Up and Running:

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.

So this week we get it again: another business publication with a poorly conceived rehash of a misguided academic study saying venture capitalists don’t read business plans.

Why poorly conceived? Why misguided? And why a molehill?

The molehill reference is to the old phrase about making a mountain out of a molehill. In this case it’s making a molehill out of something much smaller than that.

The journalists like that study because it seems like the conclusion is contrarian: It seems to deny what everybody assumes is true. Specifically, it seems to question the usefulness of an entrepreneur developing a business plan.

But the truth is that the business plans that entrepreneurs should write, review and revise frequently were never really there just for VCs to read or not read. They were there to figure out what’s supposed to happen, when and why, how much it costs and who’s responsible.

The business plan is for you to plan your business. Whether somebody else reads it or not, you need to know what you’re talking about; and if you don’t have a plan, it shows.

So it’s a ruse, really: To say that VCs don’t read business plans is like saying audiences don’t read screenplays. The VCs get the results. The plan is for the entrepreneur.

Oh, and by the way, that study they’re citing lately, done at the University of Maryland–it was done almost 10 years ago at the height of the dot-com boom, when it wasn’t clear that VCs were reading anything, let alone business plans.

And of the million or so new businesses that start up every year, only about 5,000 of them are financed by VCs.

I posted New Entrepreneurial Seal of Approval earlier today on Planning Startups Stories, my main blog.

It’s about The Funded Founder Institute, a four-month, $450 program to run selected entrepreneurs (including, by the way, wanna-be entrepreneurs) through weekly sessions with mentors and experts, ending with a certification that should smooth the path to investment.

This is just starting, but it looks like a great opportunity. Adeo Ressi, the founder, has a great track record in startups–with VC funding and successful exits–and what he’s after is getting a few people a better chance at a more level playing field. Learn the ropes before you get in too deep.

If you can’t hack the $450, he’s got a number of Microsoft BizSpark scholarships to offer, too.

So if this sounds at all interesting to you, apply now. Applications close May 9. The application costs $50. The window is closing for this first run.

I think this is likely to be a really interesting opportunity.

Adeo promises that selection will be reasonable. He wants a broad group of potential founders. And they won’t necessarily all be headed for venture capital, not even necessarily for angel investment or even any investment. There’s even some language on the main site inviting bootstrapping startups as well.

Also, he says he doesn’t want just sophisticated, experienced startup people. He’s also looking for people without experience who want to learn.

I get asked frequently what’s the deal with friends and family, as in funding your startup with people who aren’t sophisticated investors as defined by securities and exchange laws. What that means, in a nutshell, is that it can be illegal to take money in exchange for stock from someone who doesn’t have the income or net worth as defined by the government as the minimum that makes that person a “sophisticated investor.”

I was browsing for an explanation of why not, yesterday, when I came up with this one: The Trouble with Raising Money from Non-Accredited Investors on The Startup Lawyer. That looks to me like a very good summary.

(Note: this is posted here with permission from Bplans.com, where it originally appeared.)

Last night we were talking about getting angel investment and valuation, which is one of, if not the, most important points in the discussion. Valuation is essentially price.

Say you want to bring in $150,000 from an angel investor. The immediate question from the investor will be something like: “at what valuation?” Sometimes that’s called “pre-money valuation,” because the instant the deal happens the valuation will change into post-money valuation, which is always higher–because your company just got some new cash.

Your answer sets your deal equivalent of an asking price. If you say $500,000, then you’re offering the investor 30 percent of your company for $150,000. If you say $300,000, you’re offering 50 percent. If you say $1 million, then you’re only offering 15 percent.

Which leads to the question:

So how do I know? How do I set valuation appropriately? What is that based on? Is it some multiple of sales or intellectual property or what?

And that’s a good question, and very hard to answer. Sure, you want some compromise between what you want to give as a percent of ownership in your company and what investors would want to buy. Investors will simply say no if it’s not an attractive offer. But that’s still very vague.

• In the case of an existing business with some history, you do have some formulas you can use. For a great site on that business interpretation of valuation I suggest bizequity.com, the Zillow.com equivalent for small business.
• When we’re talking about startups, however, you don’t have history and you can’t really apply formulas based on sales, revenue or even intellectual property (although that could be more relevant).

So here’s my concrete suggestion:

1. Calculate starting costs. That’s two lists, the expenses you have to incur and the assets you have to have at the starting point–except cash. Leave that blank for a bit.  Add those all–except for cash assets–to the starting costs, to get an amount, a number in dollars.  Click here for a lot more on that. So for example, in the illustration here, that would be about $40,000. Yes, I know it says $38,750, but this is just an estimated guess; always round up. You never guess just right.
2. Calculate cash flow through the lean period at the beginning, before your sales cover your costs.  Make a good guess at how much money you need to cover the deficit spending to get you to an operational, month-by-month break-even level of cash. That’s where the cash requirement number in the illustration came from: it seemed like this company would need about $400,000 to survive from startup to break-even. You can’t see much in the chart below, because it’s small, but it shows a projected 12 months of cash flow (in blue) with a minimum balance, a deficit (in red), of about $400,000.
3. That gives you a number. In this case, it’s $400,000. That’s what your cash flow shows you you’ll need to get to cash-flow break-even. In the last two months, the cash flow is positive, so the negative balance starts shrinking. With that estimate as a best guess, you go back into your startup costs calculation and add in the cash required. It’s $400,000. You can see what that does to the startup costs worksheet in the next illustration here.
4. Having done that, you now know that you need about $500,000 from investors (again, technically it’s $458,750, but you’re using best-guess estimates, so round up.) Set that as the amount of investment you’re seeking. Then–and here it gets hard, to be sure–you need to decide how much of your company you’re going to offer to an investor in exchange for that $500,000.
5. Get some help here if you can. Ask somebody with experience in startups, or dealing with angel investors, or both. Ask an attorney you can trust, who should also be somebody with experience. The thing is, how much of your company you offer to investors is about a compromise between what you’d like–none, free money–and what will entice the investors to write checks. At this point a lot depends on your overall business offering, the cards your company brings to the table. Investors want as high a return as possible, with as little risk, but in relation to return. How experienced is your team? How defensible is your product? How rich is the market? All these factors determine what kind of a deal will be acceptable to investors.
   • Let’s say, in this case, you’re new at startups, you have very little track record, and you want to attract an active angel investor as a partner. So maybe you set your initial valuation at $750K, meaning you’re offering to give away 2/3 of your ownership to get the money you need. You’re being realistic about what will attract an investor. You’d better really, really like that investor, because he or she will essentially own your company. But this is a hypothetical case and, without a lot of experience and defensibility, that may be the best you can do.
   • Or maybe you’ve got better cards to play: You’ve got a team with startup experience and a defensible new product, with some intellectual property, and it looks like an attractive market. That makes you able to set a stronger valuation, and maybe–we hope–still make it an attractive offer to investors. So maybe you say you’re valuing it at $1.5 million. You’re offering investors one third of your company for $500K.

So there’s a quick and (I hope) simple summary of how you set the initial (pre-money) valuation when you want to attract investment.

Dennis Lankes of startupslive.tv commented on my recent post, asking me this:

You work with startups and talk to investors all the time. What is it that really catches people’s eye and attention at a pitch? What are the questions the investors want to hear answered? Can you help me out?

Sure.

That seems like a reasonable question. What’s really fun is to start by thinking about what you’d want, if you were to invest money in a startup. You’d want a big payoff later for money invested now. You’d want as little risk as possible, in a very risky business, for as high a payoff as possible.  Right?

Yeah, for sure, but how do you get there? That’s the end point. So here’s a list:

1. Potential growth.

Usually that means products rather than services. You can sell more products by making more and ramping up–which we like to call scalability. It’s about leverage. If you sell boxes, not hours, you can sell more boxes without having to bring on proportionately more people. The investor makes money when the successful startup goes liquid. Liquidity comes from either IPO–not likely these days–or getting acquired by some other company. That doesn’t happen without growth.

Services, in general, are harder to grow than products because there’s not as much leverage. But that’s not true for all services. Web services, for example, can be very attractive to investors. As a quick test of whether a service might be interesting, ask yourself how many people you have to add to double the volume. With a lot of services–say business plan writing, for example, or graphic artistry or limo services, you have to double the people to double the volume. Investors call that a “body shop,” and they don’t like it as much.

Another major concept that’s wrapped into potential growth is the product/market fit. I like this phrase, which I saw first in a post by Marc Andreessen, “The Only Thing That Matters”, because it absorbs both benefits and market size. You don’t separate those two concepts.

This basic concept flows into many facets, such as positioning, defensibility, potential market, proprietary technology–all those factors that generate potential growth.

2. Potential Payoff in 3 to 5 Years

They call that an exit. It means a way out. And just like prisons, investments without any way out are very confining. Investors want an exit strategy.

Entrepreneurs take note: Investors don’t want to hold a share in your happy and healthy company that lasts forever and never creates liquidity. How would you like to put money into somebody else’s company and never see it produce any money for you? That’s why they call it investing.

If you have that dream about building your own company and turning it into a lifestyle business, then passing it on to your children, be aware that this scenario is an investor’s nightmare. You’re happy, so you don’t want to go liquid.

You can pretty much assume that a professional investor or sophisticated angel investor is looking to get at least $10 back for every dollar invested, and preferably $20, $50 or $100, and in three to five years’ time. Investing in startups is a risky endeavor.

As an aside, I’m amazed at how often entrepreneurs take this as some sort of character flaw on the part of the investors. Why do they want so much return? What’s wrong with them? The reason is that they know that startups are very risky. Lots of them fail. So investors want to hit big with the winners to pay for all the losers.

3. Reassurance on Risk

Investors know this is risky business. Nobody’s pretending you can produce a new business without risk. There are, however, factors that reduce the risk, keep it at a minimum level. For example:

• A good team: Founders they can believe in. People who know the industry, people with product development and market expertise. The best proof of intellectual property, better even than patents, is credible founders.
• Startup experience: Sorry, I know this is tough for first-time startup people, but having been through the process at least once before makes people on the management team much more credible.
• Defensibility: Might be patents, might be know-how, might be first-mover advantage, proprietary technology or maybe something else. Investors don’t want to see a good idea that serves the world only to point competitors in that direction.

I can’t say I like its title, but the post called “Earth to Venture Capitalists: Are You Out There?” on the American Express OPEN forum is a good reminder that there is some money available for new investments. And you might, if you need investment to get your startup going, just have to look harder.

Though it’s tougher for small businesses to come up with financing today than it was even a year ago, there are more resources to help locate capital that is available, says Wharton management professor Gary Dushnitsky, who studies entrepreneurs. And, he says, there are more opportunities for entrepreneurs to network with industry veterans and learn about previously unknown funding sources.

That’s posted there by knowledge@wharton.

It recommends several specific sources:

• Your Encore,
• youngStartup Ventures, and
• the National Venture Capital Association.

Don’t forget as well to ask your local SBDC or chamber of commerce about local angel investors as well.

I’ve posted similar stuff on this blog before, but it’s always nice when you get it straight from The New York Times. I just read Financing, With Strings Attached on NYTimes.com. My favorite line–I heard it first from Portland, Ore., venture capitalist David Chen — which I use a lot is “choose an investor like you choose a spouse.”

It seems obvious to me. Somebody puts money into your company, and that person has ownership; and you have a partner and, depending on how things go, a boss. At the very least, a partner. Doesn’t it seem that compatibility should be important? It does to me.

Author Dalia Fahey reports lots of anecdotal examples of strings attached by investors:

His complaint is echoed by other entrepreneurs. They tell of putting years into finding a business strategy that works and how their success attracts a professional investor. Then, while negotiating the terms of his involvement, the investor asks for changes. He might want to move a company’s headquarters or fire the chief financial officer. Or he might ask to replace one product line with another.

Especially in this weak economy, entrepreneurs may feel pressured to comply. And many times, complying is the smart thing to do because investors usually have more industry experience than the entrepreneurs they finance. Some entrepreneurs also cling to irrational ideas. But agreeing to such requests just because an investor offers cash is not always the best thing for the business, experts said.

Another reminder: Bootstrapping has its advantages.

And there is also the underlying obvious point. Plan well first, before it’s too late, to match the funds requirement to the opportunity. Some ventures need more investment than you can bootstrap. In that case, go into it with your eyes open, and be careful. Don’t just look for money; look for partners you can work with.

It’s hardly surprising, given the obvious need, that investors are ready and willing to put money into green clean technology. That’s not a hard prediction to make. Still, given the down economy and the generally down numbers and poor outlook on investing, how about this:

During 2008, green-tech venture investments jumped to $8.4 billion, a 38 percent increase, according to preliminary figures released Tuesday by the Cleantech Group.

Cleantech Group’s senior research director, Brian Fan, said in a statement:

2008 saw solar take a 40 percent share of clean-technology venture investment dollars, led by mega investment rounds in thin-film solar, concentrated solar thermal and solar-service provider companies.

Investors also continued to migrate from first-generation ethanol and biodiesel technologies to next-generation biofuels technologies, led by algae and synthetic biology companies. Other sectors with healthy investor interest included smart-grid companies, small-scale wind turbines, plastics recycling, green buildings and agriculture technologies.

So that’s good news to me, on two levels. First, it’s hard evidence that some business is doing fine, still growing; second, I think it gives us hope that there might eventually be real solutions to some of the global problems that plague us all.

What’s wrong with this idea? My answer below. First, the idea, as posted at  Startup Meme:

If you think your developer skills are waiting to be brought out to the world but funding stops their creation, worry no more. Consulting firm Herman Blackbook has initiated a mini fund for such developers. The funds that can sum up to $3,000 will be given to those developers who create apps on the Twitter, AppNexus, Trulia and iPhone platforms (others as well). The New Platform Fund investments will only be given to the ten most brilliant ideas. There are many other fund providers who invest in a range from thousands to millions of dollars, and another one joining the group would be an added benefit. If your app hasn’t been considered worth money, give The New Platform Fund a try too.

What’s wrong with the idea? I hope it’s obvious to you. Investors are partners and also bosses at times, extra voices, extra management. That might be well worth it when you need hundreds of thousands or millions of dollars, particularly if you hook up with good partners, who add value.

And, disclosure, for all I know, Herman Blackbook Consulting is such a good partner. But still, God bless the child that’s got it’s own.

Here’s what TechCrunch says about that:

Let’s be honest. There is very little reason for an entrepreneur/developer to apply for the New Platforms Fund. Incubator micro-funds like Y Combinator, TechStars and Seedcamp don’t give you much in the way of capital ($15k-$20k), but at least it’s enough to live on for a few months while you work on your idea. And those funds have very deep connections in the venture capital world to get you your first round of capital after you’ve spent their initial funds. It’s not clear at all that this new fund can do any of that for you.

The idea keeps coming up: “How can I find investors who won’t take control?” And the variation on that theme, “Where do I find investors who won’t want to take a majority stake in my new business?

And that is basically wanting to go into business with stupid people. Not a good idea.

The question you should be asking is more along the lines of: Where and how can I find investors who will work with me as partners, listen to me and give me a hearing but tell me when they think I’m making a mistake, contribute to building my company, and be compatible with my life style and work style.

If you think I’m kidding, click here for the LinkedIn question and the answers to it.

The Huffington Post confirmed Monday that Oak Investment Partners invested $25 million last week. I read it on Venture Beat:

HuffPo, as it’s commonly called, is looking to build on its momentum from the presidential race. You’d expect a lot of that energy to dissipate, but early numbers suggest that traffic continued to grow in the weeks after the election. Not that the site is betting solely on politics; it says it will be adding local sections–it already launched a Chicago site–as well as pages focused on entertainment, living, style and the environment. HuffPo plans to spend its new funding on that expansion as well as increased advertising capabilities, acquisitions and an investigative journalism initiative. I hear that video will probably play a big role in its growth and that a book site should be launching soon.

If the advertising climate is as bad as some are predicting, New York-headquartered HuffPo will definitely need all the money it can get. It’s also good to see a news site expanding at a time when almost everyone seems to be cutting back, and to see it putting money into investigative journalism, an expensive but important pursuit that big media organizations are making less and less time for. The site can probably grow in a more cost-effective way than most traditional publications, since so many of its blog posts are written for free.

This is a third-round investment, which means that The Huffington Post already has had a couple of rounds of VC money before this one.

Still, it’s not exactly your super-new technology, clean tech vs. old tech or alternative energy, but there you have it. Traffic is way up, and at least some investors still have money to spend.