Startups and angels: Along the way to success

You paid how much for that fish?...Or, the cost to acquire a customer

Well, perhaps this isn’t the perfect analogy.  (You think customers are like fish?  Etc.)

But it is a great photo.

Nonetheless, if you think about what it costs per fish caught to go fly fishing, it seems an uneconomic activity.  And while fly fishing has obvious benefits in addition to acquiring fish (and usually returning them to the stream), the cost to acquire a customer is a critical number for an entrepreneur.

It can drive all sorts of new knowledge that gets us moving faster in the direction of proprietary information that helps us and isn’t obvious to others.

Customer acquisition cost calculations probably should include all activities devoted to finding new customers, including direct sales costs, advertising and other media efforts, and so forth.

As en example, let’s say it costs $1,750 to acquire a software customer in a “software rental” (also known as an ASP) type business.  The customer pays per use.  Customer revenue for this customer is $12,000 per year. 

Good or bad?

Area for improvement in lowering acquisition cost or really quite good?

Well, how long do you have to keep this customer to get your $1,750 back?  At a profit of 10% ($1,200 per year) it will take about 18 months. 

How long do they remain a customer?  If it’s less than 18 months, there’s a problem. 

Next, what is the industry standard for acquisition cost in this category?  (How am I supposed to find that out?  Call my competitors and ask them?  Hire a consulting firm?  Isn’t this awfully esoteric?)

Well, here’s a little secret.  Any member of the Direct Marketing Association in New York City can use their library online.  It contains years of entries in their annual contest (the “ECHO” awards).  Winners are based on numerical results like, yes, acquisition costs.  With just a little digging it’s possible to find some pretty interesting figures. 

One company I’m familiar with sells an annual subscription in the mid six figures and has had no attrition over five years.  Their “hit rate” (number of prospects converted to customers) is quite high.

These facts give them the savvy and the latitude to be aggressive in customer contact opportunities.  Their low attrition rate (0%, usually considered good) encourages an appropriate emphasis on continuing world class service and product design.

The best salesperson is...

...the entrepreneur. 

.

Ask a VC -- half of the write downs they make are due to inability to gain sales.

I love it when the entrepreneur is the chief sales person.  After all, this is the person who has convinced others of the value of the concept.  Often that has included hiring people, scraping together resources the entrepreneur doesn’t really control, and finding those early adopter customers who willingly “wire together” a product that’s almost ready -- because they’ve been sold by the entrepreneur.

It’s a bit disconcerting to hear a very early company leader propose that the first hire should be a sales “guy” to “take care of” the sales stuff. 

The mind of the customer is the entrepreneur’s greatest resource.  Usually that does not mean that the customer should -- or can -- specify the design of the product.  But it does mean that he or she knows the ultimate goal of the business and how the proposed product fits in.  Only the person selling to the customer has access to that first hand knowledge.

Inevitably, a transition occurs to a sales VP or similar.  But the best entrepreneurs never lose touch.

Jack Welch, not an entrepreneur but a canny business guy, used to love to sneak off a couple of days a year and ride with sales guys from GE Plastics.  He never lost his gut feel for the customer

Ten questions the entrepreneur should ask the (prospective) investor

Of course, not all money is created equal.  Some comes attached to investors who are making their first investment, for instance.  If they’re making it as part of a group that the entrepreneur likes, fine.  If they are “solo,” though, the entrepreneur will want to know a lot about their attitudes and expectations, especially when things go wrong.

In that situation, or when meeting a new group of investors for the first time, here are ten suggestions for discussion starters that will help both groups come to know each other better, and set up a prospective investment for success.

1.  What are your screening criteria for investment opportunities? 

Listen for an answer that includes “the people.”  Betting on the jockey has been and continues to be the obvious direction investors take.  How they figure that out will be important to you.  You, your team, and the advisors you’ve chosen will enter into this calculation for investors.

Does the group have an interest only in a specific area?  What are their expectations for intellectual property-protectable businesses? 

When they discuss market size, do they distinguish between current and addressable markets?  Are you able to explain why your product is a compelling purchase for the customer, and how the customer will make buying decisions?  Can you describe what will make the company grow?

2.  What development stage is your primary business focus?

Where along the journey of seed-early-growth does the group like to invest? (Is this consistent with their actual investments?) 

3.  What would you like to know about our competition?

It would be great to see a presentation that proactively addresses this issue.  A business might or might not have direct competitors, but it might have a competitive substitute.  (What is being replaced by this new product?)  Even in biotech businesses, new tools, methods or discoveries almost always eventually displace something.

This whole topic is of interest to investors for a number of reasons beyond the logic of market dynamics.  It tells them a bit about how you think and plan; it may provide hints of who the 800 pound Gorilla may be who will want to eventually acquire (or crush) your enterprise, and it may provide ideas about who else to talk to for more background on your company.

4.  What is your due diligence process?

Most groups use some sort of list.  I’d ask for a copy upfront.  You may want to proactively begin to prepare the responses called for.  As you discover gaps, you can discuss them with your prospective investor.

This process will again provide factual results, of course.  It also gives investors information about your intellectual integrity and some glimmer of how you will face adversity in the startup process. 

5.  What’s your added value?

What sort of involvement can investors provide?  Do they have members or connections in places of importance do the business?   Can they help as advisors and does their experience line up with your need?  Do they have an index of members’ experience that you can see?  Are they well regarded in the community?

6. How do I get that added value into my company?

What has been the investor’s practice about getting their members to help?  Can you get references from their portfolio companies?  Where something hasn’t worked well, (and if they’ve been at it for a while, that’s going to be inevitable) how have they handled the situation? 

How do you get to know the members who may have the experience to help you and the interest in doing it? 

Does the investor know any Venture Capitalists and have they done deals with any?  It’s a great idea to have a group with good relationships with VCs based on doing deals together. 

7.  What’s your attitude about “next round” financing?

A list of possible answers:

    1.  We are open to them and have done (X) number on               
         our own.

    2.  We are open to them and prefer to begin to co-invest at
         this stage when the company can justify a higher
         valuation than the previous round.

    3.  We don’t like them and would prefer not to be involved
         past round one.

8.  What is your ideal total investment size (amount)?

If the investor's ideal size is smaller than your need, you ought to ask about syndication.  If they don’t like to syndicate, or don’t have a track record of doing it, you will want to consider your options.  A mismatch here can result in a smaller amount of investment than the business needs, combined with some limited flexibility to seek more. 

9.  What factors will drive your proposed investment structure?

Underlying this question is really “How will you manage the risk in this opportunity?” 

Common stock is a vehicle for sharing risk equally with insiders who have more knowledge and ability to affect business results.  Fewer investors will take common stock in early stage transactions. 

Debt with some sort of conversion provides greater risk abatement in that debt comes “due” at some point if the conversion terms aren’t met.  It is used by some investors who like the deal but can’t come to terms on valuation. 

Preferred Stock is the most usual form of investment today.  It has superior rights to common, usually is converted to common for the purposes of a sale, and sometimes has a sort of bonus payment to investors, called a “participation.”

In each case, some sort of “exit strategy” will be part of the structure.  This might include a maturity date on debt, or the right to sell the stock to the company, sometimes at a minimally agreed upon amount. 

10.  How do you approach valuation?

I suspect there are a thousand answers to this question. 

The only two components of this process that really should come into play are “How much money do I need?” and “What  percent of the company will I be willing to give up to get it?”

The percentage owned by the entrepreneur after the investment has been made is the “sweat equity” that  represents the work the entrepreneur has done to get to this point. 

It’s only human for the entrepreneur to want to retain as much equity as possible and for the investor to want to minimize risk.

Let’s consider “How much money do I need?” 

The investor wants to know how this money will be used to grow the enterprise.  Other purposes, especially paying off loans from the entrepreneur, or others, raise concerns on the investor’s part.  Less money, intelligently used, can sometimes get the company to a level worthy of raising more capital and at a higher, more favorable, valuation. 

Second, the fundamental question about the percentage for the equity is value.  If the entrepreneur offers 25% of the company for $1 Million, this implies a valuation of $4 Million.  If  the company is in a very early stage, many investors would find this price high.

When an entrepreneur gets to this conversation with a pre-set number in mind and a “calculated investment return,” it can be a difficult conversation.  As an example, if you, the entrepreneur, have prepared an investment document, with a set valuation, it implies “take it or leave it,” and may result in attracting a less value-added investor than otherwise might have been possible. 

This is hardly an exhaustive discussion.  I’ll write more later if I get questions. 

"What Makes an Attractive Angel Investment"

This is an overview prepared by the Marquette Golden Angels Network for entrepreneurs. 

Download what_makes_an_attractive_angel_investment.pdf

(PDF 1.5MB)

What is the angel pondering? Eight points

Here's an insider's view of what angels are thinking about when they talk to entrepreneurs.  Keep this in mind in your angel conversations.

OK.  So puppy pictures are a cheap, sentimental attention getter. 

Nonetheless you’re reading this.  And we’ll come back to the puppy in a moment.

 

1.  Does this entrepreneur have a passion for this business?

Before the investor gets to the question of knowledge and ability, passion is the ticket to admission.  Passionate entrepreneurs see a larger purpose in their endeavors.  It shows, and it is infectious. 

I once had a competitor in the software business who had worked out a way to “grow and flip” a software company.  He didn’t care much about the customers but sure understood the financial engineering to appeal to the public markets.  He succeeded, too.  For a while.  However, without much passion for his customer, it felt like a higher risk endeavor for investors, as it turned out to be.

2. Is this team great? 

If this is a pre-seed business with one person, then it may be too early to ask this question.  Without a team in place it isn’t possible to assess execution ability. 

As the entrepreneur assembles the team, in a strong company, team members will have complementary skills and will be A players in their own right.  Great leaders hire A players; weak ones hire lesser players. 

Investors would like to know that the entrepreneur has a view of the team hiring and building process that has the goal of the company in mind.  They want to see objective self-awareness reflected in action.

One of the companies I’m familiar with has done exactly that.  Team members have distinct areas of expertise and all have great leadership potential.  They’re led by a CEO who has selected them solely for their ability to be industry leaders in their work and complement each others’ skills.

The CEO views his role as providing resources and support for their work.  And the investors love it. 

We have all seen situations where the opposite occurs.  The leader hires weaker players and winds up working 25 hours a day intervening in every decision.   

3. What are the key drivers for success in this company?

Most businesses have a couple of key metrics that drive success. 

This might be cost vs. price, for instance.  (Can I get paid for substantial value added?  Or is the competitive situation crowded enough that the value add is my differentiator but not at a premium?)

In an early biotech business it may well be the team’s ability to move more rapidly toward commercialization.

Is it capacity for product innovation?  Maybe the team’s industry position (there’s that A team again) gives them a vantage point on the customer’s need that can translate into new products with high intrinsic value at a rapid pace. 

Is it excellence in execution in customer service?

Does it embody a defensible strategic position?

You get the idea.

4.  Will the dog eat it?

(See photo above.)

This is really the business growth imperative.  If an entrepreneur hopes to attract investors (and has figured out that he need so) substantial growth rates will be required.

Sooner or later every business faces the question of how much the dog will eat, and how rapidly.   The entrepreneur reduces his own risk by knowing the answer sooner rather than later, and at the least cost.

Is the business predicated upon a government subsidy?  A lot of energy proposals fit this description.  If so, what are the chances the subsidies will dry up?

Is the benefit to the customer compelling?  What are the criteria for buying?  How long will it take to acquire each customer?  What has to change to improve these metrics, if anything?

I have seen a product designed and built that comes to market only to find that it isn’t quite right.  It needs something else.   Problem is all of the available resources were spent in the 18 months it took to develop.  The dog won’t eat it and the fix is costly.  Companies die for that reason.

5.  Does the entrepreneur know how to test?

Many of these “needs to know” can be discovered by testing ideas.

Sometimes testing means acquiring the criteria of the potential customer.  (If our new molecule gets through phase one, what level of interest do you have? )

More often it means market tests that rapidly acquire information at marginal cost.  If successful, rollout follows.  If not, there are resources left to adjust and try again.   Every successful catalog is based on some variation of this concept.

Tests are usually segmented, and should be as often as possible.  Two pricing concepts are offered; product configurations vary; acquisition costs per customer are tracked; and, very important, potential customers are grouped and tested as distinct entities.

6.  What’s the customer’s lifetime value?

If you have good testing results, and we know the scope of the opportunity, what is the probable lifetime value of the customer?  If keeping a customer for five years adds $15,000 per customer per year to the company’s revenue, it focuses attention on all of the things the company can do to keep customer satisfaction at a very high level.   

7.  If the business is reliant upon a “home run” to succeed, what are the chances of that happening?

What is the ability of the team?  How difficult is the required technology breakthrough, if any? 

Is the home run required because the average price is low and the development and support cost very high, so double digit market share is required to succeed? 

8.  Are we on the same page for an exit?

Sometimes entrepreneurs scrutinize this for hidden meaning, but there isn’t any, at least that I’ve found.  The straightforward question is “how will the investment be repaid, and under what terms?”

Whatever the answer, (a subject for another time) it is a topic that must be put on the table and one that the investor will be pondering.