By Steve Gormley, John G. Hayes and Mark E. Evans
You remember exactly where
and when the idea first came to you.
You had turned to a business associate and said something along the
lines of “if someone were able
to provide this service to us, we’d sign up in a heartbeat.” After spending the next six months
researching and analyzing your new business idea and discussing it over lunches
and dinners with friends in the industry, you decide you are ready to become an
entrepreneur. Having spent
hundreds of hours putting together a business plan, you are ready to begin the
task of raising the necessary capital to launch your new venture. As you prepare for your first meeting
with a venture capitalist, you ask yourself questions such as: “How do
these guys look at investment opportunities? Will they share my vision for this venture? Will they think I have the right skills
to pull this off?”
Perhaps we can shed some
light on answers to these questions and others by sharing with you how Great Hill
Partners looks at potential investment opportunities. Entrepreneurs are often surprised to learn that we use a
methodology similar to the one they used to identify and create their new
business venture. Great Hill
Partner’s “Initiatives in Private Equity” strategy is used to
proactively analyze, create and select investment opportunities among our
targeted markets. We use a
rigorous research oriented process to educate ourselves on an industry segment’s
relevant trends, economic profile, competitive landscape, technology and
regulatory developments, etc. This
allows us to have a strong opinion on where an industry is going, what the best
investment strategy is to pursue, and sets a course of action for investing
capital in that industry sector.
As a result of our research, we will often times seek management
candidates to partner with us to start a new venture. We will also seek out existing companies in the targeted
industry to determine if they might need a strong strategic and financial
partner to grow to the next level.
On occasion our research indicates some market segments are not as
attractive as we might have thought initially and we will cease our efforts in
that market.
So what key elements of a business strategy do we focus on before deciding to invest? While the exact list of critical questions is likely to vary with each specific opportunity, the following is a list of key points that we look at when considering an investment.
On this score, most business plans break down into two camps: capturing a small percentage of an extremely large market opportunity or being the dominant player in a smaller market opportunity. In general, we prefer targeting larger market opportunities in which there is likely to be room for several successful companies, particularly for entrepreneurial ventures that are attacking the market with a new strategy, innovative network or some other competitive advantage. Larger market opportunities also tend to attract multiple sources of financing, including bank debt and publicly funded debt and equity, which are useful in financing a company’s long term growth. If a market is too small, these key funding sources may not be readily available. With that being said, niche strategies can prove to be extremely attractive investments when based on a well-executed market domination strategy.
How do we get comfortable with the size of a market opportunity? Although no business plan would be complete without the requisite time-series bar chart, displaying phenomenal market size growth projections from a credible source, such as the Yankee Group or Gartner Group, we prefer to discuss a simple but logical bottoms-up analysis of the targeted marketplace. The global market for data services may be increasing at phenomenal rates, but that does not mean that residential dial-up Internet access in small, rural U.S. markets is an attractive investment opportunity. A credible analysis might include the total size of the addressable customer base, the percent of the market that you expect to capture over time and the average revenue per customer. Building your business model in this fashion will allow potential investors to quickly understand your plan and test the sensitivities against their own assumptions for market prices, market share and customer demand.
Establishing barriers to entry
Great market opportunities do not stay secret for long. What barriers can your company establish to protect your investment from excessive competitive pressures, which tend to have an adverse impact on prices and margins over time? Competitive barriers can be created by numerous ways, including regulatory matters, capital resources, proprietary technology, etc. Even if you possess one or more of these structural barriers, an early mover advantage is also critical. Although a large market opportunity can support multiple players, a company that is late to enter the market and has no differentiated position is unlikely to make an attractive investment. Web hosting is a large, fast growing market, but do you want to be starting the 50th web hosting company operating in your region? Probably not, nor would we want to invest in that plan. One of our current portfolio companies, American Broadband (ABI), a cable system “overbuilder” providing broadband services to residential customers in the Eastern United States, exemplifies an investment with strong barriers to entry and significant market opportunity characteristics. ABI is using the regulatory approval process in its targeted markets to create a significant time-to-market obstacle for competitors that might be targeting the same market. While the company’s business model proves out with reasonable assumptions on its ability to compete profitably with the incumbent telephony and cable providers, a second cable overbuilder is unlikely to enter a market if ABI has already received regulatory approval.
Strong management foundation
Whether you plan on starting a company by yourself or as part of a team, investors will want to get comfortable with the founder’s prior experience, applicability of the current skillset to the new venture being pursued, and abilities to scale with the business plan as envisioned today. This does not mean that you or your co-founders have to have been featured on the front page of the Wall Street Journal to receive venture financing. Rather, we seek leaders that have experience in the targeted market, proven successful records in scaling organizations, and a strong network of potential executives and industry contacts that can be utilized to help the business grow. Sometimes a single individual is of high enough caliber for us to start a company around and at other times it is the complementary skills of the founding management team that convinces us that management has the wherewithal to execute on an opportunity.
In a tight labor market, a company’s ability to attract executive and staff level employees is going to be significantly impacted by the respect and reputation of the company’s senior management team, the quality of its venture partners, and the prospective employee’s outlook on the company’s success potential.
A scalable business model is a key element for capital-intensive telecommunications services investments. If a company’s basic business model is only designed for the specific market conditions in one city, it is unlikely to be a large enough opportunity to get venture investors excited. While there will always be nuances in each new market served, a business must plan to rollout each cluster or segment with similar penetration rates, revenue per customer and capital spending assumptions.
Edge Connections, a Great Hill Partners portfolio company based in Atlanta, demonstrates this point clearly. Edge is an in-building provider of communications services, targeting small and medium enterprises in commercial office buildings. Edge’s business model is very consistent: 28 cities, all with similar return-on-capital ratios. While the competitive dynamics in New York City differ from those in Nashville, the Edge model allows the company to forecast the relevant capital requirements and employees needed to capture the opportunity in each market, while maintaining a consistent level of profitability.
We hope this helps you understand how venture capitalists
may evaluate investment opportunities.
After you have determined that the investment opportunity is exciting,
it is time to start thinking about investment partners. While there are numerous directories
listing VC firms, the best source for finding a partner is often other
entrepreneurs in the industry.
Think hard about what you are seeking in an investor: all money is
green, so take time to think about the intangibles. Take comfort in the fact that strong business plans led by
high caliber management teams almost always find funding.
Steve Gormley is a Managing Partner, John G. Hayes is a Managing Partner and Mark E. Evans is a Partner with Great Hill Partners, a private equity investment firm based in Boston, formed as a successor to Media/Communications Partners in January 1999. Great Hill Partners have invested in more than 35 companies in the communications, media/information and IT infrastructure services sectors and has over $700 million under management. Their recent investments in broadband services include American Broadband, Edge Connections, and DURO Communications. Great Hill Partners is currently pursuing investment opportunities in several segments of the broadband services market including wired and wireless voice and data services and next-generation carriers. The authors may be reached with questions or comments via email at
Steve Gormley: sgormley@greathillpartners.com
John G. Hayes: hayes@greathillpartners.com
Mark E. Evans: mark@greathillpartners.com
BACK TO OCTOBER ISSUES