Should I Invest?

Someone comes and asks you to invest in a deal. If you were only given the opportunity to ask three questions using just 17 words in total, what would you ask them?

Spend a few minutes thinking about this and write down your three questions. The point is that by thinking about the core issues, you can save yourself time and money by asking the right questions – and your time might be more valuable than your money.

Should I invest?

Whitwell Rule #1: start by asking the person who is soliciting the funds, “How much are you investing?”

Understanding the motivation of the key players (principal and broker) in an investment situation is important. Motivation has a lot to do with emotion and little to do with theory. Remember that the things that motivate people can differ from person to person. Do not blindly assume that money is the best and only form of motivation. That said, when someone has invested a substantial amount of their own money, they tend to be more focused on the success of that investment than they would otherwise.

The best scenario is when the sponsor has invested money into the deal from their own wallet. However, sometimes people try and make it appear that they have cash at risk, even when they did not actually take cash from their wallet to put into the deal. For example, sometimes people forgo fees that they will have the right to earn pursuant to the deal and “invest” these into the deal. Although this is positive, this is “future money” that they are putting into the deal as opposed to cash from their wallet. Remember, a dollar today has more meaning than a dollar tomorrow.

Another way people try to persuade you that they are committed is by pointing out that because they share in the profits, they have a strong interest in the success of the deal and therefore your interests are harmoniously aligned. Wrong. True alignment means you both stand to either lose or gain based on performance. If he does not have any capital at stake and the deal goes bust you lose capital but he does not.

Another argument that ranks up there with election year promises by politicians is “I have invested sweat equity” when said by someone who in fact also has the means to invest capital but chooses not to do so. You might be surprised how often this is the case.

Real example: I was at a meeting in Tokyo earlier this year listening to a film producer pitch some investors on the idea of investing in his film. He is personally worth millions. He was asking for them to make an initial investment of $5mm. He repeatedly told the group that this movie would return multiples on their money (multi-hundred percent) and that it was virtually risk free due to his connections in the business. I casually asked him how much he was investing and the answer was “zero.” This guy is now a contender for the Hammerhead of the Year Award for 2004. Invested capital tends to increase your motivation and motivation increases your commitment.

Whitwell Rule #2: the second question that I suggest you ask also requires no investment jargon: “When will I get my money back?” An important corollary is “How will you generate the cash needed to return my principal?” This is something we all care about.

How people answer this question reveals a lot about their thought process and the nature of the investment. I like it when their answer shows that they have thought a lot about the importance of returning my principal. I also like it when they talk about back-up plans – since not everything goes right all the time and it helps to have alternatives. In addition, I like answers that are specific and concrete and involve actions that can be taken by the team. Answers which largely depend on external events make me nervous – both because the team does not have the power to control the outcome and also because the team might lose motivation if they face externalities that are less positive than expected. Once team motivation is threatened then the whole deal is at risk.

I also like simple answers. When they cannot answer the question in one sentence I almost invariably do not like the answer. When I worked at James D. Wolfensohn, Incorporated as an mergers and acquisitions analyst, we often drafted “deal memos” for the partners; these memorandums contained summary analysis regarding potential clients or potential deals. Some partners preferred long documents. Notably, our Chairman, the former U.S. Federal Reserve Chairman Paul Volcker demanded one page memorandums. He believed that if you cannot communicate the ideas on one page then you do not really understand the core issues. The same applies to how people answer the second question.

Whitwell Rule #3 : the third question is “Have you done this before?”

If the answer is “yes” then the team is well-positioned. If the answer is “no” then you need to spend more time understanding the qualifications of the team.

Just because the answer is “no” does not mean it is not a good investment. For example, two years ago, I helped sponsor a new residential construction company called Primera Homes in Austin, Texas. The other founders had never created a construction company before but they all had extensive experience in construction and one of the founders had built four businesses from scratch that he grew to $100mm in sales. I believed in their integrity (I still do) and the business proposition was attractive and simple (better quality homes, for less, and built two times faster than the speed of other home builders). They have executed day in and day out and in just 18 months have returned all my capital. The company is profitable and well positioned for the future.

The third question is also designed to help identify key areas that might require more investigation. For example, much to my surprise I still see many business plans that depend on an IPO for the return of investor capital. Many of the authors have never taken a company public and have no clue how burdensome this process can be -- before, during and after the IPO. This hurts their credibility in my eyes.

In review, without reading any thick books on investing, without utilizing any fancy financial theory, without an MBA or CFA, and without memorizing any investment lingo, you can learn a lot about potential investment deals by asking three basic questions:

#1 – how much are YOU investing?
#2 – when will I get my money BACK?
#3 – have you DONE this before?

Investing in these 17 words will save you a lot of time and money. Like most things in life, the good old basics prove to be reliable time and time again. It is amazing how many people preoccupy themselves with all sorts of investment ratio calculations, financial lingo, ultra-detailed legal analysis and in the process forget the basics.

Make It Happen!

Stefan

Comments

[Caramia]

POSTED:Jul 25, 2004 "Whitwell Rule #3 : the third question is “Have you done this before?”

If the answer is “yes” then the team is well-positioned. If the answer is “no” then you need to spend more time understanding the qualifications of the team.

"Just because the answer is “no” does not mean it is not a good investment. For example, two years ago, I helped sponsor a new residential construction company called Primera Homes in Austin, Texas. The other founders had never created a construction company before but they all had extensive experience in construction and one of the founders had built four businesses from scratch that he grew to $100mm in sales. I believed in their integrity (I still do) and the business proposition was attractive and simple (better quality homes, for less, and built two times faster than the speed of other home builders). They have executed day in and day out and in just 18 months have returned all my capital. The company is profitable and well positioned for the future."

How do you feel about Primera Homes now that they have sold out to another investor after going deeply into the red? Do you think it is still o.k. to break Whitwell Rule?