Ground-Floor Investor Criteria

IDE INVESTMENT CRITERIA

IDE has reviewed, and followed up on the results, of over 3,000 companies seeking financing from individual investors. IDE measured the success of a company as investors obtaining their principal return, plus a percentage of profits from investing in a Company. By this measurement only a small percentage of the Companies reviewed by IDE have been successful.

The basic formula for any business is P = P > COG + IC + PM, or Product sales at price grater than Cost of Goods, Infrastructure Costs, and Profit Margin. If the Company fails to achieve this fundamental business benchmark, it has failed as a business effort, and investors cannot receive a profit from investing in that Company

Reasons for Business Failure

The three basic reasons for a business failure, and therefore, are usually:

Lack of sufficient funds - Not enough Money to reach the ' manufacturing, marketing and sales' stage. Due to:
Excessive cost of raising funds, or 'front load' paid to independent sales offices or in-house investor relations departments.
Slow fund raising, resulting in the money raised being used for 'infrastructure costs' to support Company personnel rather than engaging in manufacturing marketing and sales.

Inaccurate assessment by Company management on:

The amount of budgeted funds necessary to reach 'manufacturing marketing and sales'
The ability to create a market for a new product or service.
The Company's ability to achieve a penetration of an existing market on a proven product or service.
The ability to sell a product or service for sufficient profits to continue as a viable long-term company.

Failure to implement the business plan of the Company due to:

Inability to attract and hire qualified personnel.
A focus on product development, rather than product sales.
Inability to apply finances to obtain 'manufacturing, marketing and sales' for a net profitability.

Note that all of the above failures can be attributed to management assessment, decisions and actions. The Harvard Business School studied start up businesses for ten years, concluding that product was the least important factor in successful start up Companies; and that the most important was the ability of the principal who started that Companies.

Valuation of Companies

Buyout Valuation Generally speaking a business can be sold for (3) years of net income, plus the value of the asset of the company. Assuming a Company has $1 million a year in 'net revenues' and $1 million in assets, then the value of that Company in $1M + $1M + $1M = $3M income value = $4 Million

A general business, and commonsense, principle is that the higher a Company's profits, the greater it's worth, and the more investors should pay for a percentage ownership in that Company.

Stock Market Valuation the 'stock market evaluation' of a publicly traded stock uses the same methodology to calculate the value of a company as a 'buyout'.

The difference is that the stock market uses a 'floating number' for the amount of years for the Company's net revenue to establish a value called a 'Price Earnings Ratio' (PE Ratio)

The generally accepted PE ratio has fluctuated in near term historic times from 10 times earnings to 35 times earnings, and at the current time is approximately 20 times earnings. This assumes that the Company will continue to make the same amount of money for 20 years, and that all of this profit will be equally divided among the 'issued and outstanding' shares of the Company. Under this evaluation method then the formula for the same Company noted in 'Buyout Valuation' would be $1M X 20 = $20M income valuation + $1M asset valuation = $21 million.

To arrive at a 'stock market price' the $21 million in valuation is divided by the amount of stock that is issued and outstanding. For instance, if the amount of issued and outstanding stock is:

...5 million shares: then $21M valuation divided by 5M shares = Share price should be $4.20 per share.
...21 million shares: then $21M valuation divided 21M shares = Share price should be $1 a share.
...50 million shares: then $21M valuation divided by 50 million shares = Share price should be 42 cents a share.

In general a stock almost always trades above or below the should be price per share, based on PE ratio changes, general market conditions, specific industry 'groups', and predominantly on market expectations for the future earnings based on market of a specific Company, and/or a specific industry.

Start Up Company Valuation A start up Company is one that has an idea, possibly a patent, and/or current product or service sales at a net loss (that is when PS = P < (less than&# COG + IC + PM). Using the same formulas in either a Buyout or Stock Market valuation, then the valuation of a start up company that has no net income, and no assets is; 3 years Buyout, or 20 years Stock Market X $0 = $0 (income) plus $0 (assets) = $0.

Therefore any valuation assigned to a start up company is based solely on a 'perceived valuation'. This perception comes from an intuitive feeling on the demand for the Company's planned product or service, or from the Company's 'proforma profit projections'.

Sales firms are paid to create this perceived value through introducing elements of 'credibility', 'urgency' and an appeal to 'greed' in sales 'pitches' to investors in order to get them to incest. It is precisely these elements that investors need to have confirmed in writing to avoid buying a false 'perceived' value.

Proforma Profit Projections as the Company's own perception, in projected gross and net profits, of the Company's future net profits over a given period of time. Since Proforma Profit Projections are usually an optimistic 'best case' set of numbers, rarely achieved in reality, because these perceptions/projections are written/complied by:

By a management that sincerely believes in the product/service, and it's own ability to build a successful Company around that product or service.
In the case of a 'scam' or 'legal scam' (overpriced business effort) profit projections are constructed solely for the purposes of attracting investors.

It's important to note some characteristics of 'gross profits' and 'net profits'. Historically the largest 'net profit' or 'earnings' percentage is owned by Microsoft at 30%. While a Company may have a high net profit number initially, any Company that succeeds will grow, and in growing will acquire higher infrastructure costs. Most successful company have net profits from 5% to 20%.

In either case profit projections are an effort to set a current valuation to a Company based on the future net revenue for the Company. Profit projections can by:

Direct, through disclosed profit projections.
Indirect, by what the price the Company is asking for a certain percentage of equity ownership sold to investors. For example. If a Company is selling 15% of 100% divided by 15% = 6.67 X $5M = $33.5. Since this is a 'NET profit' number the Company's gross sales for product or services is the 'inverse' of it's profit margin or earnings. That is, using 17% as a presumed 'earnings' number, the Company would have to have gross sales revenue of a product or service for approximately $198,000,000 to achieve $33.5M in net earnings ($198M gross sales X .17 profit margin = $33.6M net profits.)

Start Up Company Risk Factors The risk factors of a start up Company are higher than investing in a Company that has ongoing net profitable revenue. These risks include:

Management risk. Unproven management, with uncertainty if the Company management has correctly constructed a valid profit model; is capable of creating a net profitable Company; assessed the market and market penetration potential of the Company; correctly assessed the finances needed to start a successful Company and will correctly apply available finances.
Business risk. The same risk as 'stock market' risk factors, composed of fluctuation in earnings, competition, gaining and holding market penetration, and management decisions that affect them.
Regulatory risk. While there are a few exceptions, in general a 'securities' offering is one that's offering equity ownership, or income, to investors. Private securities can be exempt from a full securities registration, but the Company has to file for the exemption to this registration to both the Securities and Exchange Commission, and each state where money is being raised. Failure to recognize or follow 'private placement' securities regulations can result in censure, fines or the SEC seeking a complete shut down of the Company through the court system.
'Locked in' coupled loss risk. Investing in private companies is an all or none proposition. Invested money is supposed to go toward developing the Company, helplessly until a failure of that Company means they will lose 100% of their investment amount; unlike a 'failing stock market Company, where the stock usually retains some percentage of residual value that can be recovered through a sale of that stock.

Since the current risk factors are much higher in start up Companies then existing 'net revenue' companies, the potential rewards to investors have to be higher to be proportionate to risk factors.

Basic Start Up Business 'Partnership' Since the start up risks are substantially higher in start up Companies or business efforts, and any valuation is a 'perceived' value, then the basic bargain that has to be struck between a Company and investors is the age old bargain between labor (the Company) and capital (investors). This basic 'investing' bargain is a 50/50 split of net revenue between 'expertise' and 'financing'.

In a start up company investors know whether or not they have the financing. But without ongoing company revenue, investors cannot know if management has the required expertise to hold up its end of the labor/capital bargain.

It is the intent of IDE to formulate a set of terms for private investing that will reward investors proportionate to their risks, and independently assess the risk factors that bear on the ability of a Company to achieve it's business goals.

Terms Reflect Management Qualifications and/or Intent A 2001/2 study of 100 publicly traded companies disclosed the following statistical data.

A Company has two earnings figures. It's actual earnings from its financial statement, and 'proforma' earnings statements released in press conferences.

In Companies where the 'proforma' earnings statement was very close to the actual earnings statement, the Companies showed an average growth of approximately 15% a year.
In Companies where there was a wide gap between 'proforma' earnings statements and actual earnings statements the Companies showed an average growth of only 4% a year.

This reconfirms our own studies, which have indicated that there is a direct relationship between this picture management 'paints' of a Company, and the success of the Company. The wider the picture of Company potential is from reality, the more like it is that the Company will fail to develop that potential.

Therefore we believe that the terms are an indication of a Company management that is focused on inflating the perception of Company valuation, rather than realistically appraising that evaluation. At best this reflected negatively on the qualifications of the management of a Company, and at worst, an indication of the sincerity of the business intent of the management of a Company.

While this relationship is only dimly understood at this time, and requiring further study, the ad hoc explanation is 'bad people offer bad terms'.

Types of Private Investments There are just tow investment structures:

Ownership with revenue sharing (partnerships) or without revenue sharing (stock).
Income, without ownership.

The following discusses the characteristics of each category, and the terms IDE has formulated to compensate investors for the risk factors noted above.

EQUITY OWNERSHIP (Stock or Partnership) INVESTMENTS

Classifications of Stock (ownership sharing)

Common Stock - A voting percentage ownership in a company. The amount of the percentage of ownership is determined by dividing the amount of stock held by investors by the total amount of stock 'issued and outstanding'.
Preferred Stock- A non-voting percentage ownership in a company. The amount of the percentage of equity ownership in the Company is determined by the conversion rights of preferred stock into common stock. Preferred stock usually carries a 'dividend' payment. In the event of company bankruptcy preferred stock holders are paid off before common stockholders.
Exit Strategies for investors
Initial Public Offering or reverse merger into an already publicly trading 'shell' company.
Buyout. Investors receive percentage of profits if a Company is sold to a third party.

Classifications of Partnerships(ownership sharing with revenue sharing)

Limited Partnership or Limited Liability Corporation, Unit Investment Trust - These are both partnerships where there is a general, managing or interim Partner, who handles the business of the Partnership. The Limited Partners are Passive and play no role in running the Partnership. In exchange they also have no liability for the Partnerships actions.
General Partnership or Limited Liability Partnership - These are where each partner is a working partner in the business of the partnership and all are equally liable for what the partnership does.
Exit Strategy for investors
Revenue Sharing - Investors own a contracted percentage of ownership, plus receive a 'revenue stream' from the net profits of the business equal to their percentage ownership.
Initial Public Offering, reverse merger or buyout - Investors receive their prorated portion of stock or buyout purchase price.
Exclusions. Partnership formed to buy stock in a Company are not acceptable if the Company principals, or affiliates, who own the Company being invested in, are also managing the partnership formed to invest in the Company. Any such partnership must be under management by the investors, because:
If the partnership manager/Company principals are being carried for an interest in that partnership, it is a form of 'double dipping'
In the event of a conflict of interest between the company and investors, if the Company is controlling the partnership the conflict of interest is usually resolved in favor of the company.
The partnership adds a layer of management 'expense' that is unnecessary and redundant, which is avoided if the investors to directly purchase stock in the Company.

General Criteria for Stock and Partnerships

Shared Risks Compensating Terms

In equity ownership in a start up company investors know whether or not they have the money. But without ongoing company revenue investors cannot know if management has the required expertise to hold up it's end of the labor/capital bargain.

Since the investors are risking 100% capital investment loss, it is only proportionate that the Company itself.

Company management must agree to place its ownership in the company, whether in the form of 'partnership units' or 'stock' in escrow until the company achieves pre-negotiated performance benchmarks.

When the Company achieves its performance benchmarks management's equity will revert to them.
If the company does not achieve its performance benchmarks, then the investors will use pre signed management proxy authorizations to obtain new Company management, in order to achieve the performance benchmarks. In this event, both the company and the investors may have to give up 'mutually diluting' equity ownership to this new management.

Shared Rewards Adjustments to the basic partnership bargain between the labor and capital necessary to start a new Company are:

If the Company management has made a cash investment in the company. for example: if Company Management has invested $1 million into their own Company (deferred salaried and consulting fees do not count), and is looking for a matching $1 million from investors: the company would retain 50% ownership for their expertise contribution to the Company, and 25% ownership for the $1 million they have invested in the company. Investors would receive 25% ownership for their $1 million capital contribution.

If the company has ongoing sales one year's net profits are counted as management's capital contribution.

To allow for possible future fund raising IDE membership terms allow for 'mutual dilution'. For example: if the company owns 50%, and the investors own 50%, and at a future date if another investor wishes to buy 50% of the company in exchange for $10 million, then the company management would give up 25% for it's equity ownership, and investors would give up 25% equity or ownership, resulting in: New investors...50%: Old investors...25%: Company...25%.

In the event there are previous investors and the Company sill needs funds to reach the 'manufacturing, marketing and sales' stage, then it is still a Company management has mis-assessed initial capital needs, and has to be classified as in the 'start up phase' requiring 50/50 ownership modeling as above, in addition to any equity owned by previous investors.

Company Performance Projections The IDE membership will subcontract an independent infrastructure study of the company's budgetary and infrastructure needs.

Infrastructure studies The purpose is to determine the infrastructure needs (budgets, personnel, profit modeling, etc.) of the Company, to determine what the Company needs to succeed. These studies are carried out by independent companies, and must be paid for by the company seeking IDE membership funding. If the IDE membership does fund the Company.
Incubator analysis The infrastructure study report will be supplied (under non circumvention, non disclosure agreements) to outsourcing companies that are specialists in the key infrastructure needs of the company, for an analysis of market competition factors.

Potential returns In investing risk must be proportionate to reward. Or:
High risk = High Reward.(Equity)
Low Risk = Low Reward.(Income)

The minimum acceptable rewards for High Risk/High Reward equity or partnership investment are a potential of 40% return per year to investors, for a minimum of five years. This would produce 40 X 5 = 200% - 100% = 100% net profits, divided by 5 = 20% real net returns per year for five years duration. In an equity investment it is expected that these returns will occur on or before the fifth year as the result of the exit strategy.

IDE Membership Exit Strategies The IDE Membership has to have and investment structure that a revenue sharing participation. However, this revenue sharing is deferred until the fifth year. If the company has not filed a public offering by that time the revenue sharing with investors, with investors getting payments equal to their percentage of the net profits of the company. If the company does file an initial public offering, the partnership or trust units convert to the same percentage of common stock in the company.

Accounting review plus project funding.

Project funding - The IDE membership financing is 'all or none'. IDE membership financing will be based on independent infrastructure studies, and if the Company cannot obtain all of the necessary funds, IDE members will provide no funds.
Front Loads - The IDE criteria of an 'automatic disqualifier' for investments with a 40% front load or higher remains in place.
Venture Capital Modeling - The IDE membership will finance companies under the classic 'venture capita' modeling. This modeling requires giving the company funds, measuring Company growth, supplying additional funds, measuring Company growth, and so on, designed to provide a training ground for management to learn how to grow and manage a profitable company.
Structuring - Financing will be accumulated in Trust Accounts, where the IDE members are beneficiaries of the Trust. When sufficient funds are accumulated to finance a particular opportunity the Trust forms a Partnership with the Company with contracted terms are contained herein.
Accounting review - An independent accounting firm will be supplied with the projected infrastructure study budget. The Company will then provide quarterly accounting to the accountant's firm for comparison to the projected budget.

INCOME (Bond or Note) INVESTMENTS

Income investments can be 'bonds', 'notes', 'promissory notes' and 'bridge loans', and sometimes even 'preferred stock'.

There are kinds of income investments, defined by their repayment terms.

Yield. The yield on income investments is stated percentage return, plus a negotiated return of the original investment amount at a specified point in time know as the 'maturity date' of the note or bond.
Distribution. While distribution is frequently mistaken for yield, in fact it belongs under the 'equity' category. The reason is that the 'distribution rate' is most often tied to the profits of a business activity, and is therefore strictly speaking 'revenue sharing' rather than a yield. Therefore distributions often do not have a maturity date, fixed rate, or a repayment of principle investment amount. The investor's distribution often includes both principle and interest repayments. Simplistically in receiving a 20% annual distribution investors would not break even on their 'distribution' investments are oil and gas wells; and insurance annuities.

Bonds or notes are 'rate' by various agencies, with the rating a 'one number' judgment on the perceived ability of the issuer of the note or bond to repay the principle amount of investment.

To restate a basic investing principle, risk must be equivalent to reward:
High Risk = High Reward. (Equity)
Low Risk = Low Reward. (Income)
The only way a lower 'income' reward is acceptable, is with a lower 'income risk'. This can only be achieved if the principal investment amount is secured with collateral.

With Collateral investors don not have to concern themselves with the risk factors noted in equity investing as the collateral isolates investors from business risks. However, in order for this risk isolation to be meaningful the following conditions have to apply to collateral.

Loan Requirements

Collateral must be worth 120% of the loan amount.
Collateral cannot be secured by written 'guarantees' issued by the Company, stock in the Company, or any assets owned by the company. Ina default situation the Company is likely to liquidate Company assets before it defaults on a note.
Title to any collateral pledge as a loan must be held by the lenders/investors, or by an independent fiduciary escrow account until the loan is repaid.
It is not necessary that the collateral be 'liquid', but in the case of illiquid collateral the borrower must supply an independent appraisal of the value of any illiquid collateral.

CONCLUSION

Investing in new or start up companies can be the most profitable investing of all. Venture Capital (VC) firms, on average, make 49% a year investing in new or nearly new companies, even though the same VC firms lose money on 85% of the Companies they invest in. This 'Monte Carlo' modeling requires that the VC firm owns an overwhelming large percentage of each Company, in order for the few winners to compensate the VC firm for the overwhelming number of losing investments.

We believe this modeling is a reflection of the 'investment banking' approach to private investing; which concerns itself with the purchase, securitization (through an Initial Public Offering) and a resale of the VC's ownership in a Company. This stresses a risk transfer to those stockholders who become the 'exit strategy' for VC firms, rather than stressing a long-term partnership that allows the VC firm to share in the profitability of the company.

Their is little doubt that this modeling has worked for a generation, whether it will continue to work without an eager market or IPO's remains to be seen. Regardless of this however individual investors cannot use the same modeling for very simple reasons.

Individual investors do not have to 'clout' to negotiate the massive ownership required by VC firms, and do not have the ability to immediately finance that Company.
Individual investors do not have the financial depth of resources to lose money 85% to 90% on their start up Company investing.

Without the ability to deliberately take to 'Monte Carlo' approach, individual investors have no other choice but to introduce an approach that will increase the number of 'winners' over 'losers'.

The only way to achieve this is to introduce investment structuring designed to be 'win/win' for both the Company and the investors, where if the Company succeeds, both the management of the Company and the investors will profit; but if the company fails, neither profits at the expense of the other...and that the terms assure that both labor and management are engaged in a cooperative business effort, dedicated toward the mutual goal of a successful Company.

Taken on balance we believe that these terms and conditions will eliminate private investments that are 'scams', 'legal scams', 'others people's money', and management unqualified in money management, the development of the infrastructure of a Company; and unknowledgeable in the equity 'give up' necessary by Company management in order to obtain qualified financing.

It is to that end that the above terms are dedicated as part of a due diligence screening process that is nothing more or less than a new paradigm in private investing modeling.

However, we do not believe that these, or any, terms are 'carved in stone', and expect them to evolve, be refined, and even change; reaching to more perfect 'knowledge' from an expanding investor data base, and changing business circumstances.

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