Electronic Mortgage Bottlenecks, Part 6 – External Investment Challenges (A manager’s view on the adoption implications of straight-through mortgage processing) -- June 12, 2007 (Also appearing in the MBA Tech NewsLink)
Is there a trough of disillusionment awaiting the investors and executives in eMortgage technologies and services? When examining the investment marketplace, it is clear that the number of funds supporting startups has risen by an estimated 40% since 2002. However, in the same time period, the projections of funds raised have increased over 600%. The result is a race to find investment opportunities worthy of the deluge of cash that has been committed to support new ideas and management teams.
With this amount of funding available, it is logical to assume that we have regained the heady days of the past when anyone with an idea and a napkin could secure several million dollars? Not really. Why? Investors and fund managers (including VC, hedge, and institutional) all remember those days and are not seeking to repeat them or the lawsuits that followed. Additionally, management teams are keenly aware of the strings and governance challenges that are attached by some of those “generous” fund managers who arrive with checkbook-in-hand.
For firms seeking to establish themselves, independently, or as part of a “carve-out” within the eMortgage industry niche, the education and maturity of the past has a constant presence in their future. For employees of these startup organizations, the lure of stock options or grants, while material to the entire compensation package, no longer view these paper gains as soon-to-be negotiable securities. The lessons learned are many. The historical scars are conspicuously visible.
According to Art Ringwald, one of the mortgage industry’s best-known leaders and current President of the Eastern Division for Metrocities Mortgage, “Individuals and organizations seeking investments of capital must take a practical view of their offerings and the mortgage markets. The mortgage industry is still fragmented and executives and investors are searching out solutions that provide advanced integration capabilities. Organizations seeking funding must fit within the end-to-end value propositions that have been defined by existing customers, competitors, and market needs.”
Furthermore, there is a growing sense that eMortgage offerings and funding could be one of the last untapped “frontiers” within the mortgage verticals. When examining the comprehensive nature of products and offerings that could be of interest (to those seeking to improve margins and lessen risks throughout the value stream), there is a rush to “cash-in” on the interest by prospective buyers. Yet, what unique ideas are deserving of external funding? How will the increasingly crowded field of providers be able to formulate a winning strategy within an area plagued by slow adoption? For management teams, it continues to be about securing an initial advantage and remaining viable or “saleable.”
Cornerstones -- Reality, Pragmatism, and Honesty
Make no mistake about it there are investors in the mortgage markets seeking sustainable ideas, firms, and management teams. While investment firms are often segmented by the sectors they serve, there are nevertheless architectonic components that all startups must provide.
Mr. Ringwald knows from industry and investment experience that, “Companies seeking capital need to address their future expansion opportunities by being able to clearly demonstrate a sustainable revenue growth strategy not just for 12 months but for several or more years. Much like private equity organizations, mortgage investors understand the three to five year investment demands implicit in building and marketing new technology solutions and are willing to commit funding for organizations that have outstanding, yet sustainable partnership and alliance potential.”
Listed below are the ten most common sense criticisms from investment firms when examining requests for funding (even though many are common knowledge for teams experienced in raising capital both within eMortgage and across the industry):
- A realistic business plan based in facts that “checks and foots” between projections. Expect due diligence to be performed in considerable depth complete with background checks.
- A clear understanding of the markets, risks, and potential exits – professional funding is not a government grant or an award. “Demonstrate to us that you know how to make money with this idea and as a company!”
- Securing sustainable funding is about more than intellectual capital (IC) or a “me-too” idea (e.g., “YouTube” clones). Even though IC is important, it is the comprehensive plan of attack, team, market, revenue streams, and opportunity that provides the holistic foundation for a potential funding arrangement.
- Respect for the investor and the community providing the funding – arrogance is never tolerated.
- Being prepared, professional, and pragmatic – the “devil is in the details
- Recognition that when the total funding is completed over several rounds and a period of years, the initial management team or owners may not have a majority ownership.
- Funding is there to realize sales, growth, product or service development, and measurable results – not salaries, benefits, or pre-millennium era perks.
- It’s about more than a “killer” product or singular idea. Repeatability, scalability, and adaptability are keys in achieving projections supported by a strong and experienced management team.
- An inability to take advice and tactical directions. Corollary, “if you are seeking funding, you should expect advice, partner arrangements, and accountability for projections.”
- An inability to adapt and adopt changing market, customer, investor, and industry demands. Contingency plans should be well thought out and discussed.
“Management teams must demonstrate the distinct ability to build upon their corporate foundation, while delivering a quantifiable technology, application, or service that lenders want,” adds Art. “The ability to implement their product or service solution in parallel with existing industry offerings is critical to organizational funding irrespective of the depth of intellectual capital. Consequently, network and data integration will be a prerequisite for any investment grade solution.”
“See the World in a Grain of Sand…”
For investment firms, any idea or company that is soliciting funding must recognize the traditional “traps” that startups and their owners quickly experience. Here is a brief “tune-up” for those seeking professional funding sources and audiences with expert investors:
- Your idea is not the only good idea they have seen in this segment. If a team cannot address the basics of sales, marketing, customers served, sustainable revenues, supported by existing revenues (even if they are small), the likelihood of securing the desired monies is greatly reduced. Also, don’t assume that professional funding firms will meet your NDA guidelines – you’re the one seeking funding and they see countless pitches.
- Do your homework on what ownership rights, board seats, and stock swaps will be required for the level of investment being sought. Additionally, depending upon where the stage of company growth (e.g., seed, expansion, pre-IPO), the funding made available may vary considerably. When in doubt or as part of a confirmation effort, get an outside professional opinion or hire a recognized advisor to represent the firm and prepare the materials for submission. It should be noted, that company valuation is directly set by the market, individual funding firms, and those who are willing to invest.
- Too many small shareholders can create an investment, operational, and communication dilemma for future funding. Professional investors immediately recognize this situation when preparing term sheets -- these groups may have to be consolidated or subordinated to allow professional techniques more conducive for long-term success to flourish. There is also a legal risk with an extensive number of shareholders in these early stages, in addition to an ability to manage changing securities regulations, especially if they are required to take a reduced or subordinate ownership position.
- Surround yourself and the idea with the best people you can find. Secure them with operating, performance, and financial arrangements. A frequent mistake made by startup firms is filling the senior ranks of the company with prior “acquaintances” or seed investors who lack the operational ability to execute and the knowledge to succeed. The same holds true for the board of directors and/or the advisory board. There are numerous authors, advisors, and even books on the subject or startup organizational structures that can be used for reference.
- Listen to the feedback you receive. While you may not be funded by the firm providing the response (or like what they have to say), it can be materially useful for future presentations, documents, and discussions. However, many startups disregard the comments out-of-hand resulting in increased rejections, higher cost of capital, poor terms and conditions (i.e., T’s & C’s), and potential company disappointment. The result is eventual isolation and loss of the initial sacrifices made over a period of years.
In closing, Mr. Ringwald states, “Investment grade opportunities don’t have to be best-in-class solutions from a technology point of view. The offerings must however fit within a framework for industry solutions and be adaptable to changing market and customer demands. Delivering a solution that quantifies and mitigates the ‘pain of the customer’ elevates the chances of securing adequate funding.”
If you secure a mainstream funding source, you can with some confidence, be assured that this interest will continue if you execute according to plan. If the results vary greatly from projections, then the funded organization may find itself again searching for lead investors with a higher tolerance for unpredictability. In rare cases depending upon the voting rights and privileges, professional investors may institute a change in corporate governance and leadership.
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Remember, investment needs and criteria change as the markets evolve and investments are made. What may have been acceptable for prior investments, will not hold true as the market lifecycle progresses. These prior investments and the opportunities they represent for professional investors are analogous to shifting sands – what constitutes an acceptable investment one week, may be gone the next. Perhaps William Blake had it correct, “See the world in a grain of sand…”
Appearing next in the seven part series – “Electronic Mortgage Bottlenecks, Part 7 – An Outsourcing Q&A with Industry Leaders
For 2008 MBA entries, click here