Lesson #10: How Best to Approach VC's or Angel Investors

I can't tell you how many entrepreneurs first approach investors, either at the wrong time, in the wrong way or in the wrong format.  Today, we will tackle these simple to fix pitfalls.

Firstly, what do I mean by wrong time.  It is important you have all the required elements in place before approaching investors.  This includes completing all the necessary research supporting your business plan (see Lesson #7 on how to write a business plan).  And, if possible, it is preferred to have some type of "proof of concept" behind you.  This could include a working prototype, closed customer contracts, brand name pipeline, growing traffic to the site, proven team in place, etc.  Anything that gets the investor comfortable that heavy lifting research is behind you, there is some initial traction for the product and a solid team is ready to begin execution of the plan.  If you don't have these pieces of the puzzle firmly in place, wait before approaching any professional investors.

Secondly, the proper way to approach an investor is typically through a referral.  The investor is much more likely to hear your pitch (among the 200 they listen to each year), if it is being sent to them via somebody they already know and trust, that can vouch for you.  So, use LinkedIn looking for mutual connections that can open that door for you, if possible.  Or, asking your lawyer or accountant for intros.  If there are no mutual connections, you have no choice but to cold call the investor, your lowest odds of probability to getting a deal done.  But, if that is your only option, it is important you come across and professional, smart, enthusiastic and well-polished in both your information and your delivery.

As for the desired format, I typically find that investors are very busy, and are more receptive to getting an introduction via email (which you can access via their website or calling their office).  Email gives them a chance to research you and your idea, before committing to a phone call or an in person meeting.  So, make sure you keep a clean social networking trail on Facebook and Twitter, as they will most certainly be Googling you.  And, make sure your LinkedIn profile is complete and compelling, as it is your online resume.

The contents of that email are the most critical.  Remember the short attention span of investors: if they can't understand your business in 30 seconds of reading, they are moving on to the next one.  So, you need a very short and sweetly written cover letter that summarizes your story in a few sentences (not paragraphs!).  Something that gets them jazzed up.

For example, iExplore's email could have read: "iExplore is the #1 ranked website in the rapidly growing $10BN adventure travel industry with over 1MM visitors per month and a strategic partnership with National Geographic.  Our revenues are growing 50% per year and we are raising venture capital which should yield you a 10x return.  See attached for more details in our executive summary.  Let me know a good time for an introductory call or meeting to discuss further.  How do you look on Friday morning?"  That's all you really need, including a clickable link to your website so they can easily learn about your product in more detail (so make sure you have a snazzy website, to back up your snazzy pitch).

Notice what that paragraph did: (i) described the business and its leading market position; (ii) detailed industry size and growth; (iii) highlighted a brand name strategic partner; (iv) showed the business was driving revenues, and how quickly they were scaling; (v) and wet their beak with the opportunity to make a big 10x return.  That was a lot to accomplish in two sentences.  The paragraph also closes (as it always should) with a clear call to action, which will be very easy for the investor to hit reply and say "Friday looks fine at 9am". 

Now that the cover letter is solid, follow the above linked Lesson #7 to prepare a 1-2 page executive summary information (with the best of the best from the bigger business plan, include management bios and five year forecast).  That is it.  Do not send them any more than this, as they will not read it at this time.  They will certainly ask for much more information during the due diligence process, which you will already have prepared with your full plan sitting in reserve.  And, worth mentioning again, graphics and charts, go a lot further than text to getting your message across as quickly and effectively as you can.

You only have one chance to make a good first impression with a prospective investor.  Don't blow it!

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Lesson #9: Spreading Equity to Key Employees and Partners

As a rule, entrepreneurs are very protective of their equity, and try to keep 100% ownership for themselves.  Usually this is fine, provided that important key parties (e.g., employees, partners) are appropriately motivated to help you succeed.  Sometimes that motivation comes in the form of cash compensation (e.g., lucrative sales commission plan, profit share plan), and sometimes that comes in the form of equity or equity linked incentives (e.g., stock, options, warrants).

For employees, my rule of thumb is to set aside 10%-20% of the company's equity for the key members of the team.  You can spread that as far as you like, from as few as your senior executives (e.g., 2-4% per senior exec), to as many as the entire organization (e.g., 1-2% per senior exec, 0.1-0.2% for junior staff).  I typically reserve equity for the key individuals that are going to help my business the most, regardless of title.  For example, if your key developer has been critical to building and maintaining the code of your site, and you require his long term commitment for R&D improvements, make sure he is motivated to stick around.  And, it is important the employee thinks they are properly being motivated.  Each employee beats to a different drum, some prefer a smaller cash based package and others prefer a bigger equity based package.  So, design a package that works for both parties.  I typically give the a matrix of options (e.g., big cash/low equity, medium cash/medium equity, low cash/high equity), and let them pick what works best for them.  And, worth mentioning, equity should only be given to employees you deem are full-time, long term partners of the business (not part time contractors that may come and go over time).

And, when we talk about giving equity, there are many structural considerations.  Unless they are a co-founder at the time the company is formed, giving an employee stock outright has two problems: (i) the recipient and the company will both have immediate tax implications, as stock grant would be treated like immediate compensation; and (ii) if that employee quits tomorrow, you don't want them to walk away with the equity.  So, to address these issues, you would set up a stock option plan, or something similar, where the employee: (i) has the right to purchase equity at today's fair market value; and (ii) the options have a vesting schedule with the employee's purchase rights being earned over time (e.g., over four years, 25% of the grant is earned in each year).  That keeps the employee more committed for the long term, which is what you want, and only rewards them for actual time invested with the business.  Also, be sure that the stock option plan provides the company with a mechanism to easily repurchase any exercised shares from the employee at any time, so you can easily recapture ownership down the road (if things go awry with the employee, or if there is an impending change of control that requires recapturing 100% of the outstanding shares).

If you don't want to spread actual equity or options, you can easily accomplish the same goal with a "phantom equity" plan, that basically mimics equity ownership via a profit share plan or otherwise.  For example, employee could own 5% of all net income created each year, instead of 5% of equity.  Or, employee could own 5% of the company's valuation at a mutually acceptable revenue, EBITDA or net income multiple.  These plans typically are paid in cash, or accrue as interest bearing debt until paid out, so make sure you anticipate having the cash resources to relieve these claims before going down this road.

In Lesson #6 we talked about the important of strategic partners to help you grow your business.  And, as we mentioned before, it is important to spread the equity/upside with such partners, as well, so they are motivated to see you succeed.  Typically with strategic partnerships, you are simply granting them stand alone, 3-5 year warrants with a strike price of today's current fair market value, with similar repurchase options for the company.  Strategic partners could get 5%-20% of the equity, depending on how important they are for your business.

Now, you might be saying, you just gave away 10-20% for key employees and 5%-20% for the key strategic partner, that totals 15%-40% of the company.  First of all, you didn't "give" it away, the employees and the partner have to earn their upside before they exercise their options or warrants (e.g., grow the company's business and valuation, bound by vesting rights that accrue over time).  But, more importantly, I would rather own 60-85% of a wildly successful business, than 100% of a business where the staff and partners are not invested in our mutual success.

Also, worth mentioning, if the business requires outside capital, all parties would share pro-rata in the dilution from that equity financing.  So, an an example, post a financing, your ending ownership table could look like:  founder 50.1%; investor 30%; partner 10% and employees 9.9%.  So, forecast your desired ending ownership well ahead of time, to protect yourself from losing majority control of your business down the road (unless you are OK doing so).

It is hard to do this topic justice with one simple post, given all the variations to a theme for motivating your team and partners, but hopefully it gave you a good sense to the importance of this topic and a few mechanics you can use to implement such.  I am happy to help you think through any specific issues you may have, if there are any questions.

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Lesson #8: Startups Require Flexibility to Optimize Business Model

The #1 reason nine out of 10 starts ups fail is the fact they did not pivot fast enough, or stayed too focused or impassioned on their original failing model.  For most successful startups, their final business model was the end product of numerous iterations and evolutions from where they first started.  It is critical you constantly tinker with your model until you get it right.

Here are a few notable examples to emphasize this point.  YouTube who gained success as a video portal site, started off as a failing video dating site.  Groupon who gained success as a deal of the day site, started off as a failing fund raising site.  Trip Advisor who gained success as a hotel reviews site, first started off as a failing search engine technology for the travel industry.  Similar pivots happened at Twitter, Paypal, Pandora and numerous other "home run" startups, before they hit it big.  That is not to say that 100% of all startups require a pivot to succeed, as there are numerous examples of companies that did just fine with their original model (e.g., Amazon, eBay, LinkedIn, Facebook, Yelp).  But, the point is, identify your pitfalls and failures early enough, while there is still time to evolve the business before it is too late.

I will use iExplore, the online adventure travel business I ran for 10 years, to further exemplify this point.  iExplore's original revenue model was being an online travel agency of 5,000 adventure tours from 200 third party suppliers, earning a 15% commission on any tours we booked through our call center.  We learned there were a few problems with that model: (1) 15% commissions are not a lot of money to drive a very profitable business without tremendous scale; (2) there were too many suppliers to drive enough volume to any one to become important to them;  and (3) the huge product selection was too intimidating for the user; all the customer knew was they wanted to go on a safari to Africa, and they could not easily differentiate between the 100 safaris we offered on our site going to unknown places like Kenya, Tanzania, South Africa, Botswana, Namibia and Zimbabwe.

So, iExplore's first pivot was to dramatically cut back the trip and supplier offering, cutting to 2,000 trips and 20 key suppliers.  That made the customer experience more easy to navigate, while at the same time, started pushing more volume to a select group of preferred vendors.  This latter point was critical to driving our commissions up from 15% to 20%, the commissions paid by suppliers to their highest volume travel agencies.

iExplore second and third pivots happened in the wake of 9/11/01, when revenues were very hard to come by and the company was bleeding cash as consumers stopped traveling.  The second pivot was to evolve the travel business even further.  Instead of being a 20% travel agency, if we changed the nature of how we secured our suppliers, we could become a 35% margin tour operator, competing directly with many of the suppliers we had worked with to date.  So, instead of working with the U.S. based tour operators like Abercrombie & Kent, Backroads or Mountain Travel Sobek, we established relationships with the actual ground operations companies based in 70 cities across the globe (e.g., the same ground operators our suppliers were using), and a launched a line of 300 iExplore branded tours.

Normally a move like that could have been suicidal, abruptly competing with our suppliers.  But, in iExplore's case, the iExplore website had grown to over 1MM unique visitors per month and had built up a well known brand name in the space (compared to the traffic at our suppliers in the 50K per month range).  So, we felt we could comfortably make that pivot without impacting the business.  And, frankly, we had no choice in the wake of 9/11/01, as we needed a major model shift to stop the cash bleed.

iExplore's third pivot was its most important.  It transitioned the business from basically a break even travel business, to a wildly profitable economic model.  That involved entering the online ad sales business, as a secondary and complementary revenue stream to our travel revenues.  When we studied the traffic from our 1MM visitors a month, only 10% were in the trip finder where we sold trips and drove revenues.  The other 90% were looking at tour book content and engaging in the travel community.  So, we tested placing online advertising on that 90% of our traffic.  Once we were sure there was no negative consumer impact to our travel business,  we rolled it out more aggressively.  The resulting impact was a 30% lift in revenues, with a 75% contribution margin revenue stream (compared to 10% contribution margins on our travel business), fueling the bottom line profits to new heights.  That was the Eureka! moment for the business, and put the company in position to be sold in 2007 (eight years after launching the business).

Had iExplore stayed an online travel agency, it would have never survived 9/11/01.  Had Groupon stayed a fund raising site, or YouTube an online dating site, neither of those businesses would have become the huge successes they ultimately did.  So, constantly tinker with your business and take off your blinders for ultimate success (or survival).  Good luck!

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Lesson #7: Key Components for Writing a Business Plan

When writing a business plan, it is critical to do research and set strategy across the following key topics:  (1) your industry/competition; (2) business/revenue model; (3)  sales/marketing plan; (4) management team; (5) cash requirements; and (6) forecasted financials/expected ROI.  When you are done, you will end up with the necessary research to back up the key assumptions of your plan.  We will tackle each of these points below.

Industry/Competition:  To me, this is the most critical research that needs to be done upfront.  How large is your industry?  Who are the key competitors?  How quickly is the industry growing?  Are you a first mover, or entering a crowded space?  What share of the market is reasonable to capture for your business?  Investors like to invest in large, growing markets as a first mover with limited competition where a business can scale up to 10-20% share.  So, pitching them the "next Google search engine" is a very large market opportunity, but would be very difficult to build with large, well capitalized competitors in the search space that would aggressively defend their turf.  On the flip side, pitching them the newest patentable innovation in door hinges may be perceived as less competitive and disruptive in the marketplace, but the market is really small to build material scale.  You need that right intersection of large market opportunity, disruptive/defensible business and limited competition.

Business/Revenue Model:    Now that you have found your ripe industry opportunity, what kind of business are you building?  A hardware solution?  An installed software solution?  Software as a service?  And, more importantly, how are you going to make money?  One time purchase? Recurring monthly revenues?  Heavy repeat usage?  Where are your prices vs. competitors?  What value are you bringing vs. current solutions in the market?  Investors obviously prefer large and recurring revenue streams for disruptive businesses that bring terrific value to their customers.

Sales/Marketing Plan:  The next step is figuring out your go-to-market strategy?  Does the product appeal to business clients (B2B) or consumers (B2C)?  Is it dependent on building a big team of salespeople?  Does it require a heavy investment in consumer marketing?  If marketing, is it going to be driven by the search engines online or direct mailers or trade shows?   Does it require any social media or viral elements for success?  Typically sales-driven B2B business are cheaper to launch than marketing-driven B2C businesses.  But, B2B businesses are sometimes harder to get investor interest, as they have a much longer sales cycle (e.g., read longer cash burn) and it is very difficult for a startup to break open new B2B relationships, especially one going after large corporations.  And, B2C businesses that can be virally grown online, are much preferred to ones requiring heavy investment in expensive TV, Radio or print (which frankly you should never use to launch a business until the concept is proven out, given their heavy expense and long-term branding aspects of such media).  And, in all cases, make sure the marketing or sales investment makes sense for the scale of revenues you are trying to build (e.g., is there a reasonable customer cost of acquisition metric compared to traditional industry norms).

Management Team:  To me, this is the most important element to any business.  I would rather have an A+ management team in a B- industry, than a B- management team in an A+ industry.  You want a team that has "been there and done that" before in a start-up environment, and will not be experimenting and learning with your limited startup capital.  Please re-read my previous post for more details on how to build a team for your startup in a way that will most appeal to investors.

Cash Requirements:   Sales and marketing investment will drive revenues.  Revenues will have cost of sales.  And the business will have overhead and other employee costs.  That will determine how much of an operating loss you will need to fund.  On top of that, will be any capital expenditures that need to be put into R&D for your product, capex for your office or whatever.  So, fully think through your cash requirements before approaching an investor.  And, two words of wisdom: (i) investors prefer lower burn rate, lower cash need businesses (so a $1MM need has a better chance than a $10MM need); and (ii) whatever the model says you need, double it for your cash raise (as things ultimately go wrong and you will want a cushion in place, to prevent going back to investors looking for more later--most likely at worse terms).

Financial Requirements/ROI:  The last check is a sanity check more than anything else.  Over the next 3-5 years, will the investor realize a 3x return or a 10x return on their investment?  And, there are two drivers of that: (i) the scale of the revenues/profits in that period; and (ii) the valuation at which the investor invested their money.   Obviously, investors are looking for 10x opportunities, so make sure your financial model gives them a reasonable chance to achieve such, either via scale or valuation. 

Once you have completed your business plan, you would materially pare back this information before presenting it to investors, depending on your need (e.g., a 1-2 page executive summary for preliminary introductions to investors via email; 14-15 slides for an in-person presentation).  Never lead with a 30-40 page document; nobody will read it past the first page given limited investor attention span and lots of competing investment opportunities.  So, make sure you get to the point, short and sweet.  And remember, graphic presentations always make a better impact than words, where possible.  So, provide screenshots of the product, instead of describing it in sentences.

My uncle is a successful executive and investor, and he once said to me: "if you can't communicate your vision in one sentence, you are making it too complicated for the listener to digest".  Good advice!!

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Lesson #6: Structuring Strategic Partnerships for Your Startup

Overall, I am a huge fan of strategic partnerships, if they are structured correctly and both parties are incentivized to see the success of your business.  I built both of iExplore and MediaRecall with equity owning strategic partners:  National Geographic for iExplore and Getty Images for MediaRecall.  Today, we will: (1) define a strategic partnership; (2) highlight plusses and minuses of relationships like this; and (3) list critical items to consider when contracting these relationships.

First of all, what is a strategic partnership?  They come in multiple shapes and sizes.  Some are simply biz dev relationships with cross marketing.  Some are revenue share relationships.  Some are equity owning relationships.  To me, the deeper the better, to truly qualify as a strategic relationship.  So, don't be afraid to spread the equity to partners that can material change the upside of your business.

We structured a deal where National Geographic acquired 30% of iExplore, for cash and promotional support.  On the face of it, it sounds like a big number (as in my experience strategic equity owners are typically in the 5%-20% range depending on the level of support).  But, when you realize National Geographic is one of the most trusted brands in the world, with one of the highest-end demographic readerships to market high-end adventure travel, it was really a match made in heaven for a startup travel business.  And, iExplore clearly saw the benefit of that strategic relationship from a couple of perspectives: (i) their brand association provided a 25% increase in sales (vs. an unknown iExplore brand as a startup); and (ii) when times got tough around 9/11/01, having that National Geographic relationship made the venture capitalists more comfortable continuing to fund our business (e.g., if NG still likes the story, then so do we).  Without that relationship, I doubt we would have been able to stay in business given the 9/11/01 impact to the travel industry.

But, a strategic relationship is more than just giving equity to partners that can help you to materially scale up your business than you could on your own.  It is also, making sure that the strategic partner is contractually on the hook for the marketing support you need to implement that growth.  For example, in the National Geographic deal, there were tons of advantages for iExplore: (i) co-branding use of their logo; (ii) exclusive trip finder on their website; (iii) discounted rates to purchase advertising in their magazines; (iv) access to their 5MM customer direct mail list; and (v) access to other internal marketing partners, like their cable television and merchandising divisions.  Which at the time the deal was cut in August 2000, when iExplore was flush with cash, was a really terrific deal.

But, after 9/11/01, when iExplore found itself in a cash-tight position, we quickly learned that that deal was not properly structured for a downside scenario where we didn't have cash to spend.  Accessing NG's direct mail list required money to produce direct mailers.  Buying print ads in NG's magazines, even if at 50% off rate card, required money.  So, when you are structuring deals, make sure the promotional support will be there in good times and in bad.  Part of that means, making sure the day-to-day managers of the relationship have a vested interest in your success.  We structured our deal with the CEO and CFO of the National Geographic Society.  They were not the people in the trenches that were going to implement the marketing support--the editors and publishers at three magazines, a cable channel and website (who frankly are all busy people managing their various fiefdoms to care about building iExplore).

As for the advantages and disadvantages of strategic relationships, the plusses are: (i) they can help you grow your business faster and cheaper than you could on a stand alone basis, if structured properly; (ii) they get venture capitalists more excited about the upside of your business; and (iii) it makes other business partners more excited and comfortable with working with you.  The minuses are: (i) working with one partner (e.g., National Geographic), may make it difficult for you to work with competitive other partners (e.g., Discovery Channel), so be sure to pick the biggest, best partner to work with; and (ii) venture capitalists may think you have limited their exit options by working with one key partner, so make sure nothing in your deal requires you to sell your company to that partner or limits your exit options in any way.  It is fine to give the partner a right of first offer or a right to match offers with tight timelines, but nothing that guarantees they walk away with the business in all scenarios.

A few key considerations for any deal: (i) make sure the equity component is fair in comparison to the level of marketing support being provided (e.g, put a cash value on that support as a percent of your company valuation); (ii) make sure the marketing support is well documented so when it gets handed down from the biz dev department to the people in the trenches, they have to execute it with no wiggle room for interpretation; (iii) make sure the deal works in good times (cash rich) and in bad times (cash poor); (iv) make sure the strategic partner invests some amount of cash (even if minimal), so they have skin in the game to help protect their investment; (v) make sure the partnership has tight performance deadlines to implement your marketing support, as big companies can move very slowly without them; and (vi) make sure nothing impedes your marketability to venture capitalists or limits your potential exit options down the road, as discussed above.

Overall, as I mentioned above, I am a huge fan of strategic partnerships, and spreading equity to players that can materially change your destiny.  But, as always, the devil is in the details!!

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Lesson #5: Finding Angel Investors for Your Startup

As we read in my previous post about fund raising options for your business, angel investors (not venture capital firms) are the most likely candidates to get your businesses from a piece of paper to a proof of concept.  Today, we will tackle how do you find these angel investors across four distinct groups: (i) friends and family; (ii) angel investors directly; (iii) networks aggregating monies of angels investors; and (iv) fund raising advisors.

Friends and family investors have their distinct plusses and minuses.  The plusses are these people know you the best, so they are the closest to you in determining whether or not you are backable, as first hand references.  The minuses are pretty major:  these are your friends and family!  It is very difficult to mix personal and professional relationships.  And, as we know, only one in 10 startups is successful.  So, there are very high odds you lose all the money invested by your closest friends and family, which will make for VERY awkward Thanksgiving dinners from that point on.  So, if you decide to ultimately go down this road (which for many startups are their only option), make sure your friends and family know this investment is HIGHLY risky, and they should not invest the funds unless they are prepared to lose 100% of their investment (e.g., like money they would gamble in a casino).

As for finding angel investors directly, this by far is the hardest route.  First, because they prefer to stay anonymous.  And, second, because they don't know you at all.  Sometimes rich individuals have built formal family investment offices, with professional managers screening deals for them.  But, I have found, if they can afford a family office, they prefer to invest $5MM+ in more typical venture investments, not $500K for a startup.  Preferably, you need to find an individual that understands your industry and business model and can bring real value to the table, understands your needs and is easier for them to get over the investment hurdle.

So, for example, if you think you have the next great video gaming technology, I would research what similar video game technologies have recently been sold (meaning the founder just got very cash rich), and reach out to that founder to tap into their expertise as an advisor, board member or investor.  Notice I didn't lead with investor.  You need to establish credibility with this individual before jumping into the investment question.  And, if he doesn't want to invest, he may know others in the industry that would, so ask him for references.  Venture capital firms are also aware of key angels in their market, so reach out to them for guidance.  There is a great website called Angel List that makes finding angels for your region/industry easier than ever, so check them out as a good place to start.

This last category, is my favorite category: networks aggregating angel investors.  Like the family offices, investors set aside funds for angel investments, screened by a professional team that sources deals for the network.  So, the individual angel gets to keep their anonimity and have the comfort of a team of smart managers doing due diligence on investment targets, on their behalf.  So, instead of one angel investing $1MM by themself, 100 angels aggregate $100MM and invest as a group in the deals they like the best, individually or collectively.

Here in Chicago, the big three angel networks are Hyde Park Angels, Cornerstone Angels and Heartland Angels.  These angel networks very much prefer to invest in their own backyard.  So, if you live in Chicago, reach out to these three.  If you live in another city, you will need to research who the angel networks are in or near that city.  I stumbled on this great list of angel networks by city compiled by Andy Whitman, a Partner at 2x Partners, an early stage venture capital firm in Chicago with expertise in the CPG space.  This list applies to all industries, not just CPG, although Andy does indicate what CPG deals these networks have invested in.

If all of the above fails, you should consider engaging a boutique start-up fund raising advisor.  The problem with this road is raising funds via this channel can be more expensive, with the advisor typically taking a 5%-7% success fee in cash, plus a 5%-7% success fee in warrants, and often times, plus a monthly retainer to cover their costs.  As an example, Red Rocket takes a 5% success fee in cash, plus 5% warrants (without charging a monthly retainer), for stories we believe are fundable from our network of investor relationships.

Hopefully, this information helped to make the angel identification process "less scary", knowing there are viable angel investor options which can be pursued.  And, over time, expect more and more angels to get more active in early stage investing as a core part of their portfolios (as a way to exceed the returns in the stock market and fill the void left by venture capitalists who have gone out of business).  Good luck!

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Lesson #4: How to Raise Capital for Your Startup

Of all the consulting inquiries I get at Red Rocket, fund raising is by far the biggest need of these startups.  And, the problem is, not all startups are venture backable for a variety of reasons, which we will discuss in this post.  Today, we will tackle: (1) is my industry appealing to venture investors; (2) is my business appealing to venture investors; and (3) if so, various ways for attracting capital for your business.

First of all, angel investors and venture capital firms invest in a wide variety of industries (e.g., technology, digital media, CPG, retail, real estate, healthcare, life sciences, manufacturing).  So, before reaching out to any investors, make sure your industry is clearly in their sweetspot and skillset.  That said, there are certain industries that have a LOT more startup activity than others.  As a rule, business that heavily invest in real estate, inventory or other capital risk, are materially less desirable than simple technology businesses.  So, bad news if you are a start-up restaurant, retailer, REIT or manufacturing business.  Good news, if you are a dot com, software or technology business.  The reason for this investor bias is the extra levels of risk that get added to your startup.  Business startup risk is bad enough, with only one in 10 startups succeeding.  But, when you layer on real estate location risks, long term leases or merchandising inventory risks, it becomes a much bigger pill for the startup investors to swallow, unless they have deep expertise in that space.

But, even if your industry is in one of the more active venture markets, there are still numerous hurdles to cross in assessing your specific business.  Are you B2C focused or B2B focused?  Are you a sales driven or marketing driven company?  Do you need $1MM or $25MM to succeed?  Do you have one time revenues, or a recurring revenue model?  Are you the first mover in your market or entering a highly-competitive space?  Is your technology patentable or not?  Is your business easily and cheaply scalable, or does it have heavy overhead investment along the way?  Are you serving a $1BN market, or a $100MM market?  Is my forecasted ROI going to be a 10x return or 3x return?  Is it a first time CEO, or an established veteran?  How deep is the management team?  Has there been proof of concept, with revenues or site traffic to date?  So, as you can see, lots of hurdles to get over to get an investors' attention for your business.

Now, lets assume you are one of the lucky 5-10 in 200 that has a venture backable business.  How do you typically phase in investment.  You can't simply show up at a big Silicon Valley venture firm with your piece of paper idea and say cut me a $10MM check.  Investors are typically segmented by life-cycle stage of the business:  angel investors or friends and family typically get a business off the ground from a piece of paper to a working prototype; Series A venture capitalists will put in $1-$5MM after there has been a preliminary proof of concept, based on revenues, pipeline, site traffic or some other metric; and Series B venture capitalists will put in $10-$50MM to hit the accelerator after the model is finely tuned and scaling.  So, when you are approaching the investment community, make sure you have thoroughly researched not only their industry focus, but their stage of business focus as well.

Once the term sheets start flowing in, how do you ultimately decide who to move forward with?  At the end of the day, you need to follow your gut.  Who is going to be the best partner for my business, bringing a Rolodex of relationships to the table?  Who is going to be the most pleasant to work with around the board table, especially when things start to go wrong (as they always do)?  Who has the deepest pockets to invest additional monies in follow-on rounds?  Who is giving me the best valuation?  Whose term sheets are more or less onerous than others in terms of liquidation preferences and anti-dilution rachets?  So, hopefully, what you are hearing is, not all venture capital is the same shade of green, and it is important you do your homework upfront, to avoid misery down the road.  And, if you are not clear you are making a good decision on your own, ask an advisor to help you.

But, overriding all of this, if you can figure out a way to fund your business, with no outside capital, that is the preferred model.  It preserves the founder's 100% control of the company's equity, board control and the timing of a sale (or not), at terms 100% satisfactory to the founder.  Don't get romanced by the idea of raising venture capital, because it certainly has its strings attached, given the reasons above.   But, if you think you have the next big idea at the scale of a Google, Facebook or Groupon, the venture community will be your best partners, having funded several of those similar businesses and navigated the various pitfalls along the way.

In the words of my old boss at CSFB . . . "Happy Hunting!"

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Lesson #3: The Importance of Timing and Luck for Your Startup

In my previous post we summarized key success factors for any startup.  Today, we are going to tackle the third of the three major points: timing and luck.  This is one of the most important elements for success, but is hardest to identify and control.  There are a few pieces to the timing puzzle: (1) market timing; (2) economic conditions; (3) execution speed; and (4) knowing how long to ride the wave.

Market timing is basically being in the right place at the right time.  I will use MediaRecall, my past company, as an example.  MediaRecall had built the fastest, cheapest solution to digitize large archives of film and video content, for publishing on the web.  The business was launched in 2006, well before online video started to take off, so the big film archives had not yet began to think about digitizing their archives.  So, the company struggled to build a sales pipeline until 2009, post the rapid success of sites like YouTube and Hulu and all film archives scrambling to find a way to get their archives monetizing online.   Had MediaRecall launched in 2008, it would have saved two years of burn rate.  But, you are never that smart to time the market.  So, just make sure there is solid customer interest for your product, before investing too heavily in your business (e.g., the lean startup principle).  But, launch early enough to be the first to market, and beat any potential competitors to the market.

Economic conditions are entirely out of your control.  I will use my other past company, the adventure travel website iExplore, for this example.  iExplore launched its site in February 2000 in the peak of the dot com boom.  And, then the dot com bubble burst in March 2000, a month later, making it immediately an uphill slog right out of the gate.  Had we launched three years earlier, riding the momentum of the dot com boom wave would have made it much easier to grow the business.  Or even worse, nobody could have predicted 9/11/01 and the negative impact that event would have on both the economy overall, and especially the travel industry.  It almost took iExplore out of business entirely.  All you can do here is to keep your business nimble, so it can easily scale up or down, based on external market conditions.  And, when times are good, run as fast as possible to build your coffers for the downtimes.

Execution speed simply means build your business at light speed, be a first mover (if you can) and continually exceed the efforts of your competitors.  And, better yet, using Google or Amazon as an example, continue to widen your lead over your competitors to make the gap insurmountable.  Never get "comfortable" with your success.  Continually have a sense of "controlled paranoia", pushing your research and development efforts and sales and marketing tactics to new heights in each year.  The turtle never wins this race, if the rabbit keeps clearly focused on continued and accelerating growth with their competitors further and further back in their rear-view mirrors.

And, on the sell side of your venture, it is important you know how long to ride the wave.  Don't make the mistake of the riding the story too long.  Somethings may change to hurt the business (e.g., market conditions, competition) that will result in a much lower sale price, had you sold at an earlier time.  And, equally important, the prospective buyer of your business will want to see upside on their investment.  They will not want to buy a story that they perceive has reached its full potential.

And, overriding all of this?  Luck!  So, carry your four leaf clovers and rabbit feet in your pocket at all times!!

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Lesson #2: Building the Right Team for Your Start-Up

In my earlier post, we talked about key success factors for any start-up and determining if you have a good business model.  Today, we are going to drill down on one those factors: things to consider when setting up your management team.  The key drivers of that are finding employee partners that have: (1) the required skillsets for the job; (2) prior experience with start-ups; (3) a personality fit with the rest of the team; (4) shared vision with the rest of the team; and (5) fire in the belly.

Let's talk about the first two together, as they go hand in hand.  You'd think it would be pretty self-explanatory that for a Chief Marketing Officer hire, as an example, you should find a candidate with strong marketing skills.  But, the tactics differ for different types of marketing vehicles (e.g., digital, print, TV, direct mail), different industries require different expertise (e.g., e-commerce business vs. catalog business) and B2C companies require different skillsets vs. B2B companies (e.g., marketing vs. sales skills).  So, it is important prior to hiring, to make sure you find someone that has deep knowledge of your specific industry and has successfully scaled up businesses within your desired budget range. 

For example, don't put a $1BN budget Proctor & Gamble CMO, in charge of your $1MM start-up budget.  The P&G guy most likely only knows how to build brands with big teams and big budgets, not how to organically and virally grow your business on the cheap in new kinds of ways (e.g., social media, mobile, SEO), rolling up his sleeves and doing it himself on a shoestring.  So, past start-up experience is a definite plus.

As we all know, startups are a 24/7 type of job.  So, you are going to be spending a lot of time with your co-workers.  It is critical there is a good personality fit between the team, as in those late night hours, the last thing you need is someone getting on your nerves.  Or, having one member of your inner circle the pariah within the company that nobody wants to work with.  You don't have time for these types of issues while you are trying to win the start-up race.

Equally important, it is important each member of your team share a consistent vision on exactly what you are building.  As an example, let's say we want to build a car, which seems clear enough at the 30,000 foot view.  But, when you drill down to the specifics, it is important the team know we are all specifically building a mini-van for families, not an SUV, or a pickup truck or a luxury sedan, which appeal to different user markets, have different costs to build and require different marketing tactics.

And, most importantly, it is critical that all involved have a deep passion for the product and fire in the belly to move at light speed to own your market.  This is not a 9 to 5 job.  This is a passion you are living and breathing in real time.  Going back to our Chief Marketing Officer example, somebody that has come from a cushy role, managing a big team of employees with private secretaries and big budgets, most likely is going to have a really tough time going back into the trenches, putting in the required long hours.

So, in the words of Bo Schembechler, the old Michigan football coach: it is all about "The Team! The Team! The Team!" that will ultimately win you your championship.

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