Startups and angels: Along the way to success

Managing Investor Relationships

How does an entrepreneur manage relationships with investors and advisors?  This is a complex subject.  Oftentimes when things go well, it is because everyone - entrepreneurs, employees, advisors and investors - have the same interests. 

The benefit of things going well for investors is a "no surprises" willingness to step back up with future rounds or rolodex assistance without having to recover from the shock of sudden, usually negative, news.

Employee alignment not only reduces turnover, but it also increases productivity.  It's axiomatic how much more people contribute when acknowledged and given important work to do.

Directors and advisors can't be very helpful without detailed knowledge of plan vs. result, major developments, and so forth.

Presuming that all parties want the company to grow and proceed along the path described in the original deal, attentive management of interests falls to the entrepreneur/CEO to lead.

So how does the entrepreneur do this?

1.  Keep people informed.  While this is especially true of investors not involved day to day, it also extends to advisors, directors and employees.  It's especially important to establish metrics and then use them to continually report on progress.

2.  Confront shortfalls and misses aggressively with plans and tests to recover.  Share these broadly. 

3.  Make sure that investors know the "news" good and bad -- before they read it in the press.

2.  Abide by decisions made at board meetings; if you must change, consult first.

3.  Recognize important contributions publicly. 

4.  Teach improvement lessons in private.

5.  Ask advisors for private feedback on your performance - not necessarily on strategies and plans, but rather on where you can learn and improve.

6.  Be close to your customer so that you can credibly represent an objective point of view.

7.  Resist the urge to decide instinctively without making your supporting facts obvious.  You'll be right 99% of the time but people won't be able to follow your decision making logic and it'll look random to them.  When faced with an authority that acts randomly, people get cautious and twitchy - exactly the opposite of what you want.  So, explain, explain and then communicate some more.

8.  Don't use technical drafting oversights to gain an advantage with others invested in your deal.   The best deals, as I've said before, are the ones where the structure of the deal doesn't motivate anyone to do what is not in everyone's best interests. 

Podcast: Having A Candid Conversation with Angel Investors

Here is my first attempt at a podcast.  It's a talk for Entrepreneurs (this recording is from the State Entrepreneur's Conference in June 2006) about how to select angel investors and also meet their expectations. 

This file is large (20+MB) in a format that is Real Player, iTunes and Quick Time compatible.  I'll try and figure out how to compress the next one.

I'd be very interested in your comments about this talk and about whether you would lke to see more podcasts here.

Thanks!

Download candid_conversations_with_angels_copy.m4a

How to assure yourself that no professional investor will ever want to invest in your venture:

I normally shy away from writing “don’t do this or that” because, while it’s compelling to learn from the negative side, it’s also a bit wearing in large doses.  Additionally, I intend this blog to be for entrepreneurs as a way of helping them to succeed, in some small way, and negative stuff is the wrong orientation.

Please pardon me today for breaking that rule.  I don’t think there’s a better way to present these ideas.

So, here are some thoughts on assuring yourself that professional investors will not be interested in your venture:

1.    Be unwilling to discuss any risks in detail.  Insist that the only risk is “finding true believers” to invest.  Proclaim to everyone you talk to that “once the cash is in the bank, there’s no risk at all.”

2.    Insist on raising all the money you are sure you will ever need, all at once.  This is especially good for true startups where there is very high execution risk and steep downside risk.  Try to raise $10MM all at once so that you “can get on with building the business.”  Dismiss staged investments and rising valuations based on results as “sissy stuff.”

3. Develop a plan to amass large fixed assets in plant and equipment prior to making any sales.  This assures that the $10MM will be sunk quickly. 

4.    Proclaim that “80% is committed” already so “take it or leave it.”  Do this early in the meeting so the weary investor can politely say, “I’ll leave it,” and leave. 

5.    Tell investors that “since we are all in this together,” you will issue all common stock with no preferences or debt restrictions.  Set the valuation very high so that if there is so much as a missed monthly milestone, any new money will be certain to cram-down all of the investors.  Absolutely don’t even consider any investment vehicle used by professional investors, like converitble debt or prefered stock.

6.    Try to get an NDA during the initial presentation.

7.    Use structures and investment vehicles appropriate for three friends opening a bar to raise money for a high tech venture.  This means no exit capability on the part of investors, reliance on a pre-appointed board of directors and management team with long-term fixed contracts, prioritization of insider debt in front of investors, and, overall, makes sure that every other sentence in your presentation starts with “Trust me…” For good measure, promise to share cash income “as soon as it makes sense to the founder.”  Of course, never consider vesting founder’s shares, or holding the CEO responsible for performance.  You are all buddies and want to make sure everyone knows “you’re doing all of this on trust.”

8.     Don’t do any work on alternatives to reduce risk.  When these questions are raised, sell the original idea more loudly.  Don’t consider early testing rather than building plants; make sure you don’t understand the industry.  Tell investors “there is no outsourcing in the industry,” right before they do a google search to find out that there is a $28Billion outsourcing capability.

9.    Use analogies about buying cars, opening restaurants, and doing deals with your brother in law to persuade the prickly investor that her fears are unfounded.

Testing to Increase Valuations

Let me propose that the best use of resources (time and money) in the startup process is to reduce risk.

If lowered risk translates into higher valuations when the business either attracts investors or is sold, then lowering risk for the lowest possible dollars creates very high returns.

For instance, if a business plan with a sound idea is interesting, it may be valued at or below $1MM.  If, however, the basic business assumptions that would make the idea interesting are proven to be achievable, the value may well leap to $2MM.  If customer interest can be obtained in a live test involving revenue, valuation may rise again.  And so forth through team building, developing expense structures, etc.

The idea, therefore, is that TESTING for results is one of the fastest ways an entrepreneur can increase the valuation of her business. 

It seems that entrepreneurs often test by committing relatively large amounts to rollouts of products or services based on planning and on expectations based on experience – but not often on testing.  In this way they spend too much relative to the amount of risk they are reducing.  When they miss their projections, the cost to recoup and try again is often prohibitively expensive. 

Examples of testing lessons learned:

1.    In a seasonal retail business, the temptation was to rollout to as many venues as the entrepreneur could afford, rather than “miss the summer season.”  But, when the results were disappointing, it was hard to find the money to use the valuable lessons learned and adjust because the cash was mostly gone.

2.    In an “elephant sale” software company ($200,000 average order) the staff and infrastructure was built to sustain sales of $400,000 per month, beginning three months from product release.  Unfortunately the sales process was untested and did not work as well as was hoped.  The company quickly ramped up losses faster than expected, putting pressure on a new financing round at the same time as disappointing results were being reported.

3.    In an e-commerce catalog, new catalog releases follow a specific plan.  Very small inventory orders are placed, and ad strategies for traffic are tested.  An algorithm is applied to predict orders after the first two weeks.  During the next month, additional inventory is purchased, again in small lots, and at relatively higher costs.  Why?  At the end of six weeks, the company can accurately predict demand for six months, place larger orders, reduce costs, and successfully launch with minimum risk.  And, if it is a flop, it doesn’t cost much, leaving lots of cash for the next test.

Testing.  Try it.  You’ll like it.

If a pig loses its voice, is it disgruntled?

Should an inventor be disgruntled if he can’t raise angel money?

“I sure hear there’s a lot of angel money around here,” an inventor said a couple of weeks ago. “But I sure don’t see where it is.”

Invention – as distinct from – entrepreneurial startups – is a difficult point of view for a business startup, in and of itself.    I’ve recently had both experiences talking to inventors.

The ones who are most likely to attract investors are the ones who understand the scope of the issues they are facing.  What does that mean?

Well, if it is a one product company, or can it grow more products?  If not, perhaps the prototype and license scenario is more appropriate.  (Build a working model, demonstrate it to major industry players, and if it is successful, license it to one of them for their use – with an annual minimum, hopefully.)

If it passes that step, the savvy inventor realizes that the invention is a smaller part of the new venture than most people think.  Before the new venture spends hundreds of thousands on building inventory, it must know about the market and the  “ "five forces"  of competition.

It must have a set of assumptions about how things are going to work – how much revenue form each sale, who these customers are, and so forth.

Then, these assumptions must be scrutinized and the ones that can be tested, should be tested.

In one way or another, those most likely to attract investment understand these issues and address them in planning and conversations with investors. 

Those least likely to attract investors are the ones who believe that the product is “something everyone will want,” and that building it as quickly as possible is the ultimate goal.  They perceive everyone as a threat.  In lieu of testing hypotheses and building financial models, they sell harder and harder, trying to get the potential investor to make a personal judgment about the efficacy of the product.

A budget discussion with an entrepreneur

When you get to the point in the discussion where projections are relevant, there is a drill-down method here used by virtually every investor.  Some may be subtler than others, but I guarantee you that the thought process is exactly the same.

At the end of the discussion, the investor wants to know:

1.    What must go right for the plan to succeed;
2.    What can possibly go wrong;
3.    What it costs if it does;
4.    Whether it is fatal or not.

In general, the first part of the discussion runs to whether or not your numbers are tied to metrics with an underlying set of assumptions, or if they are simply a function of  a mathematically applied growth rate.  Do you have assumptions about how long it will take to achieve each order?  What it will cost?  This cost and timing can easily be laid out in a matrix that may yield to testing easily.    In other words, if you are forecasting 100 orders in the next quarter, at $10,000 each, I’d ask how many potential orders there are in the market, whether there is any existing competitive experience, and how you derived your timing.   Timing relates to cost and I’d like a sense of the total cost of each of those 100 orders.  This includes selling costs, marketing costs, and so forth.  I’d want to know that you had an “in the ballpark” sense of what this all might cost.

(Of course, it goes without saying that no one would bottom-up an expense budget then fill in revenue to make it “come out,” right?)

Then, on the expense side, I’d like to begin to understand how the growth in the business will drive costs as complexity increases.  Growth involves, in many businesses, more customer service, product development, support, marketing and so forth – in addition to more R&D. 

I’m going to ask about ratio analysis based on what you know about what others spend in similarly situated companies, and where your data come from. 

So, if all of your costs rise smoothly in direct proportion to sales, I would suspect you built these costs for the first month and then just scaled them going forward.  That’s longer a budget; it’s a math exercise.

Out of the many facets of this discussion, a savvy investor will get a feeling for your understanding of the market you are in – or entering – and your level of experience about the planning process.   

All of that is antecedent to assessing your reaction to the process of discussing the assumptions.  I’d like to quickly begin a conversation about how “we” will go about finding validation for those assumptions or gaining new information that will help us change them. 

This takes a lot of risk out of the business process.

In our first startup, my partners and I built a customer acquisition model and tested it.  We pinched and scrimped to do that on our own money (about $75,000 in 1989 terms, which lasted us six months).  By the time we were done, we proved the model and gained enough new business that we didn’t need venture capital for almost a decade. 

How do you present your venture to an investor?

Do you think of this as a sales call?  As an attempt to convey your enthusiasm for an idea to a potential investor?  Do you use most or all of your meeting time in "persuasive" mode?

If so, you are in the vast majority of people who present business concepts and plans.

The implication is that you expect the investor to react to your idea, and while that is a required entry level conversation, what follows is really where the initial judgment begins to be established.

After a few minutes of presenting your venture, be prepared to discuss the interests of the investor, aside from the product idea. 

I'd suggest starting with risk assessment.  The canny angel wants to understand where the big risks are and how much time and money it will take to ameliorate them.  They will think about who may be the next investor in this business, if one is needed, and what risks that next investor will be happy to see solved, so that they can pay a higher price for the stock.  This is a discussion between potential partners and it engages the angel pretty quickly on the topic of "how can I be of assistance?"  It gets both people on the same side of the table.

The elephant in the room, of course, is the entrepreneur herself.  Evidence of how you have high integrity, a background that lends itself to this venture, a commitment to the enterprise, and a willingness to align your interests with the investors, are the deal makers.  Be proactive and address them rather than wait to be asked.  Supply detail about your history, your advisors, and your previous employment. 

Go lightly on the 5 year projections.  And, I'd avoid anything like a table showing 50% annual returns and the like.  Everyone assumes these are guesses. 

Of course, one place to understand how well you understand your business is walking through the expense and revenue assumptions with you.  More on that tomorrow.

Do let me know if this is helpful and what else you'd like to hear on this - or other - topics. 

Do you know how a banker looks at your business?

Bankers, first of all, are lenders – not investors.  So, their business lending approach is the initial screen through which you will have to pass.  More on that in a minute. 

Before you open that first checking account, you have an opportunity to build a relationship at a bank with people (emphasis: plural) you like.  But with whom?  Well, probably not with simply the deposit-side people who will open your checking account.

Banks have commercial lending groups who oversee the lending process.  Eventually, these are the people who will make a lot of difference to you.  (And, by the way, this isn’t a task you delegate to your financial manager.  The eventual banking relationship needs to be with you.)

The lender you want will be someone who understands your business, and who has had experience lending to other businesses with the same banking characteristics you are likely to have.   They will have the ability to be responsive on additional requests or needs that you will have as your business grows.

So, as you begin to build this relationship, you will want to profile lenders based on their experience and their references from others who have worked with them. 

To do that intelligently, understand how a bank is structured, how much their own lending limits are, what approvals are required and at what levels, and how easy it is for you to meet these people.

Who is on their board?  Bank boards, especially in smaller, “community” banks, use boards to build community relationships and meet people in the community who may be, or may become, good customers.  Look at their directors.  Do you know any of them?  If you do, call them and ask these questions. 

Are there entrepreneurs among them?  If you don’t know any of them, a call to one of them whose bio indicates they may understand something about what you are doing will be valuable.

Do they build long term relationships with people and companies who are not yet ready to borrow?  Find this out by making an appointment with a commercial lender and talk to them about your aspirations.  See how they react.  Do this at least twice – three times would be better.

Ask about downside situations, as well.  How have they handled situations that have not gone as well as they had hoped? 

What criteria do they look for to screen potential customers? 
Anticipate how much you might need, for what, and when.  Be prepared to discuss their lending practices as they relate to your future needs.  In other words, have a discussion about what those lending standards are that they would apply to your request for a loan.   Manage your business accordingly.

Before you do any of that, look at this link to the Risk Management Association    website and read as much as you can about how banks use RMA services for risk assessment.  Tell your prospective banker what you’ve learned and ask for his help in learning more. 

Then, open that first deposit account with someone with whom you hope to have a longer term relationship.  Then monitor the relationship;  update them a couple of times a year on how you are doing. 

Advisors are People Too.

"OK, so 'it's all about the people,' you say," writes Bill. "But don't your criteria include the investors and professional advisors, too?"

Great comment.  Of course they do. 

The entrepreneur certainly has to ask whether she can co-exist with the people that are potentially investing in or advising the company, as a first step. 

Then, she needs to structure a way to use their experience to learn and grow more rapidly than would be possible without it.  To do that, it's necessary to test the advice against the market and make sure that it is consistently accurate.  This will build the entrepreneur's confidence in the advice-provider which makes the ensuing cycle faster and more valuable. 

Next, as the business grows out of the advisor's experience, it's time to move on.  I didn't do this very well; I kept adding people.  In the end, we had a football team, and the quality of the advice declined to nothing.  Terms are a great idea as a way to start a discussion about whether to re-up or not each year.  (Of course, this is not a compensation issue; whatever equity deal she makes with each board member should outlast their tenure.)

Have an independent view of the role of each advisor.  Measure that view against the benchmark of what you can find about these roles in other enterprises.  If  someone is not a good fit, talk to them and then make the change. 

I've seen a great team of two business savvy advisors click with an entrepreneur and advance the company's learning curve by years as well as a law firm gut a company by demanding payment from an angel round of investment for two years of past work and mis-represent their intentions in the deal documents.

Not all advisors are good ones but the good ones are great for the venture. 

It's always the People!!

Want a guess at the success of an entrepreneurial venture?  One key area is the quality of the people running the show.  If the venture can't pass this test, it probably isn't going to be very successful.  (High growth and profitability, longevity, etc.  Doesn't mean it can't be a nice family business.)

1.  Would you work for the entrepreneur?  Is her enthusiasm infectious?  Do you get the idea?  Can they communicate it to you?  Do they care about you and your desire to be a real part of the enterprise? 

2.  Where are the founders from?  What is the overall caliber of this group of people?

3.  What is their reputation in the business community?  Who do I know that knows her/them? 

4.  How committed are they to this venture?  Do they have skin in the game?  Are they motivated?  How?

5.  Do they know where they will need to strengthen the team as it grows, or do they have fear of losing control?  Are they capable of recruiting high caliber people, and will those same high caliber people want to work for them?

Then you'll have a pretty good idea.