligence aspects of the process were more rigorous than he had anticipated. “We wanted to be nimble and maintain the flexibility of our start-up,” he says. “But we quickly realized that due diligence takes time.” After entering into the private equity partnership, Clendenon realized he would have to spend a lot of his time forecasting possibilities and trending conditional aspects of his business. Perhaps the most difficult challenge for him was dealing with reporting and accounting requirements for the monthly board meetings.

“Executive management spent as much time analyzing and running what-if scenarios and preparing documentation for board or committee meetings as we did operating the business.

As you can imagine, that was very difficult when we were in the midst of growing from 17 to more than 60 employees, while at the same time developing new applications for existing technologies.” Although Clendenon and his iSun colleagues had anticipated the need to be accountable to their investors, he admits they could not have anticipated the type of investment deal to which they would eventually agree.

“We didn’t understand the true meaning of a tranche deal. We didn’t realize that every move we made strategically would have to be analyzed at a financial level beyond our capabilities… . We also thought that all venture capitalists were strategic advisors and an extension of our management team. We thought wrong.” Then, in June of 2001, as a result of market conditions and a vision that was incongruent with that of his investors, his private equity partner opted to not invest the $5 million second tranche.

In the end, iSUN fell victim to the same fate as many other technology companies. The only thing Clendenon says he and his colleagues received was half the capital promised and an education. “A very expensive one… . With every venture comes more experience.” With the benefit of hindsight,

He can now reflect on what he should have done differently.

“I would have found out if our company was a strategic fit to their portfolio. I would have asked them what their investment philosophy is and ascertained whether they were active or passive investors.” He also says he would have done as much due diligence on the venture capital firm as they did on iSun, asking himself, ”Would I want this company to be my partner forever?” Clendenon’s latest venture, Heatwave Interactive, has a unique competitive advantage in the interactive entertainment and games market.

But Clendenon says the “boot-strapping” they were doing before they sought private equity investment was slowing the pursuit of their core business model.

“We knew we had to take on outside capital in order to execute on our plan in time to maximize the probability of success.” He was directed toward SYNCOM Venture Partners around the same time that they were directed to him.

“SYNCOM Venture Partners was looking at our industry, and we happened to have the expertise, experience, and had just decided to seek outside capital. The timing was right. But more importantly, [we asked ourselves], ‘who were the partners at SYNCOM? What had they done and what could they offer us more than capital? Did they get our vision? Were they as genuinely passionate about our business as we were? And, could or should we get married to this VC, and would we be better off for it?’” With SYNCOM, Clendenon has found a private equity partner that shares his passion and understands his vision. Perhaps the biggest difference between his past experiences with private equity investors and his current experience with SYNCOM is that the due diligence process was bilateral.

“We got to know them as well as they got to know us,” he says. “We made sure that both our goals and expectations were aligned and that the people with whom we’d be working, we could work with closely.” To entrepreneurs who are new to the private equity arena, Clendenon offers the following tenpoint checklist of considerations (not in order of importance):

1. Make sure you understand that you are taking on a partner, one with whom you will be accountable.

2. Get legal representation.

3. Learn as much as you can about the investors’ investments, investment history, and philosophy and performance expectations.

4. Make sure your plan/vision is bulletproof.

5. Make sure your investor’s expectations are managed properly.


7. Don’t agree to milestones you are not 100 percent confident you can achieve.

8. Make sure that you can make the business fly with only the first tranche (cash investment) because you might not get a second chance.

9. Remember: 100 percent of ownership of an idea or concept is NOTHING! Sixty percent of a funded business is SOMETHING. Be prepared to give a little.

10. Come prepared. Bring your “A” game! The margin for error is narrow.

Clendenon also offers a few words of advice to venture capitalists and fund managers who work with first-time entrepreneurs. First and foremost, he says, “be straight.” “Take an educational approach to dealing with first-time entrepreneurs. There are lots of nuances that first-timers don’t have experience with; there is an educational curve that first-timers don’t have access to. [They] may expect the private equity partner to give money and then go away, but it is a partnership, a marriage. The investor has to outline the “strings” and expectations clearly. They should be as up front and honest and operate with the mind-set of full disclosure, the same as they would expect from the first-time entrepreneur.” Finally, Clendenon encourages investors to “invest in people, not products or ideas.” “Investment is all about managing risk,” he says. “Build a business model that mitigates risk, and investors, once shown the light, will follow”.

Business is about PEOPLE and how they come together to create something while maximizing ROI.”

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