by Scott E McGlon
In 2013, e-commerce will surpass $1.5 trillion in revenue. Online merchants are estimated to lose 1 percent of revenue in fraud and an additional 3 percent annually in wrongly declined transactions or charge-backs. Simply put, the majority of e-commerce platforms merchants are using today (internal or external) do not protect against fraud at a level that could significantly reduce losses incurred by losing billions in potential clean revenue.
Typically, fraudsters detect or stumble upon areas with weak online check-out security points. Often online merchants simply do not do enough to set up rock-solid security features and processes that go well beyond the basics. This white paper’s main objective is to introduce the different ways you can check the validity of every order you receive through your online store and provide tested viable solutions against the significant liability fraud creates for many online merchants.
To start, the fraudster’s are looking for websites that do not do the basics in making sure each online order is valid. Unfortunately, there are thousands of sites that do not do what’s necessary to limit fraudulent activity on their sites. Many online businesses lack the in-house capability to carry out such complex anti-fraud tasks efficiently and at sophistication levels that work.
Some online businesses can get away with limited fraud detection internal processes due to the certain categories that have a much lower probability in receiving fraudulent orders. These categories include, but are not limited to, low-end specialty goods, custom or made-to-order goods, grocery or perishable items, raw materials, and heavy or bulky products (furniture, etc.). Fraudsters love small, high-end products like jewelry, electronics, and collectibles that can easily be resold in almost any market. It is highly recommended that you do your research before investing into certain high-risk product categories.
There are over 100 risk indicators that look for footprints in both online and offline data to determine the validity of a transaction. Knowing and understanding the various risk indicators and what your company can actually execute in regards to the highest level of fraud detection is critical. A simple example of what a fraudulent transaction looks like starts with the addresses used in a transaction. A consumer making an online purchase from an IP address located in Atlanta but has a billing address in Mexico City, Mexico and a ship to address going to Miami should kick out and immediately either put the order on hold for review or decline the transaction altogether. Depending on the complexity of the fraud detection solution your company goes with, the more risk indicators that are integrated into your solution, the higher probability you will stop fraud in its tracks.
Over the last few years, the automated level of sophistication fraud detection solutions has been impressive. This is great for merchants and bad for the fraudsters. For example, some solutions use social media in qualifying transactions as legit or not by seeing which country the card was issued and the strength of the consumer’s social profile on Facebook, Twitter, LinkedIn, and other social networking sites. If the consumer’s LinkedIn account indicates they live around Los Angeles and the issuing card bank was in Switzerland, fraud detection solutions today can flag the order within seconds or minutes of being completed.
There are many things you can look at regarding how to detect fraud. Below outlines some of the more popular ways to detect fraud that can be coded into your shopping cart steps. Depending on your complexity level in how much you can control the ways to detect fraud, you can create a scoring system that determines the level of validity of each order you receive online. The following is ranked based on what is done most frequently.
1. Credit card authorization at time of sale but capture funds at shipping – this option is becoming more popular as e-commerce companies develop their internal SOP’s for fraud prevention. By only authorizing your customer’s credit card allows extra time to review the information and details before you collect payment or ship the order.
2. Address match requirement - by requiring the bill to address to be the same as the ship to address will distract many fraudsters at checkout. This is a top choice and is sometimes bundled with #1 above. By only using this method is not recommended. Fraudsters have been known to wait for delivery at the bill to address and sign for the package.
3. If the distance between bill to & ship to is different, call and verify the reasons why with your customer. Just talking with the customer using their bill to phone number verifies whether or not the order was placed and the right ship to address was entered. This option is not used with high-volume online retailers due to the inefficiencies it causes.
4. IP Geo-Location or Proxy Setting (U.S. – accept, foreign – reject). This is simple for most hosting and shopping carts available today but the fraudsters are getting smart by linking to U.S. based IP address or masking their foreign IP address.
5. Different names on bill to / ship to and not noting it as a gift in the cart. Using different names on the bill to address and ship to address is a definite red flag. Depending on the shopping cart software you use, blocking transactions that have different names can be a sign of a fraudster who plans to intercept the package at the delivery point that requires a signature. A “Gift” check-box option in the shopping cart (if checked) allows this rule to be ignored. However, it is recommended that you call your customer to verify the information entered is correct.
6. ARPS, or Average Revenue per Sale, is another great indicator of fraud. If online sales ARPS is currently $100 but suspicious orders are hitting at $200+ throughout the day or week, it is a good idea to flag these orders and verify them with the customer on record. It is not recommended to only use ARPS as the determining factor for fraudulent activity.
7. If you sell a highly targeted product (jewelry or electronics for example), it is recommended to flag all first time customers. Some companies use this as an opportunity to call and verify the purchase and welcome the new customer to your company. Others use first time customers with at least one additional potential fraud violation before contacting them by phone. Do not verify suspicious activity using chat or email.
8. If you have an online order that shows time on site less than 50% of site average coupled with another fraud violation could equate to fraud activity. It is recommended to call the customer to verify information, request they recite the purchase, and total spent on order.
9. Develop if/then logic based on your target customer demographic historical stats or business intelligence and build your own potential fraud profile. If you have built your shopping cart in-house or work with one of the larger content management system (CMS) or shopping cart providers, you should be able to build out a more comprehensive demographic with a goal that highlights “misfit” customers (successfully checked-out) or visitors. The higher the sophistication, the more fraudulent activity your online business will catch.
10. Flag all high-risk geographies in the United States and, if you ship internationally, worldwide as well. Firewall rules can be set that do not allow transactions from South Africa, India, Russia, China, and Southeast Asia that are known for fraudulent activity. Also parts of Los Angeles, Chicago, Miami, and New York City can be flagged by originating zip codes.
11. Guest checkout vs. registered user checkout. Fraudsters avoid sites that require you to register before checking out since most information is verified during registration.
One of the more important aspects of fraud detection is just paying attention to details of each order. Customer service representatives need to be on the lookout for the obvious potential threats of fraud including ship-to phone numbers that are entered as “(123) 456-7890” or a fake domain extension within the email address provided (email@example.com). Before getting excited about a $1,250 online order that just hit, review all elements of the order either manually or through fraud detection rules. It is critical your CSR’s and sales team ask all the right questions and complete a thorough due-diligence before fulfilling unordinary orders! It never ceases to amaze the number of transaction that slips through the cracks by simply ignoring or not catching the easiest signs of fraud.
To utilize the prevention methods above while optimizing the efficiencies of your customer service department, it is recommended to first define what capabilities you have with your current shopping cart. If you have an in-house IT department, it is much simpler to integrate the most thorough fraud-detection strategy. If you outsource your e-commerce platform, you might be more restricted but most “top-shelf” CMS and shopping cart companies offer fraud detection components within their platforms. Because of the many different product categories sold online, the majority of these platforms require the clients to “turn on” the fraud detection components. Either option, it is recommended to define the level of detection you are shooting for to reduce fraudulent orders getting through your system. The level should be based on what fraud is costing your business today before a plan and budget is put in place.
Most third-party fraud detection companies use a scoring system that meets their client’s objectives to eliminate fraudulent orders. For example, ABC Enterprises, LLC sells high-end GPS tracking devices for multiple applications. Because their sales are both in the electronics and technology industry, their exposure to fraud has hit as high as 7% of gross sales. ABC built a scoring system that best countered the fraudulent activity that they collected. Their example of scoring also included deducting points on checkout information associated with low probability of fraud. The scoring system that ABC put in place automatically declined orders that scored 25 or higher, put all orders on hold that scored 15-24, and fulfilled orders that totaled 14 or less.
ABC Enterprises, LLC Fraud Score Sheet:
The flexibility that comes with a successful scoring system to detect fraud is the flexibility you have in what you score, how you score, and the threshold that ultimately defines whether or not the order can be fulfilled, put on hold, or denied altogether. Many companies tweak their fraud scoring system throughout the year by lowering the threshold totals during the holiday season for example.
In the example above, ABC found through its business intelligence that the majority of fraud orders had Yahoo email account with low time on site. So, ABC gave all orders with Yahoo email accounts a score of 10 plus another seven points if the visit was also under two minutes. Just on these two parameters, ABC saved over $2Mn in potential loss sales in the first year of implementing their fraud scoring system.
A strong fraud detection process has other benefits as well. By successfully defining the characteristics that drive fraudulent orders specific to your online initiatives, allows growth in other markets that were previously cautious in going after.
A well-designed and implemented online fraud detection plan is based on both the transactional and historical business intelligence analysis. The more in-depth the analysis and understanding your core customer demographic, the stronger your fraud detection will be. Any online business can significantly reduce the chance of fraud occurring if both the scoring rules and excution is successfully implemented. The sooner that indicators of fraud are available, the greater the chance that losses can be recovered and address any weaknesses within your SOP’s or CSR training. Effective detection techniques tailored to the merchants order history through scoring every order will build a stronger wall and serve as a deterrent to potential fraudsters.
As e-Commerce continues to grow, online security is an increasingly important issue that you must assertively address to keep your business protected from unnecessary losses. Unfortunately, statistics clearly show the continued growth in both fraud and Internet-based scams. Using every tool and resource to counter fraudulent activity will save you both time and money. It is important to collaborate with other similar e-commerce companies to review what anti-fraud initiatives that have worked well. Good luck!
Scott E McGlon is the President of McGlon Properties, LLC and the author of many blog post on MP Blog. He has been a serial entrepreneur, investor, and president of many successful start-ups since 1998.
by Scott E McGlon
There are some important considerations before investing in a rental property. Let's take a look at these critical points and evaluate for clarity:
LOCATION, LOCATION, LOCATION! (get it?)
BUILDING PERMITS AND WHAT IS COMING
COMPETITION IN THE AREA
WHAT TO START WITH...
In our strong opinion, the best starter real estate investment is a residential, single-family home or condo. Condos are low maintenance because the condo association is there to help with many of the external repairs, leaving you to worry about the interior. On the flip side, condos can nickel-and-dime you to death with monthly association dues that are mandatory.
Single-family homes do attract a favorable tenant. Expect longer-term renters (up to 36 months!) in the form of families and couples. Families (more than one person) are generally better tenants than one person because of the double-income probability and the because of pooled resources and stability. As an investor to maximize your return, you want to find properties that attract this type of demographic. Make sure your renter application clearly asks for all sources of income from all parties that plan to live in your investment.
SHORT and LONG-TERM REAL ESTATE RETURN ON INVESTMENT...
Once all of your choices are narrowed down, it is important to research the appreciation of other similar properties over the last two years, five years, and 10 years if applicable. In most cases, checking out both the lower end and higher end (real estate that you can't afford) of the market could help define what you are buying is in the most aggressive appreciation bracket. Also, define the variance between asking price and actual selling price of similar real estate investments in the area. To expand your estimate toward appreciation potential, look at what easier cosmetic changes (landscape, exterior color, etc.) could do and the kind of tenants it could produce. What you put into your investment might be a significant factor if you decide to sell within a few years vs. a longer-term investment.
DEFINE AND MANAGE CASH FLOW and WORST CASE SCENARIOS...
Be truthful to yourself when breaking down the financials of your new real estate venture. Projecting monthly cash flow is critical so ALWAYS look at the best case scenario but focus on the worst case as well! Evaluating your projected rent minus your fixed expenses (mortgage payment to your bank, property taxes, escrow (if any), and insurance is just the first step. However, be aware the variable expenses usually hurt real estate investors the most. Before closing, invest in a certified home inspection that you pay for!...do not use the sellers or their real estate agents inspection report! Be present for the inspection and walk around with the home inspector so you can see and hear all of the potential issues with the property. Electrical, plumbing, heating & air, roof, and foundation are all expensive to repair or replace. Do not hire the cheapest home inspection - you want and need the best in your area with a great reputation for conducting a thorough inspection every time. Once you get both fixed and variable expenses defined and your projections are still profitable, act quickly before someone else purchases this great property!
RESEARCH RESEARCH RESEARCH
There is a lot of to be made in real estate and the more thorough due-diligence you conduct, the stronger probability your real estate investment return will yield. Keep your expectations realistic and make sure you rely solely on the numbers - not emotion or how much you like the property. There have been many mistakes made in the investment real estate market - make sure that your own finances are strong enough to cover the worst case scenarios. Good luck!
Scott E McGlon is the President of McGlon Properties, LLC and the author of many blog post on MP Blog. He has been a serial entrepreneur, investor, and president of many successful start-ups since 1998.
You are on track for a successful merger if you plan and execute with no excuses while keeping your ultimate pre-defined objectives in tact.
Part I: Planning
Begin Planning at least 100 days before deal completion -- the earlier you begin planning your merger, the higher the chance of success. In fact, starting to prepare for your integration before you even find your target company is critical. Advanced preparation allows you to excel in negotiations, but also let's you get prepared for any challenges that may arise. Trust me, there will be quite a few surprises throughout the process. If you do not have a plan for the target company, you are going to pay the wrong price and you are not going to be ready to handle the integration on multiple fronts. As a deal progresses, it is easy to focus all your efforts on completion and forget about the day after. Oftentimes, in the rush to do the deal, managers put off what they think could be easily done after closing. Ideally, you would start planning as soon as you decide to buy another company. Building a full integration plan around 100 days before you believe the deal will take place will define a lot of things - both positive and negative. To prevent a failed merger, it is important to begin planning early and comprehensively. Although such extensive planning may seem excessive, the benefits are extremely important. By having a strong plan established, you can communicate effectively right out of the gate. Many problems in deals originate from indecisiveness. Good planning and early planning leads to quick decision making, quick delivery and good communications.
Standardize a List of Items to Review During Due Diligence - To maximize your 100 days of planning, it is important to have a prepared list of items to review. For each merger, you should have a very thorough list of items to consider that you should expect to grow throughout the first 30 or so days of your plan. The list will serve as a database of questions and considerations that's sole purpose is to build a targeted list for each deal. This ever-expanding list acts as your insurance that every question, factor, or variable is or will be covered so be as thorough as you can right out of the gate. When determining merger criteria, you need to consider absolutely everything. If you were to start with a blank sheet of paper and invent a 2,000+ person company, you would need to consider every process and every situation to determine the best overall strategy.
Don’t Try to Salvage a Failed Deal - Walking away from a failed deal can be challenging and frustrating. Since most deals tend to take on a life of their own, all parties will have invested so much of their time, effort and career equity in the deal that they typically feel intense psychological pressure to shepherd it through to completion. Do not get yourself in a position where you start favoring information that supports the deal while ignoring information that was originally defined as breaking the deal. If it wasn't meant to be, accept it. Do not let the "pressure to close" drive a bad decision. Just getting a deal done has nothing to do with the ROI you set up to achieve originally Also, transaction urgency is institutionalized and magnified by a reward system that emphasizes deal completion over ROI. Finally, significant deal momentum can often take over an M&A process leading to management blinders around transaction risk or the cost of the deal, especially if multiple parties are still involved near the letter of intent (LOI) stage.
Don’t Forget Basic M&A Principles - Even without the pressure to close, many deal professionals deviate from traditional M&A best practices. Many organizations regularly and inadvertently deceive themselves into thinking they follow M&A best practices when in fact
they don’t. For example, managers often delude themselves around the extent of their
market knowledge, only to bump against deal-breaking information deep into the process at which point they are less likely to acknowledge it. This false-confidence in knowledge or ability can often lead involved parties to miss vital information in due diligence, have ineffective negotiations, and possibly pay the wrong price for an opportunity. Additionally, the people running the deal usually lack the expertise to plan and implement the messy work of post-transaction integration. This lack of attention will quickly derail the initiative and push out the time to value, especially when the post-transaction integration isn't part of the compensation for completing the deal. This myopic tendency can have both short-term and long-term consequences. The turnover in target companies is double the turnover experienced in non-merged companies in the ten years following a merger. M&A best practices and processes, although often cumbersome and detailed, exist for a reason. Companies may have a disciplined M&A approach (designed to reduce risk and streamline their efforts) but they will regularly ignore the process out of laziness, arrogance or difficulty of use. Finally, leaders will frequently over-estimate their firm’s capabilities and under-estimate competitive threats, resulting in a significant increase in deal risk and resources required. It might be worthwhile to critically re-examine your processes, instead of simply relying on past methods.
Expect Information to be Leaked - Although deals are traditionally conducted with an element of discretion and secrecy, it is extremely difficult to guarantee total confidentiality. It is rare that prospective deals stay under the radar for very long, particularly when low to mid-level managers become privy to the process.” As the number of people involved with the deal process grows, it becomes progressively more difficult to ensure confidentiality. Although some leaked details may seem harmless, “a confidentiality breach can have major consequences, including a rapid and unexpected rise in the target firm’s stock price, if they’re public,” explains Osak. Even for private companies, excessive sharing has its risks. Osak continued, “A confidentiality breach can also can incite a competitive response from industry peers or can provoke turnover in the target firm. While proprietary deals are rare to begin with, the fact that a deal is garnering significant interest can lead to ‘deal fever’ which makes an otherwise good deal less profitable.” Because of these risks, it is ill-advised to rely on confidentiality as a prerequisite for deal completion. If possible, anticipate the effects of leaked information and plan them into your acquisition process or negotiations.
Accept that Due Diligence Won’t Uncover Everything - Although thorough, proper planning can help prepare you to navigate a merger successfully, there will be inevitable, unplanned challenges to overcome. As you plan, there will be a whole slew of information that you can’t plan for because your due diligence only throws up a certain amount of information. Although you may have a full plan there will always be information to find out.
At a certain point, Davis believes it is better to accept certain unknowns and simply prepare for the unexpected. “It is better to wait until you’ve bought the company to discuss these issues. After the first few days or weeks, you will be much better equipped to answer these questions and issues,” says Davis. “In some cases, the target company may have already thought about the issues and you can adopt their strategies.”
Part II: Execution
Communicate - One of the most important qualities of a successful post-merger integration is open communication between the acquirer and the acquired. During the entire process, there will be many questions, concerns, and uncertainties on both sides. The more proactive you can be in addressing these various qualms, the smoother the integration will run. Danny A. Davis -- a UK-based merger integration specialist -- emphasized the importance of communication in a successful merger. He explained, “I always look at communications very early. These days, with e-mail systems, it is very simple to promote company-wide communication. Many companies do not do that.” Tom Nelson -- CFO of Racine Federated until they were recently acquired byBadger Meter -- echoed Davis’ sentiments. “Typically, communication is what makes [a merger] work. The best approach is to just get everyone on one page and communicate the best you can. Once the deal is done you want everyone to feel like they’re being treated fairly so that they jump into their job with both feet. If there is uncertainty after the close it can cause real issues in integration.”
Integrating Divisions One-by-One - As soon as your deal closes, it is important to begin integration efforts immediately. To make the process as thorough and as effective as possible, it is important to integrate the two companies on a division-by-division basis. As Davis explained, “It is important that you go through every function and every division - HR, Finance, IT, Sales, Marketing, Distribution, etc. It is vital to think about how to integrate each of those functions because each one pervades the whole organization. IT, for example, helps to manage the data and systems used by all the functions, in all the parts of business. To successfully integrate an entire company, you need to consider each of its pieces." Reviewing divisions piecemeal create new problems if any inter-division lines of communication are cut. “Since you have split out each function to integrate each of them, there is a possibility they may stop communicating with each other,” says Davis. “It is important to ensure that the functions of the divisions remain linked.” Disconnected and de-linked departments can cause serious problems in the long term -- especially as you lay the groundwork for further growth.
Address Conflicting HR Policies and Pay Structures - Combining two unique HR policies can be one of the most sensitive and challenging issues in a merger. If handled improperly -- whether in hiring policies, reporting, hierarchies, or employee benefits -- it can cause vital talent to leave and can crush company culture and morale. Nelson explained, “The real challenge is in the perks that some smaller companies offer to mid or senior level people that you’d prefer not match. Compensation patterns and compensation structures are some of the things to deal with early in the process. However, compensation is just one pain point for the staffs of merging companies. Deeper HR policies, like job reviews, can also create challenges. Nelson noted that “A lot of the policies have to do with supervision. If you can keep as much of the existing supervision as possible you’re better off. Look at HR patterns when you’re looking at the deal. During due diligence or near closing the skeletons start to come out of the closet. You’ll get a sense for the good managers and the ones you need a more hands on approach with. Then you have a meeting with those managers. You’re also sensitive to the fact that if they’re not getting on the bus you need to address that issue.”
Take Control of Finances - After spending so much time focused on financials and purchase price during negotiations, it can be tempting to postpone further financial planning until later in the integration process. However, to postpone would create serious risks. As Nelson explained, “Many times in smaller companies the CEOs or owners don’t do a lot of formal bookkeeping so there is a lot of legwork to get all the numbers and information.” If this informal bookkeeping persists unchecked for too long, cash may begin to disappear. According to Davis, “There are examples of employees at the purchased company, with access to the bank accounts, stealing money. Surprisingly, that still happens today. That is why it is important to get control of the bank accounts, get control of signatures on the bank accounts, and control the drip-feeding money.” This stolen money is particularly problematic because it could include some of your invested capital. “When you purchase a company, there is usually little money in their bank accounts. As a result, you often inject some money early on. Ensuring that money does not go missing is very important. Since the whole point of the deal is to increase profit, it would be a horrible waste to see money just disappear,” says Davis. “That is why finances need to be consolidated relatively quickly.”
Handle Politics - “There is always a lot of politics in a merger,” says Davis. While politics may
seem more of a nuisance than a real threat, ignoring them can yield new, more substantial problems. “For example, if you have two sales and marketing directors, you generally only need one. The consolidation will probably cause some politics, unrest, and issues.” Even more problematic, however, is if the political unrest drives competition and performance misrepresentation. Davis continued, “If you have two sales and marketing directors, you will need to consider the product range each director represents. If you keep only one product range after the merger, will you keep that director? If so, people may be incentivized to lie about future sales of products.” Suddenly, office politics can begin to impact your projections and your financials. "This falsification could lead you into a difficult situation for the next year. If everyone has lied about sales, you will probably predict an unreasonably large profit. Inappropriate estimates can mean mismanaged capital, inappropriate strategies, and even a profit warning (if you are a public company). As a result, some of the politics and ‘lies’ may cause a double set of problems -- issues with integration, products, and people, but also with financial predictions.
Build Identity through Under-branding - For the acquired company, a merger can mean the abrupt transition away from a culture, brand, and identity they have come to value. If dissolving of the identity occurs too quickly, employees can become dissatisfied, which may result in lower productivity and create territorial behavior. Nelson -- very cognizant of the risks of identity shifts -- helped integrate new companies and cultures through the process of ‘ under-branding’. “In this process, the target company’s name is kept in a premier position for a while (XYZ, a division of Racine Federated). This situation allows employees under the new management to retain a sense of identify from the past company,” says Nelson. “Then, over time -- maybe a year or so -- the two brands are more thoroughly merged. By then, the employees feel comfortable being part of the larger organization.” The results of under-branding speak for themselves. Nelson explained, “At Racine, we didn’t see much employee turnover. I think because of the under-branding, which usually lasted a year or so, most of the people are onboard by the time we fully integrated the companies. The people who leave right away are the ones who don’t want to change to the new hiring policies, HR reviews, new culture, etc.”
Remember that each M&A process is different so treat every step you go through with a clear lens. Yes, past experiences can help mold the next deal but keep focused on maximizing the results, good or bad, of every pre-defined step of the process.
by Scott E McGlon
If you really want to be proactively positioned with potential investors, you must be able to answer what I call "the critical ten". These questions remove any doubt in potential investors minds that you, as a founder of a start-up, have what it takes to get your start-up to a self-sustaining business.
Over the past few years, "boiler plate" answers, "canned" presentations, and flying start-up lingo and buzz-words are in almost every executive summary, business plan, and/or start-up presentations to seed, angels, or VC's. If you get nothing out of this blog entry, take the following with you: show sincere passion and be yourself. There is nothing more unappealing than listening to a young founder going over-the-top to try impress the investor(s). My simple advice to every start-up is to be upfront, honest, and straight-forward with the answers to the following questions:
Relax! Being cool under pressure defines confidence with an audience that knows it well. Understanding these questions and presenting the right answers will determine the level of success you achieve with any investor that you get in front of.
Now, go get'em!
Scott E McGlon is the President of McGlon Properties, LLC and the author of many blog post on MP Blog. He has been a serial entrepreneur, investor, and president of many successful start-ups since 1998.
As a start-up looking for seed or early-round capital, you should avoid both "tire kickers" and "information/idea seekers" in the process even if you think it could serve as additional experience or networking. After spending many hours building a qualified investor list, nothing could be more frustrating than having an investor (angel or VC) waste your time and, more importantly, your resources.
However, tire kickers can pose much more long-lasting negative risks to your investment seeking process including losing the legitimate investors along the way. So, to avoid this, it is critical that you recognize who is legit and who is not.
The following are four techniques that you can execute that helps deter this possible liability in your investment deal process. Again, your goal is to spend 99% of your time in quality conversations with the right, pre-qualified investors.
1. Review past Transactions/Investments:
Most investors do not mind talking through their past successful deals. Approaching every investor with the same goal of eliminating tire-kickers or information/idea seekers sets the tone early in your conversations. So, ask for details of past transactions, investments, or even consulting contracts with other start-ups that the investor has been involved in. All sophisticated investors should have at least one of the following apply:
2. Build a Quality Teaser:
As we have previously seen, one of the most important steps to eliminate tire kickers from your process is to build high-quality teasers on your business. A strong teaser is defined as straightforward and informative. More sophisticated and discerning capital providers are wary of sensationalist and promotional material, and will often discount valuable deals if they are advertised excessively. If you build your initial potential investor list with your ideal buyer in mind, it is much more likely that your process will be clean and precise.
To ensure your teasers are high-quality, you should avoid:
3. Keep Notes on Relevant Investors:
One of the best ways to prevent tire kickers or info seekers from slowing your capital deal is to prevent them from ever learning about your company. If you mass distribute or broadly auction your opportunity, the probability of attracting partial interested investors is significantly higher.
Quality of your investor contacts, not the quantity, is what you need to focus on right out of the gate. It is critical for any business or start-up to have relationships with potential investors and to fully understand their expectations and interests. Keeping track of the interests of your potential network of investors requires detailed notes on all of your connections that specifically fits your expectations as well (move fast, has contacts, brings experience to the table, etc.).
4. Prepare and then Communicate:
No matter how well you write your teaser, deck, and/or company intro-video or keep notes on potential investors, some less than "tire kickers" seem to always creep in the process. Every business owner needs to have the objective of identifying and eliminating from conversations as early as possible. The best way to do this is through experience, preparation, and validation. While early-stage preparation and planning may seem lengthy and unnecessary at the time, it can save you tremendous time later and assist in your credibility with the true investors that are interested in your company.
Preparation can take on many legs including so get organized on what you want to ask to your vetted list of qualified investors. Your question list should produce productive answers in helping you further qualify an investor. Lack of engagement, slow to return emails, voice mails, and weak questions are all red flags that the investor might just be a tire kicker.
Another approach is including a cover letter in front of your NDA outlining the type of investor you are looking for and your investment stages before going to a Series A financing. If this approached is used, it is critical that it is professional, straight-forward, and non-offending. Info/idea seekers and tire kickers will often indicate interest early on but later back out once the specifics of the investment is known. Having a cover sheet to your NDA is an easy way to document your expectations right out of the gate. Some investors will request a formal introduction which is usually a 10-30 minute conversation. Make sure you take this opportunity to ask questions as well. Remember that your due-diligence on potential investors is just as important as their due-diligence on your company. Asking the right questions and outlining your fair expectations equates to credibility and raises the possibility of your opportunity to be shared within the investment community.
By following these four guidelines, you will increase your deal speed, close more deals, and build lasting relationships for your future ventures.
by: Frank Demmler
RATIONALE FOR A CONVERTIBLE NOTE - You've started your company and have done a great job of bootstrapping it so far. You've been able to convince some friends and business associates to join you, or to work nights and weekends, so that your product is really beginning to take shape. You know that it will just take a little bit more effort to do those things that will attract an investment from a venture capitalist.
BUT, you need just a modest amount of money to make it from here to there [hence, the term, "bridge loan"].
You get linked up with some angel investors and they get excited about you, your company, and its investment return potential. At that point the conversation usually goes something like this.
You:"Your modest investment will help me get to the point where venture capitalists will want to invest and then it's all downhill from there."
Angel: "You've convinced me. What did you have in mind?"
You: "We need to put together a convertible note with a premium for you for coming in now. That's what all the companies at this stage do."
Angel: "I'm not sure I get it. Please explain."
You: "Once we have done the things that your money will enable us to do [gotten a customer, completed an alpha or beta test, attracted someone to the management team], the VC is going to want to invest. Since we can't really value the company today, we'll let the professional investor establish the value when he invests. In exchange for you coming in now, though, I will offer you a sweetener so that you will buy your stock in that round at a discount to the price the VC pays.
"By making it a note, if something were to go wrong, but nothing will, but if something did, your note will be higher in the pecking order for repayment than stock.
"Besides, if we tried to value the company today, the VC would probably use that value against us when we negotiate his round. I'm just looking out for you so that you're treated fairly."
Angel: "Gee, thanks. Who do I make the check out to? What do I need to sign?" As I've done before in this series, I've taken some poetic license, but it's not too far from the truth. The logic appears to make sense. In many cases, both sides think that they've done the right thing and that it's onward and upward.
STANDARD FEATURES OF A CONVERTIBLE NOTE - A convertible note is a loan to the company, with an interest rate, that the investor has the right to convert the entire principal amount of the note (and often any accrued interest) into equity when an institutional investor subsequently makes an investment. Usually there is a premium for investing at this time. More specifically:
This is the amount that the company is "borrowing" from the investors. In most circumstances, each investor will an identical note with only the names of the note holder and the amount of the note being different. For example, a round of $100,000 might be shared by five investors investing $40,000, $25,000, $15,000, $10,000 and $10,000, respectively. Sometimes, a limited partnership, or its equivalent is formed; the investors invest in that; and then the LP becomes a single investor in the company.
In my recent experience, annual interest rates on these loans are usually in the 6% - 10% range.
In exchange for investing now, the investor is given additional consideration that effectively lowers his price per share as compared to the price paid by the subsequent investor. Often a specified discount in the range of 15-40% is used depending upon lots of circumstances. This number may be fixed or may increase over time. An alternative would be to issue warrants based upon an agreed to formula.
The convertible note is done with the presumption that it will, in fact, be converted. If it isn't, then the method of repayment must be defined.
Further, your private investor is doing this deal for the thrill of potentially making a lot of money. As such there will be restrictions, or prohibitions, related to prepayment.
The interest may be treated in several ways. You may want to have the interest accrue so that it doesn't impact your cash flow. That may be agreeable to the investor if the accrued interest will convert with the principal. Alternatively, you may want to pay the interest quarterly to avoid the additional dilution that would occur with it accruing and converting. Having current income from the investment may be desirable to your investors as well.
You have solicited this investment with the explanation that it will enable you to attract a significant investment on favorable terms. The investor will want to define what that means. Not that you would, but the investor doesn't want your Uncle Charley to invest $1,000 at $10 per share, and have that cause his loan to be converted as well. Usually, there needs to be at least a minimum amount raised before the conversion would occur.
As in any such security transaction [and a loan of this type is a security and must comply with the relevant securities laws], the investors will have certain protective provisions. Usually, certain transactions will require a majority approval of the note holders for such things as taking out loans above a certain amount, selling some or all of the important assets of the company, creating a new security that is senior to theirs, and the like.
This is the date upon which your investor can seek repayment of the note. Depending upon circumstances, this might be as short as 30 days or could stretch over several years.
Default & Remedies
If your investor requests to be repaid per the terms of the agreement, and the company is unable, or unwilling, to make that payment, then your investor will have certain rights that he can invoke through the judicial system.
POTENTIAL FLAWS OF A CONVERTIBLE NOTE
While this may all sound reasonable, the consequences may not be.
Operating objectives won't be met on time - Nine times out of ten (actually more), a first-time entrepreneur will not achieve the operating objectives on a timely basis.
The consequence of this is more money will be needed, and guess who is the only likely source of that money? Look in the mirror.
Achieving operating objectives doesn't attract investment - Even if the operating objectives are achieved, there's no guarantee that an investor will be ready and willing to invest.
The consequence of this is more money will be needed, and guess who is the only likely source of that money? Look in the mirror.
Institutional investors may not honor the terms of the note - Even if you hit your operating objectives and attract an investor to the bargaining table, there's no guarantee that he will abide by the terms of your notes. If you only have one investor at the table, and you're running out of cash [which are both highly likely if you get this far], the Golden Rule will prevail: He who has the gold rules.
If a new investor agrees to invest only on the condition that the convertible note holders waive some, or all, of their rights, your original investors are between a rock and a hard place. They are faced with the decision of giving up all those financial benefits that you had promised them, coming up with additional money themselves, or let the company crater. Remember, a legal agreement is only the default if parties can't negotiate an alternative agreement. In this example, the potential investor can choose not to accept the default, and just walk from the deal.
Institutional investors will probably ignore your valuation as a frame of reference - The premise that not valuing a round today will induce a higher value later is based upon a flawed premise. An institutional investor will establish what he believes to be the company's value at the time of the investment consideration. Valuations of prior rounds, if any, may serve as points of reference, but will not be major determinants of the company's current valuation.
This is particularly true in today's funding environment and applies to all new rounds, not just those funded by angels.
The downside protections aren't really fair - If it gets to the point where the maturity date of the note comes and goes, it's highly unlikely that will be because the company is so prosperous. More than likely, you have not been able to raise the follow on round of investment. As a result, it's highly unlikely that you will be able to repay the notes when requested to do so. Further, the default provisions and remedies won't yield much. You've heard the saying, "You can't get blood from a stone"? Well, you can't get cash out of a close-to-bankrupt company.
Counter-intuitive investment incentives - Quite often, a first-time entrepreneur pitches the convertible note structure so long and so hard, that he begins to believe that the follow on investment by the institutional investor is inevitable. After all, the convertible note is a "bridge" from here to there. That mind set can be very dangerous. The discipline of controlling cash flow can get lax.
Another unintended consequence of this structure is that the institutional investors will have a disincentive to come to the bargaining table. Even if you do everything that you say you will do, you are still going to be an early stage company with lots of risks. The seasoned investor knows that when a first-time entrepreneur raises angel money, it is highly likely that the angels will pony up more money if there are no other alternatives. The investor knows that if he sits on the sidelines, you will further reduce risk with someone else's money and that the Golden Rule is still likely to be in effect when he comes to the table.
APPROPRIATE USE OF CONVERTIBLE NOTES
I opened by saying that I didn't like convertible notes except in specific circumstances. Since I've slammed them so hard, I owe it to you to give you my opinion as to when they are appropriate.
I believe that they are absolutely the right vehicle for economic development organizations such as InnovationWorks, Idea Foundry, the Pittsburgh Digital Greenhouse, and the Pittsburgh Life Sciences Greenhouse. If their early funding launches a great success, then by all means, they deserve to participate on the upside.
I know for a fact that if current policies had been employed by InnovationWorks' predecessor organization when Sean McDonald launched Automated Healthcare, the return on its investment would have been staggering on a relative basis, and awfully darn good on an absolute basis.
I also believe that convertible notes are appropriate investment vehicles for companies that have already raised money at a fixed price and all of the current investors are willing to take their pro rate share of the round.
ADVICE TO ENTREPRENEURS
Think long and hard as to whether a convertible note is really the best way to structure a round of financing, even if it's possible to do so.
A convertible note just delays the resolution of a fundamental difference of opinion about valuation. The passage of time and intervening events are likely to exacerbate those differences, not resolve them. While likely to be painful for all involved parties, it is my sincere opinion that pricing the round, putting that issue behind you, and building value from that point forward will prove to be best for everyone. Surround yourself with professionals, mentors, and advisors who have "been there, done that" and can help you level the playing field.
Frank Demmler is Associate Teaching Professor of Entrepreneurship at the Donald H. Jones Center for Entrepreneurship at the Tepper School of Business at Carnegie Mellon University. Previously he was president & CEO of the Future Fund, general partner of the Pittsburgh Seed Fund, co-founder & investment advisor to the Western Pennsylvania Adventure Capital Fund, as well as vice president, venture development, for The Enterprise Corporation of Pittsburgh.
by David S. Rose
Let's start by understanding that because we are talking about something called "Convertible Debt", it means that whatever it is will start out as one thing, and potentially convert (or "change") into something else. In this case, what the investor receives in exchange for his or her cash starts out as debt, and potentially converts into equity.
Debt is a fancy word for a "loan". That is, I lend you money, and you agree to pay back the money that I loaned you at some known point in the future, along with a specific additional amount of money (called "interest") which is your payment to me for having been willing to loan you money in the first place.
Equity is a fancy word for "ownership". That is, I give you money and you give me part ownership of the company. Because I'm now an owner right alongside you, you don't ever have to pay back the money to me (remember, it wasn't a loan), and even if the company goes broke you still won't owe me a penny. HOWEVER, also because I'm now an owner right alongside you, I get my share of any increase in value that ever happens with the company.
The difference here is that debt results in a fixed payback regardless of whether good things or bad things happen to the company, while equity results in completely variable payback from $0 (if the company goes under) to potentially billions of dollars (if the company ends up being worth a lot of money.)
The key functional aspect of these two very different things is that if I'm putting, say $100,000 into your company as debt, the only thing we need to discuss is the interest rate that you'll pay me for using my money until you pay it back. But if I'm putting it in as equity, then we need to decide what percentage of the company's ownership I will end up with in exchange for my investment. To figure that out, we use the following math equation:
[Amount I'm Investing] ÷ [Company Value] = [Percent Ownership]
Therefore, since we can calculate any one of the three terms if we know the remaining two, and we already know how much I'm investing (remember, we said $100,000), in order to figure out what my ownership percentage will be after the investment, you and I need to agree on a way to figure out what the company valuation is (or will be) at the time I purchase my shares of stock.
So, if I were just going to buy stock in your company today, we would agree on a valuation today, I'd give you the money today, you'd give me the appropriate percentage of the company's stock, and we'd be all set. But that's NOT what we're doing.
Instead, I'm loaning you the money today (for which, as you'll recall, there is no need to set a valuation on the company). HOWEVER, since I really don't want only my money back plus a little interest (heck, I can get that just by putting my money in a bank account, instead of into a very risky startup), we agree that at some point in the future I will be able to convert my loan into the equivalent of cash, and use that money to buy stock in the company.
But because that conversion is going to be happening at some point in the future, while I'm giving you the money today, we need to figure out a few things today,before I am willing to give you the money. Specifically, we need to decide (a) when in the future the debt will convert to equity, and (b) how we will decide the valuation of the company at that point in the future.
The answer to both turns out to be the same thing: we will wait until a richer, more experienced investor comes around and agrees to buy equity in the company. At that point we will convert the debt into equity (a) and we will use as the valuation whatever that other investor is using (b). However, the fact is that I was willing to invest in your company at a time when that other big shot investor was not, and you used my investment to make the company a lot more valuable (and therefore got a high valuation from the other investor) so it doesn't seem fair that I should bear the early stage risk, but get the same reward as a later stage investor, right?
We solve this problem by agreeing that I will get a discount (typically anywhere from 10% to 30%) to whatever the other investor sets the valuation at...which is why we call this a Discounted Convertible Note.
But you know what? Although that sounds fair, it really isn't (or at least serious investors don't think it is.) That's because the more successful you are at using my original money to increase the value of the company, the higher the valuation the next guy will have to pay...and pretty soon the little discount I'm getting doesn't seem so fair after all! For instance, if that same big shot investor would have valued your company in the early days at, say $1 million, but is eventually willing to invest in you at a valuation of, say, $5 million, that means you were able to increase the company's value 500% using my original seed money.
But if my convertible note says that it will convert at only a 20% discount to that $5 million, for example (which, if you do the math, is $4 million), I would seem to have made a very, very bad deal! Why? Because I end up paying for your stock based on a $4 million valuation, instead of the $1 million it was worth in its early days when i was willing to make my risky investment! No fair!
So how do we solve this problem? What we do is say "OK, because I'm investing early, I'll get the 20% discount on whatever valuation the next guy gives you...BUT just to be sure that things don't get crazy, we will also say that regardless of whatever crazy valuation HE is willing to give you, in no case will the valuation at which MY debt converts ever be higher than, say, $1 million." That figure is known as the "cap", because it establishes the highest price at which my debt can ever convert to equity.
And that is why we call this form of investment (which these days is used by most angel investors) a Discounted Convertible Note with a Cap.
About the author: David S. Rose, Entrepreneur, Investor, Mentor - serial entrepreneur and active angel investor, based in New York. As an inveterate startup guy, I've founded half a dozen companies since my first at age 10, and as ‘super angel’ technology investor, I have funded over 80 others. I am the founder and CEO of Gust, the entrepreneurial finance industry's infrastructure platform; founder and Chairman Emeritus of New York Angels, one of the leading angel groups on the East Coast; Managing Principal of Rose Tech Ventures, an early-stage ‘super angel’ fund specializing in Internet-based business; Partner in True Global Ventures (an international super-angel venture capital fund) and Chairman of Egret Capital Partners, a middle market private equity firm.
MP, LLC credits blog post with the original author and links (if available).
Scott E McGlon is the President of McGlon Properties, LLC and the author of many blog posts on MP Blog. He has been a serial entrepreneur, entrepreneur-in-residence, investor, and president/CEO of many successful start-ups since 1998.
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