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.)

I’ve seen this happen so many times: the entrepreneur gets the company going and wants financing to push it to the next level, and the investors want the company but not the founder.

It’s not at all unusual, and it’s not as bad as it sounds either. The underlying problem is that growing a company often takes different skills and talents than starting a company.

BusinessWeek.com has a good story on that this week: An Entrepreneur Prepares to Pass the Torch, by Nick Leiber. It’s about Michelle White of Michelle’s Miracle:

It’s a classic dilemma. A first-time entrepreneur creates a thriving company from scratch with the potential to be The Next Big Thing, but her investors thinks she needs an experienced CEO and management team to take it there. They also bet future investors will want to see seasoned leaders in place.

It happens to a lot of people. My favorite example these days is Steve Jobs, who was kicked out of his post at Apple Computer in the 1980s to make way for John Sculley, who ran the company from the late 1980s to the early 90s. Then when Jobs came back to run the company again in the late 1990s, he brought it back from near death to prominence. 

(Photo credit: that photo appears in the businessweek.com story online. You can click it to go to the original.)

I try to read Stu Phillips’ Soaring on Ridgelift whenever he posts. He’s a venture capitalist. He’s also, judging from his posts on the blog, a smart person, thoughtful about business, a good writer. And his latest–about the future of venture capital–is important.
He acknowledges a lot of talk about venture capital being broken, but disagrees.

Like any “system” that has been “enhanced” over decades, the architecture of the venture capital business isn’t broken but has fundamental issues that slow or even limit its ability to adapt to new market requirements.

Instead, he says, venture capital is caught in “an architectural transition.” He cites four factors:

1. Too much capital. Interesting, no? You wouldn’t think that would be a problem, but it turns out that it is.
   

   The supply of capital into venture funds isn’t balanced by the market exit potential (IPO, M&A) to generate an acceptable rate of return.

2. Too little expertise. Also very interesting, but a bit unnerving, too, because the VCs I’ve dealt with in my career were always at the pinnacle of the startup business. Stu says there are “a lot of smart people with very little operating experience.” Consider this thought:
   

   You wouldn’t want a medical procedure to be performed by someone who had been trained but was about to conduct their third or fourth procedure–on YOU. Yet in the VC world, this happened with new VCs sitting on the boards of private companies and dispensing guidance and business advice. The rapid growth exceeded the capacity of the experienced VCs to mentor the new folks coming into the business.

3. The Internet effect. This is my personal favorite. Fascinating. He calls it a “little-known side effect” of better information flow and decreased latency.
   

   But this same improvement means that ideas, concepts, description of problems, etc. quickly spread to be known by many people. The time advantage of knowledge has been reduced and places an ever larger premium on being the first mover and flawless execution.

4. Technology markets are mature.

So where does this take us? He has an interesting view of declining searches for startups and venture capital. He says venture capital 1.0 was the birth of Silicon Valley (my summary, not his words) and 2.0 was the internet boom.

And what’s 3.0? Still to be determined. AndPhillips doesn’t venture a guess. But his conclusion about either fire or water is worth repeating:

Big problems or unmet needs create a fire–big pain and urgent need. If you decide to play with fire, you must execute with perfection and precision. You won’t get a second chance, and VC investors should quit funding the moment execution becomes flawed or someone else does a better job.

Difficult problems or emerging trends benefit from an approach like the erosion of water. Relentless and slow like a river or getting into the cracks and freezing to break down the problem faster, like ice. Build entry barriers with fundamental IP, good execution and careful deployment of capital–together with deep and meaningful strategic relationships with established companies that realize they need your help.

Pick one!

I love it: facts, information, surveys and information sources. You could have read here Monday, posted by me, how venture capitalist investment was up a bit in the second quarter of this year. And you can read here today, also posted by me, how venture capital investment dropped 51 percent in the second quarter.

Contradictory? Yes. Venture Source said $5.27 billion on 595 deals. But Bloomberg cites a PriceWaterhouseCoopers and National Venture Capital Association survey saying $3.67 billion on 612 deals.

Both sources seem to agree, however, that things were slightly up from an even-worse first quarter, although way down from last year.

And the moral of the story? There’s an old saying: “There are three kinds of lies:  lies, damn lies and statistics.” In 30 years of business planning, every year I trust actual sales and entrepreneurs knowing the market more than market statistics and surveys.

If you’re working your startup right now, even if you’re going for VC investment, statistics mean next to nothing. What matters is your plan, your team, your market and how well you communicate that to investors.

(image: indecision, by sporadicity on Flickr)

This is sort of good news: Dow Jones VentureSource says venture capital investment recovered somewhat from its dismal downturn at the beginning of the year.

Venture capitalists invested $5.27 billion in 595 deals during the second quarter of 2009. That’s way up from $4 billion in the first quarter, which was also the lowest quarter since 1998. But it’s still way down from the second quarter a year ago, $8.33 billion in Q2 of ‘08.

The health-care industry is holding up the numbers: $2.23 billion on 184 deals was the first time on record that health-care investment outpaced information technology.

VC investment in IT deals, $1.88 billion on 284 deals, was slightly better than Q1 of 2009 but still very low, on a par with 1997 in money and 1995 in number of deals.

Software investment was $696 million, about half of the $1.42 billion in 2008. Energy and utilities investment fell to $317 million, less than a third of the $1.07 billion for the same period in 2008.

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.

Adeo Ressi says entrepreneurship is getting a lot harder.

“Compared to when I started my first company, in 1994, things for the entrepreneur founders have gotten exponentially worse. There’s steadily more regulation, less liquidity, more difficult labor situation; things are always getting harder.”

“When I was a newbie in 1994 it was complicated, stressful and difficult. But it was significantly easier than it is today. The only reason that I could easily start a seventh and eighth company recently was that I have 15 years of experience starting and running companies under my belt. If I were like at ground zero, in today’s market, I couldn’t do what I’ve done.”

Ressi should know. As you probably already gathered from the quote here, he’s been around this block a few times. I posted about his newest venture, The Founder Institute, on my Planning Startups Stories blog last month. And he is the founder of theFunded.com, a site where entrepreneurs can review investors.

“Honestly, I think more and more, these days, the entrepreneurs get a raw deal. They are victims of a lot of predatory and exploitation behavior. A lot of this is on the part of investors, taking advantage of their position with founders looking for capital. But it’s not just them. It’s the whole gamut of service providers, regulations and so on.”

In what feels like ironic understatement, he says TheFunded.com “has tried to address some of the problems of the predatory and exploitative things that happen when founders are seeking capital.”

He goes on quickly, though, to point out that schools aren’t teaching entrepreneurship well. Legal regulations keep pouring on new obligations and the life of a would-be funder gets tougher. Reflecting on The Founder Institute, which offers a three-month educational program backed by some big names in startups, he says:

“If we could eliminate all the headaches that modern bureaucratic layering adds to start a company, and allow these founders to focus on the core business challenge, the likelihood of success increases dramatically.”

And this is not about the depression. At least, not specifically. Asked whether that was the reason for starting his new institute, he told me:

“Why now? Well, now is the only time to do it. When things are good, help isn’t all that helpful. When things are bad, the ability to do something like this can have a bigger impact. Hopefully we can help people get companies off the ground that wouldn’t make it otherwise. And everybody knows that what really drives this economy is small business and entrepreneurship.”

So there’s a point of view for you. I hope he’s wrong, that things aren’t harder–at least not in the long term–but then, what do you think?

You might call it “I pitched my business to venture capitalists and lived to tell the story.” Scott Gerber, who wrote this piece for Entrepreneur.com, called it 6 Steps to the Perfect Pitch. He didn’t get the money, but he learned a lot:

As you might have guessed, I didn’t walk out of that meeting with a $15 million check. I later realized, however, that this was one of the greatest educational experiences of my young career. I learned more about real-world fundraising in 30 minutes than many entrepreneurs learn in a lifetime. To this day, whenever I pitch investors for capital, I always remember these six hard-learned lessons:

And as you can tell from the context, he goes on to share six well-written lessons, worth reading.

If you’re at all interested in business pitches and venture capital or angel investment deals, you’ll also enjoy his lively retelling of a pitch session that didn’t work. The interruptions, the questions he answered wrongly and the disappointing result.

I consider this a nice addition to my suggestions on making the business pitch, and perfectly compatible. For the record, that includes a five-part series on Bplans.com, and this short video on making the pitch.

There’s an excellent post yesterday from Steve King of Emergent Research on his Small Biz Labs blog: If You Are Raising Money, You Need a Business Plan. Steve acknowledges that people say venture capitalists don’t read plans, but adds: “that is totally missing the point.” He says:

The goal is not to get a VC to read your plan.  The goal is to get a VC to invest so you can build a successful company.

Yes, VCs like to get most of their information through pitches, pitch meetings or just talking to entrepreneurs. But they have to have a plan to make that work.

Steve explains:

I’ve been through this many times.  VCs always ask lots of detailed and specific questions that cover all aspects of the startup’s business.

And entrepreneurs [who] cannot succinctly explain the opportunity and show they have thought through the key issues facing the business do not get funded.

In my opinion, the best way to prepare for the pitch process is to develop a business plan.  Preparing a plan organizes the entrepreneur’s thinking, requires going through all aspects of the business and helps to identify important issues facing the company.

So I agree with him about the plan, and I think it’s important to not take the fake here: When people say venture capitalists don’t read business plans, most entrepreneurs are tempted to take that as a reason not to plan. It isn’t. Planning isn’t just a document that somebody else reads. It’s how you run your company.

And if you are talking to venture capitalists, then the plan is also the backbone of what you have to say. Whether they read it or not.