Up and Running:

There was a good reminder placed on The Funded yesterday. It’s a note from an entrepreneur entitled The Gift of Not Getting Funded (Early). I really like this quote:

What our lack of funding made us do is go back to basics. We know we had the seed of a good idea but struggled to come up with a sustainable model. Along with lots of hard work we talked with potential customers and came up with a solid way to generate revenue. Our potential customers are now signing letters of support saying they like our product and find it beneficial for their business and are willing to be contacted by investors. We have never had this in previous attempts to raise money and now feel confident in our plan.

The author, who has a screen name but not any additional details, makes this excellent conclusion:

Don’t despair if you haven’t gotten funded yet. It could be a gift in disguise.

Good point. And good example.

Which reminds me: If you’re an entrepreneur looking to get funded, go to thefunded.com and angelsoft.net. Both of those are excellent sites, very valuable for entrepreneurs, free and very useful. Oh, and by the way, if you’re an Oregon entrepreneur and looking to get funded, go to Willamette Angel Conference. Please.

(Photo credit: William Attard McCarthy/Shutterstock)

This may surprise you. From an investor’s point of view, self-sufficiency in a startup or emerging company isn’t always a good thing. In many cases, it’s an investor’s nightmare.

Here’s a hypothetical example. Suppose you just invested $250,000 in Acme LLC, a promising startup. Let’s say you got 25 percent ownership for your money. Years go by, and Acme grows in sales, profits and cash flow. In fact, it’s so good that it becomes cash-flow independent, meaning it’s generating enough cash, month by month, to pay salaries and fund growth.

As a successful high-tech company, Acme doesn’t make high profits. Instead, it pours as much money as it can into more growth through better marketing and better products. It buys ad words and search terms. It grows. Let’s say it reaches $1 million sales in three years, and $2 million in five years. And it keeps a healthy balance sheet, just enough cash to feel safe and no real debt.

In theory, and on paper, your investment value in Acme grows too, along with the company. Let’s say that by the time Acme’s running at $2 million annual sales, it’s worth $4 million, twice sales. So your 25 percent is worth about $500,000, twice what you invested.

Sounds like a great story, right? It is for the founders. They’ve been employed all along, and let’s assume they’re taking fair salaries and working on their own company, and their own dreams. Now they have 75 percent ownership in a good company. As long as they keep minding the business and watching the cash flow, they’ve made it. They can brag on their blogs, join the speaking circuit and send their kids to really good schools.

But it’s not necessarily great for the investor. Because that theoretical valuation of $500K is just that: theory. You, the investor, don’t get paid unless you can turn that value into cash. Acme, without an exit, also known as a liquidity event, is an investor’s nightmare. You end up having spent big money to build a business that may last forever without giving you any money back.

If you ever wonder why investors want majority shares, or why they tend to invest in groups with other investors, this example might help. It’s not that they don’t trust your  motivation, but they know that things change; sometimes entrepreneurs who started a company with an exit strategy end up changing their minds. They want to keep it forever. And where does that leave investors?

(Photo credit: FuzzNails/Shutterstock)

I found this list in a very good post from Charlie O’Donnell on his blog This is going to be BIG. I don’t know him, and I didn’t know his site, but on digging I discover he has done time with Union Square Ventures, teaches entrepreneurship and practices what he preaches with a couple of startups that he runs.

But what really matters is that this is a very good list. It matches my dealings with startups and investors, on both sides of the table.

1) Strong sense of the key milestones–Entrepreneurs often ask what metrics they need to get to in order to get an investment. I often turn that question around and get them to tell me what the important milestones are.

In a nutshell: Metrics. Trackability. He adds: “Milestones are a waterfall–and having them as goals should inform product, marketing, financing, etc.” Agreed.

2) Implementation of a product strategy–More so than any other aspect of the business, the thing I see early entrepreneurs tend to drop the ball on most–myself included–is product strategy.  I’m not saying you have to know all the answers, but you should at least know what your landing pages are trying to accomplish, where they’re going wrong and what steps you’re taking to identify the solution. I like to know that, even if you haven’t figured everything out, you have a process around product–so this way I can bet that you have the tools to figure it out.

The product road map included, and this gets even more powerful when you add on the milestones in the first point. In the post he adds the practical question, “How do I know you’re not going to spend the whole financing moving the search box around when it turned out that being on mobile was more critical to your success?”

3)  A theory on customer acquisition–You may not even have your product out yet, but having a reasonable sense on how people are going to discover it–past the buzz around your launch–is necessary. Just tell me how the first 10,000 users who aren’t your friends find it–and if it’s viral, tell me why people pass it on other than “because there’s an invite friends link.”

And, within that, this very real note about what doesn’t work:

If your strategy is to reach out to all the bloggers in your industry and get them to write about you, that’s pretty much what every other startup is going to do–and anyone who has done it will tell you the results will likely be underwhelming.

So make it real, and also realistic. Don’t just do what everybody else has done.

4) A financing strategy that gets you *somewhere*–When I say *somewhere,* I really mean one of three outcomes: getting critical mass (whatever that is for you) or at a product milestone that makes your venture fundable, starting to get revenues or cash-flow positive. When someone asks you, “What does this money get you?” they really want to know that it gets you to some amount of users, coverage of certain platforms, first enterprise customers, whatever it is. Just something more mission critical than “18 months.”

Notice that it’s not necessarily all the way to the exit strategy. I find this very refreshing, looking at some real next step, and going back to the foundation of metrics and milestones, trackability.

5) Specific value creation –The easiest way to show value creation is to say that each customer is worth X dollars in revenue. Pair that with the cost of customer acquisition and net worth; there’s your business. I don’t care if these are wild-ass guesses–at least make some attempt at showing that at customer N, your business is worth X.

That’s a very nice summary of “value creation.” Units times price.

What I like about this post is that it gets away from the standards I find myself listing too often: exit strategy, differentiation, growth potential, defensibility, management team and so on. This different way of looking at it seems very useful to me.

Old saying: “I don’t know art, but I know what I like.”

I was surprised to read that a Palo Alto, Calif., venture capital firm had invested in an art business. And perhaps it’s the surprise element that has this one featured recently in Business Week and The New York Times. It’s an $825,000 VC investment in Jen Bekman Projects, an art gallery and online art business.

At first glance, this seems like an exception to the general rules. Venture capital generally wants innovative and high-tech businesses that have a reasonable chance at high growth leading to a lucrative exit three to five years from now. How does an art business fit into that?

Dig deeper, and you see that it’s not that much of a surprise. This is not just art, it’s a new way to gather and market art online. The Times story says:

The popularity and reputation of the site, which has won fans for its affordable collections of quirky work, were enough to grab the attention of Tony Conrad, a partner at True Ventures, which led the financing.

And the Business Week story refers to a “disruptive business model” (emphasis is mine):

Cash flow positive. Growing revenue. Disruptive business model. If you’ve got those three things in place, it may not matter whether you’re the kind of business VCs typically fund.

Ironically, “cash flow positive” and “growing revenue” aren’t always qualities that investors want in a startup, because they can create a company that doesn’t need to go public or get acquired later on. Investors don’t want to get trapped in a minority share of a healthy company that never generates liquidity. They have to be able to sell their share within a few years, which means either a public offering or acquisition by a larger company. And a cash-flow-positive growing company doesn’t automatically do that.

So without actually knowing her or the background, I’d be willing to bet that Jen Bekman, the founder, is personally impressive, dedicated to growth, and that she has a real exit strategy. In the background, she’s working with well-known angel investors. Her capital structure probably gives the angels who invested early some control, too, which also increases the odds of a successful exit later on.

Congratulations to Bekman. And exception or general rule or both, it’s nice to see a bootstrapped company make it to a big-time investment, and positive cash flow show up as one of its better qualities.

(Image: from Jen Bekman Project. Chad Hagen’s “Nonsensical Infographic No. 2?. Linked here from NYTimes.)

One proven way to build a company from zero to winning angel investment is by pitching, listening and correcting. Fill gaps. Strengthen weak points. Listen to your customers.

I watched Precision Plant Systems pitch at the Bend Venture Conference last Friday for the third time in a year.

• The first time I was thoroughly unimpressed; it seemed like science–sensors of nitrogen content in leaves–disguised as a business.
• By the second time, last spring, founders had been out in the field putting technology into the hands of selected farmers, and the farmers wanted more features and better handheld technology. It had become a system, including CPU- and Web-based software, with humans walking around fields noting conditions in handheld units equipped with GPS, so the underlying software could output the results overlaid on maps of actual farmers’ fields. It was much better, but it was still hard to tell whether the business was about the software, the handheld units, the Web, the science or all of the above.
• The third time, last Friday, it was an integrated system with a clear value proposition, making it easy for humans walking in fields to record information that can be retrieved later as part of a system–including notes, sensor data and GPS data. It’s a nice compromise between all-automatic data sensors that might be ideal, and entirely old-fashioned handwritten notes. With a lot of practical touches, like an option for Spanish. And, by the way, the team now includes two people who had been involved in other local ventures competing with this one for local angel money, but were now part of this one. One was an advisor. The other, a software pro, was a featured team member.

And this time around, the listening, the additional development and the fine-tuning paid off. The company took first place at the competition, which means an estimated $120,000 angel investment, pending further due diligence. And that was against some stiff competition.

CEO Larry Plotkin told the local newspaper he was surprised to win. What surprised me, as I watched his pitch, was how much stronger the pitch looked this time around. And the pitch had improved, but then the improved story line was much more significant.

Here’s the summary from the local Bend Bulletin:

Precision Plant Systems is developing a hand-held device to help farmers measure and map the health of their crops. The device is synchronized to meters that measure soil salinity, pH and compaction, leaf greenness, nitrogen, water content and the sugar content of the actual crop. The information is transferred to a map using GPS technology, Plotkin said, providing farmers with a comprehensive overview of what’s happening in their fields, allowing them to make better decisions.

And for me, this is a great example of how the process works when it worked well. It involved the two local Chambers of Commerce, two angel investor groups and a lot of people helping along the way. And a management team prepared to listen and react to criticism. Congratulations to this company, for a victory well-earned.

I got an e-mail about this one overnight:

Return of the Angels: How Angel Investment is Changing

It’s a $40 evening affair in San Francisco, with a panel of three good speakers and a very interesting agenda. If I were in the San Francisco Bay area working on any kind of a startup, or even thinking about it, I’d probably attend.

Here’s the summary:

Angel investors are the new black. In a down market, with venture activity slowing, many entrepreneurs are looking to angels for salvation.
But they may be in for a rude awakening–angels are not exempt from economic pressures, and their outlook, strategies and requirements are changing.

If you’re not in the Bay area, it’s still a good reminder that things have changed. Angel investment is more organized than it was, and with the changing financial landscape . . . well, if nothing else, start doing Web searches for angel investors and see what comes up.

If you do that Web search, be careful with the paid or sponsored results. Here are a couple of tips:

• Buying lists of investors is a bad idea. You need to target your investors carefully, not send out mass missives. Investors you can’t find by a combination of asking locally and searching the Web are not good targets. Here’s some background on that.
• Buying ready-made business plans is another bad idea. You make your own plan; you don’t buy one from a consultant. If you have the budget to work with a consultant, check references first, and make sure that consultant helps you do your plan, rather than doing a plan for you. Here’s some background on that one.

Here’s a case for discussion. You be the judge.

Mary comes up with a great idea for an iPhone application. She works on it for three months in her spare time. She develops sketches and designs, trying to figure out how it would work. She looks at other iPhone applications doing related things.

About three months into it, her enthusiasm has waned a bit, but she’s still thinking about it. She’s spent maybe 10 to 20 hours on it so far. Her best friend suggests she talk to Ralph about it. She doesn’t know Ralph, but her friend does. They meet for coffee. Ralph is a programmer. He works for a company in town doing web programming. He’s also an enthusiastic iPhone user and has been thinking about taking an online course on programming the iPhone. Ralph is excited, and his excitement rekindles Mary’s excitement. They agree to be partners in a new business based on this initial iPhone application.

Four months go by. Ralph takes Mary’s initial idea and starts developing. It turns out, as he gets into the code, that what Mary imagined isn’t quite possible on an iPhone. Ralph revises the idea radically, makes it practical and develops a prototype. Mary meets with him three times, they talk, she accepts his changes begrudgingly. At this point Mary’s total hours have gone to 15 to 25, but Ralph has worked a lot, probably 120 hours, on the programming.

At Ralph’s suggestion, he and Mary take the prototype to Terry. Both of them know Terry, but neither knows him well. Terry has been through a failed startup, has a business education and is looking for a startup to do again, this time the way it should be done. Terry’s skill is mostly marketing, but he knows how to develop a plan and seek investment. Terry does a business plan and networks with local business development groups to find angel investors. They win an opportunity to present to an angel investment group.

Another three months have gone by. Mary has now put in more like 40 hours, Ralph 250 hours, and Terry 120 hours.

The three of them meet to plan their approach with angel investors. Ralph wants to quit his job and work full-time on the new thing but needs to get paid. Mary doesn’t want to quit her job but wants to stay involved; she’s not quite sure how. Terry wants to lead the new company as soon as he can get financing.

The business plan indicates it’s going to take $250,000 to develop the business for the first year, after which it will probably need another $750,000 to become cash-flow self-sufficient.

During this meeting, Mary and Ralph and Terry come to an extremely awkward realization: They’ve never really talked about who should own how much of this company, much less how much they are willing to offer to investors in exchange for $250,000.

So what do you think? This is a typical case.

1. How would you suggest that Mary, Ralph and Terry divide up the 100 percent ownership of the company now, before they go to the angel investors. Who owns how much?
2. What do you think of the management team here? Ralph and Terry both want to work full-time on the business when there’s money to pay them. What titles should they take? How much salary?
3. How much of the company should these three offer to the seed investor for $250,000?

Today I want to answer another question from email, on another subject that comes up a lot. Here’s the question, as I received it:

I’ve read many times how investors would rather invest in a quality “A” team with a “B” level product than with a “B” team and an “A” product.  According to most, I have what would be coined as an “A” product and business model. However I only have me. I am looking to apply for formal Angel investment and the team part is an integral part. I am listing that I do in fact want to find a CEO who can run the company. I am listing CEDO (Commission for Economic Development) as a team of advisors. I am listing legal as on retainer. Please share with me what I should do at this point to make the team viable in the eyes of the angel investors.

My answer:

Fill in the team first.

Find that CEO, and let him or her help you find somebody to run either the marketing or the product development, whichever of those two functions you’re not going to do. Look for somebody who’s been down the road, done a startup, made it successful, and sold it. And while you’re looking, keep an eye out for a finance/admin person as well.

What you’re looking for most is experience. Credentials are nice too, but in a pinch, experience trumps credentials, and if you possible can, get both.

Compatibility is a big deal too. You’re going to want people you can work with, who share the same values, who believe in what your company is going to do. Compatibility doesn’t mean sameness, either; same values maybe, but diversity broadens a company. Look for people who have skills and experience that you don’t. Fill gaps.

I assume what you’re thinking is that the investors can help you fill in the team, and that having people they know and trust on the team might seem to be an advantage. But the problem with that idea is that the team is so much of what they’re investing in that it’s like trying to sell a car without tires or an engine.

Investors don’t want to do it themselves. They want you to do it. That’s where the value comes.

Core problem: valuation. Divide how much money you want by how much of your company you’re offering, and that’s valuation. So for example if you want $500K for 33 percent of your company, you’re valuing your company at $1.5 million. Not having a management team really kills your valuation.

(Illustration: istockphoto.com. The point? an individual playing a team game.)

A friend asked me: What about seed capital? Good thing or bad?

For the uninitiated, here’s how I defined “seed capital” for the bplans.com glossary:

Seed capital is investment contributed at a very early stage of a new venture, usually in relatively small amounts. It comes even before what they call “first round” venture capital. How much is that “relatively small amount?” We’ve heard some high-end high-tech ventures in the heart of Silicon Valley call an investment of $500K seed capital, and we’ve known of other ventures that called $35K investment seed capital, and the following $300K investment the first round. It depends on the point of view.

My answer:

1. It’s not easy to generalize. Notice even in the definition how much the terminology depends on the point of view.
2. I like the reminder, in the name of seed capital, that it’s supposed to be like seeds, something that makes something grow. If it’s just a small amount of money but isn’t supposed to lead to more investment later, then it’s just a small investment amount, not seed capital.
3. If by seed money you mean just a small amount, but you’re not sure that will be followed by a larger amount later, then I’d always recommend that you at least consider bootstrapping instead. I’ve posted before my reminders that owning it all by yourself, if that’s an option, is good, and working with investors as partners involves a lot of compromises. For example, here last month, and here on my main blog.
4. Seed capital from good partners, professionals who add value, is almost always good. Subsequent investors from later rounds expect that and will like their participation.
5. Seed capital from bad partners, incompatible partners or unsophisticated partners who get in the way of future rounds, is bad.

So it’s easy to summarize with a reminder that startup funding isn’t as simple as just finding investment–which, as I think of it, is not that simple anyhow–it’s getting the right kind of investment, from the right investors, to match your long-term goals, strategy and practical reality.

A friend asked me last week if I know an investor interested in the T-shirt business. I don’t know him well, I don’t know his business, but I’d like to help. So it occurs to me that there’s a predictable series of questions to ask to point a plan in the right direction.

1. Is your business plan investor-friendly?

To interest arms-length investors (meaning not friends and family but people who don’t know you and don’t believe in you already), a business plan has to have an experienced management team, a product and market focus that offers real growth potential (like at least 10X, but preferably 50X or 100X growth in three to five years), and a believable exit strategy. These days the only credible exit strategies are about being acquired by a larger company.

2. If no, you have two realistic choices.

If your business plan doesn’t have all of these qualities, stop here. None of the rest of this applies to you, so don’t waste your time. You have two options:

• Focus on people who know you and believe in you to get friends and family investment
• Scale down so you can bootstrap.

3. If yes, do your homework; find friendly investors

Never, ever use the shotgun approach–mass mailing, e-mails or postings–to find investors. That’s about as bad as taking out “spouse wanted” ads. Instead, use the internet. Look for the right kind of investors, preferably local, preferably interested in and knowledgeable about your type of business.

Never think of investors as money; they are partners. It’s a relationship like a marriage. An incompatible investor, like an incompatible spouse, is a shortcut to hell. One of the biggest fallacies in startups is the myth that getting the money is the goal–not if you have bad partners.

Refinement: Does your plan have VC potential?

Do you have a strong team, strong product, strong market, clear exit, defensible business and a good use for several million dollars? Do you have a good shot at generating a huge return on several million dollars in three to five years? Like 20 or 30 times the initial investment?

• If and only if you can answer “yes” to every one of these questions are you looking for professional venture capital.
• If not, then you’re looking for angel investment.

And either way, whether VC or angels, turn to the web to find investors who are either local, know and like your industry or, better yet, both.

The professional VC firms are relatively easy to find. Do an internet search. You can refine it to add geography (for example, search for “VC Atlanta” or “VC Texas“). You can also find free venture capital directories with searchable entries for geography, industry, deal size or stage preference, starting with the National Venture Capital Association at nvca.org, which has a good directory of other resources.

Another great site for a VC search is thefunded.com, a database of entrepreneur reviews of dealings with venture capitalists and angel investors. Membership is free for entrepreneurs.

(Hint: you probably don’t want to buy lists of venture capitalists, because most of this information is available free. Sometimes a hundred or so bucks can save you time, which might make it worth the expense; but unfortunately there are a lot of sharks in the listings-for-sale market. Be careful.)

Angel investors are harder to find but still findable. Do a web search for local angel groups, talk to your chamber of commerce, ask the nearest Small Business Development Center, ask at local business schools at nearby colleges and universities.

It’s still easier to get an investor’s attention if you first get an introduction from somebody he or she knows, no doubt; but even without that, if you do the research first and find investors with local or industry interest, the odds of getting a hearing increase dramatically.

And for angel investors, there’s also the Harold Lacy strategy of asking everybody you can think of who they know who might be interested. It takes the edge off asking directly for an investment and, if you know enough people, it can actually work.

If so, prove it. Get recognition for it. Publicity is good, right? Give it a try.

Go to visit Forbes.com’s America’s Most Promising Entrepreneurs. Take the survey. You may end up on the Forbes.com list, coming later, to be developed using the survey that you just took.

A survey which, by the way, was developed especially for this Forbes.com use by the Venture Alliance, whose CEO Jim Casparie has an excellent article on the same site about getting angel investment. Jim’s post there fits rather neatly with my post here on Up and Running, earlier this week, about questions to ask yourself before you start looking for angel investment.

A Twitter friend (Matt Riopelle) asked me to help his friend (call him Ralph) find investors for his business.

Offhand, even without knowing either of them, I’m sympathetic. After all, if you keep up with this blog, you’ll know it’s a topic I care about. And I’ve posted here about my recent experience as an angel investor (and if you’re wondering, no, I’m all tapped out at the moment), so I’m not surprised by the question.

I looked at Ralph’s website. It’s an interesting business, local to me, with new technology for an otherwise traditional and low technology business. New materials, a new take on old products. And they’re making a product I use.

So I’m interested in the problem.

(And if you wonder why I’m not being more specific, I don’t have anybody’s permission to mention the business, and seeking investment can be sensitive. Besides which, it’s also possibly illegal (depending on interpretations) to mention a business that’s looking for investment on a blog like this; could be taken as soliciting investment improperly. That’s why I’m not giving details.)

But first, some questions:

1. Are you really sure you want to go that way?

Sometimes I think we all (we entrepreneurs, that is) move too quickly to the investment alternative. Having investors is like having a spouse. No, it’s like having a spouse who is also a boss. Your business is not going to be yours ever again.

Oh? What? You want minority investors who give you a lot of money without attaching any strings? Fat chance. You mean you want somebody who has a lot of money (they have to have a lot of money, to make the transaction legal) and is also relatively naive? And really generous? Good luck with that.

Take a good look at your prospects. Do a business plan, not for outsiders, not formal and hard to do, just a business plan with realistic forecasts for sales and expenses. Then ask yourself whether you can get by without the investment. Can you borrow enough to make it work? Can you live with the burden of debt? Have you considered SBA-backed loans (they are moving again), which lessen the debt burden?

Don’t go down the investment path just because everybody says you should. Think about the rewards of making it work without the outside investors, so you own it all yourself. Food for thought: this post on Planning Startups Stories.

2. Do you have a business plan?

The good news is that you don’t have to have a plan you can show to investors tomorrow. You do, however, need to have a plan for yourself, covering strategy, markets, sales, profits, cash flow, all the key points. These factors are all related to each other and you can’t just wing it. You need to have real numbers.

And it’s not about showing the investors your plan. That may or may not come later. It’s about knowing what you need, and why, and what that’s going to produce.

3. Do you need enough money to interest investors?

Angel investors don’t usually want to deal with less than $100,000, and venture capitalists don’t want to deal with less than a couple of million dollars. Sure, there are exceptions, but those are general rules.

And you can’t just say you want it; you have to be able to show you can use that money to grow the business. You have to have a real plan, what you’re going to spend the money on, how it will increase your business.

If all you need is tens of thousands of dollars, then bootstrap. Maybe you have to get friends and family involved, but really, for less than six figures, it’s not worth it to professional investors.

4. Can you grow your business a lot, in a few years?

Investors who put money into small businesses are taking big risks and they deserve big returns. They don’t have to invest in entrepreneurs, they can lose their money just as easily in the stock market, and they can get safe interest with no risk. So you have to give them the hope of a big payoff.

That means big growth. Can you convince them your business can sell five times what it’s now selling in two years? Or ten or 20 times in five years? That’s what they need to make money worth the risk.

5. Do you have a convincing team?

Investors are going to want track records, people on your team who can run the production, marketing, sales, and administration of your business. They want people who have done that kind of thing before, sucessfully. If you don’t have them on your team, then the investors won’t be interested.

If you can answer yes to all of those questions, then you’ll likely be able to get investment (although not from me, but I can point you in the right direction).