Lesson #11: Considering Incubators or Accelerators For Your Startup

One way to help get your business off the ground, is to leverage the mentorship benefits of an incubator or an accelerator.  First of all, a quick definition of each.

An incubator is physically locating your business in one central work space with 10-20 other startup companies, typically all venture funded by the same investor group.  You can stay in the space as long as you need to, or until your business has grown to the scale it needs to relocate to its own space.  The mentorship is typically provided by proven entrepreneurial investors, and by shared learnings of your startup CEO peers.  Examples include Tech Nexus and Sandbox Industries here in Chicago.

An accelerator is very similar, but has some distinct differences.  Your time in the space is limited to a 3-4 month period, basically intended to jump start your business and then kick you out of the nest.  The cash investment into your business from the accelerator itself is very minimal (e.g., $20,000), but your time in the accelerator should largely improve your chances of raising venture capital from a third party entity on the back end of the program.  And, mentorship could be coming from 40-50 entrepreneurs that are affiliated with the accelerator (many of which are proven CEOs and investors looking for their next opportunity or simply helping the local startup community).  Examples include Excelerate Labs in Chicago, and the wildly successful Tech Stars, Y Combinator and 500 Startups in other cities.  Here is a great list of accelerators by city curated by Robert Shedd.

Deciding on whether or not you should pursue starting up your business via an incubator or accelerator largely comes down to your personal confidence in the defensibility of your business model, your execution skills and your fund raising skills.  If you have a credible story and your business is nicely progressing on your own, you probably don't need to be part of one of these programs.  But, if you need help fine tuning your business model or revenue model, or may be a first time CEO wanting to hone your skills from proven peers and entrepreneurs, then this type of mentorship could be perfect for you.

Here are the high level advantages and disadvantages of programs like this.  The plusses are: (i) shared learnings and mentorship (helping avoid typical startup pitfalls and speeding up your efforts); (ii) access to capital, either within an incubator or post an accelerator; and (iii) the PR value and exposure you get from these programs (not to be underestimated).  The minuses are:  (i) they can be distracting at times, with lots of related meetings and events with mentors and investors (getting in the way of focusing on your own project); (ii) they can be confusing at times (getting 10 different opinions from 10 different mentors), so you need a good "filter" on any advice; and (iii) sometimes, sharing space with other companies is not always a plus, especially in long term incubators that may be carrying dead weight of underperforming companies.

Overall, I think these programs are terrific for first time CEOs, that can quickly get up the learning curve with the help of mentors and investors that have "been there, and done that".  Plus, your odds of raising capital are vastly improved given the tight screening processes of these groups, that naturally raise the creme de la creme to the top, from the 1000's of applicants they receive each year.  Competition is naturally fierce to get one of these coveted spots, so make sure you have a fine tuned pitch and leverage your network to help pull some strings for you.

Good luck!

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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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