Startups and angels: Along the way to success

Reducing Startup Risk: A Video Comment

This video is only a couple of minutes long.  It's a brief comment I made during an interview about reducing risk.  Download reducing_risk_small.wmv I'd like to tell you that you'll see the entire program on 60 Minutes soon, but I can't.  And, yes, the forehead glare is real, unfortunately.

Who Gets To Break The News That Your Puppy is Ugly?

I'm at the National Association of Seed and Venture Funds meeting in Rochester NY today. 

One of the speakers this afternoon, talking about helping entrepreneurs get ready to present to investors, said something like this:

"Instead of letting people who I don't think are investable spend a lot of time on presentations to investors, I just tell them they either aren't investable or shouldn't be in business."

Now, let's assume that there are potential entrepreneurs that "shouldn't be in business," and that a smart advisor can accurately identify them.

The question is, though, who gets to tell them?

There isn't anything in it for the investor to tell them, especially if the entrepreneur(s) are in sales mode.  The investor does not want to be critical, is concerned he may be incorrect, and worries about protecting his reputation-based deal flow.  So he says things like "we aren't investing in these type of businesses right now," or "our investors don't seem to be sufficiently interested to warrant you spending any more of your time."

Occasionally the investor gets a frustrated blowback from the potential entrepreneur, perhaps underlining that "uninvestable" belief. 

If you're getting these kinds of vibes, and before you shop a deal so thoroughly that the guy bagging groceries at the local store knows about all of its flaws, figure out your personal best way of getting critical feedback.  Try using a diligence checklist (you can find them anywhere) to walk through a series of questions with the (now-ex) investor.  Listen.  Don't argue.  Seek to learn.  Or devise some other way to disarm the investor enough to get helpful information. 

Look yourself in the mirror and ask what you are hearing.  Do there seem to be areas of importance that you don't know about?  (As an example, are you getting signals that your claims/beliefs are hard to validate?  Does that suggest you ought to seek validation prior to pursuing more investment?)  How can you cover these?

Have you benchmarked yourself against others to see what you may not have?  Or may need?  Have you tried asking the investor about these things?

Are you looking for the wrong kind of investor?  What kind of investor is your business best suited for?  And so forth.

I'm a bit surprised at how many potential entrepreneurs really don't want feedback and waste a lot of time - years - finding out they're not investable.  And then finding something to blame (environment, poorly educated investors, low risk taking attitude here in ---fill in the blank --) rather than learning.

Four weeks of experience is repeated twenty times.  (No mistakes in life, just lessons repeated until learned!)

Planning for a Harvest

In a lot of startups (especially good ones) the founder/CEO/leader is a customer-oriented sales person.  After the idea/product/service is built, and the market mapped, the company begins to grow.  Because of the virtuous feedback loop right at the center of the company, innovations for customer benefit come more rapidly. Some level of premium pricing for the attentiveness and quality the company provides is possible.  Even with bumps along the way, the major customer facing components add up to more and more success.  Everything is great, right?

Well, yes.  And in businesses that are not on a "harvest path," this system, (combined with a constantly updated market map) should work well for a long time, potentially providing a lot of positive cash flow for the company and its owners. 

But...for a company with investors who expect a "harvest," just as things get good on the revenue side, the strategic plan for the company's future becomes very important.  A new customer emerges - the buyer of the company.  Whether this sale is going to be an LBO or a Private Equity transaction, or a sale to a strategic buyer, the process of selling to the buyer is critical, and overlooked.  The sales oriented CEO needs to manage this process as intently as the customer facing sales process.

It's amazing how fast this happens, especially in companies with short product development cycles in non-medical industries.  Without a pretty good understanding of all of the potential acquirers, and an informed view of how the company will fit with the acquirer, it's possible to leave cash on the table, or not to complete the transaction at all. 

So, the second market map the company needs is the world of potential acquirers and as much as we can learn of their preferences, practices and plans.   How long is their buy cycle?  How do they like to be approached?  Have they done a lot/a few/ no transactions with Investment Bankers? 

For strategic buyers --

What gaps in their offering exist that we fit in?

What do we sell that complements what they sell to the same customer base? 

Can they take our product to a new group of customers?

What can we do to their revenue?  EBIT?  How much synergy?

I Wish I'd Sold More

Rare is the entrepreneur who at the end, whether good or bad, hasn't said "I wish I'd sold more. "

Distribution is everything.  I am in the midst of at least four deals that focus on this topic.  In the successful ones the leaders sell.  They understand their customers and the market the customers live in.

They get the idea of value creation, of delivering more for the customer than they promise.

When it doesn't work so well, the leader either won't or doesn't sell, or doesn't think he can.  They delegate to all kinds of talented people and sometimes that's second best.  But it isn't the same as having the sales instinct down so well that he can taste it.

Jack Welch, certainly not an entrepreneur, was a salesman.  He used to sneak out every now and then and go on sales calls with GE sales guys, often from Plastics, where he grew up at GE.  He appreciates selling. 

Sometimes the leader caves in to the customer.  This is easy to do when the customer is big and you are small and knows you are starting out.  (Smart customers ought to treat startups very well.  Who won't remember that when the chips are down?)  We had a very large customer who once said at a conference when asked "whether our product was worth its price" that he never paid us "a net nickel.  They made money for me a lot faster than they ever sent bills," he said.  I still send him a bottle of wine at Christmas, twenty years later.

Sometimes the leader caves to the sales manager he's hired.  Whether it's price, terms, or features, without understanding all of the dynamics of what is going on, this can be pretty bad,too.

Good selling is creative.  It listens to needs and offers honest solutions, alternatives, insights, compromises.  Then it makes sure it delivers. 

My Dad sold for GE.  He never missed being at a construction site to make sure his deliveries (of major appliances) were right.  He designed his own cabinet layouts and helped developers with all kinds of products he didn't sell directly.  None of those things were in his job description.  And when he retired he was doing so much volume they replaced him with three salespeople.  Make sure you deliver.

In a venture, the leader is ultimately the guy who can deliver.  If the customer isn't buying from/talking to him, it's an obvious opportunity for the competitor to gain a foothold.

Go sell something and make your customer successful.

Doing Lunch Rather Than Being Lunch

I got an email the other day that I've excerpted a bit of as follows---

Good Morning.

My business partner  and I are in the process of setting up a company and looking for money. We have been offered 2 million dollars from (X)  but he is looking for a very, very substantial return and I think we can do better.

We have a patented process to manufacture (Y) products different than they are currently being manufactured. Our process has many advantages and we believe will take off once introduced to the market. We are in the process of having a machine manufactured so we can make samples to show potential investors.  We believe that our business plan is attainable and the numbers are on the conservative side.  We also have several potential customers waiting for the samples.

Here's what's interesting about this.  I called the person who sent this to me.  The product is pretty credible and will address the home construction market.  But the deal that they were considering was not very good.

They were going to sign up to performance penalties that potentially would cost them the company if they missed their projections by six months or so.

This is a product that ought to produce nice growth, but inevitably growth takes longer to achieve than plans call for, especially out three years, and especially when beginning with only an idea (albeit a pretty good one). 

So why would an investor offer a couple of million dollars?  An industry insider would know the value of the product in the market and the distribution required to make it go.  Perhaps the long term prospects are excellent.  (Perhaps the "offer" was only meant to be so egregious as to suggest that any sane entrepreneur should walk away.)  In any event, the entrepreneur was going to put herself in a corner from which there is little escape.  If things don't go perfectly in this case, the investor owns everything. 

The nightmare scenario is one in which the product performs, but not as well as projected, and the investor takes over and forces the entrepreneur out.  A year later, the thing is a growth story.

What's a better idea?  A partnership with someone on the distribution side might be a better answer, as well as a prototype developed on friends and family money - or on a good deal with that partner.  Yes, a deal like that will have a buy-sell, but constructed properly, everyone can win.

This probably isn't an angel deal because the returns will be good but not in the range of returns angels look for.  Also, I told him, this may be a very nice company for a long time, and forcing a sale may not be in the best interests of the company.

How do you avoid these situations?

1.  Know what is being proposed.  This seems obvious.  It's not.  Understand what the mechanics are for warrants, common vs. participating preferred stock, convertible debt, and all of the terms investors are talking about to you.  Of course, consult experts - but make sure you understand what is being proposed - not what their interpretation is. 

2.  Have a low burn rate.  Easier if you are younger, I suppose.  But the ability to require very little cash as you develop your venture pays huge dividends in flexibility and opening up choices.

3.  Don't think that all equity investors want the same "harvest" event.  People who invest other people's money invariably want it back on a schedule, and therefore invest in deals with a sale of the company as a goal.  But, there are investors who may be happy with a piece of the action for a long time (as long as there is a way to trigger a buy-sell in the future) especially if they may have another strategic interest in the deal, such as a distribution partner.

4.  Beware of individual investors who do not have to worry about their public reputation as investors, as VCs or angel networks do.  They can make this kind of predatory offer with little regard for who may know about it. 

5.  Ask yourself what value the investor can add - beyond the money. 

Paul Graham on Funding Startups

So, Paul Graham is a brainiac.  He is a partner in a pretty much exclusively software seed stage fund, Y Combinator that you can read more about. 

He writes challenging essays at paulgraham.com (8 million hits it says!) that are very thought provoking.   Read Want to Start a Startup? carefully.

It's refreshing to see several of these ideas in print.   For instance:

1.  ...A way to fund a startup is to get a job.  This frequently starts as consulting - which is how RTMS, Inc. started.   We worked all day building market strategies for customers while we tried to embody our expertise on software that would expand the company's reach.  (This was 1989.)  Interestingly, the consulting business remained and is a mainstay even today.  They got better and better as the software application got more capable.   There's hardly a major US retailer they haven't worked for.

2.  Some angel groups charge you money to pitch your idea to them.  Needless to say, you should never do this.  Amen.

3.  One of the dangers of taking investment from individual angels, rather than through an angel group or investment firm, is that they have less reputation to protect.  I've seen that more than once, but I thought I was the only one talking about it.  The flip side is true, too.  Individual angels can get sucked into situations that a group's experience might have avoided. 

4.  Angels can allow founders to partially cash out if they choose to.  It's true; we've done this once.  It isn't the rule, but it's a possibility.

5.  Angels who only invest occasionally may not know what terms they want.  Paul goes on to develop the story of "vanilla" documents prepared by the angel's attorney.  When this happens, (due in part to the need to keep fees low) things get both left out and included that later wisdom will suggest should've been included or left out.  Groups tend to use more standard terms and -- more important -- develop an understanding of what they really do want.

6.  Like VCs, one of the advantages of seed firms is the advice they offer.  But because seed firms operate in an earlier phase, they need to offer different kinds of advice.  Good angel groups, too.  That advice is often both technical and srtructural.  Groups don't all do this.  Be sure and ask - for examples, not intentions.

7. ...the disasters of the Bubble showed that generic business guys don't make such great CEOs (in reference to replacement of founders.)  Yup.  Been there. 

8.  Angels like to invest in deals that come to them through people they know.  Absolutely.

9.  ...being slightly underfunded teaches them an important lesson: cheapness is power.  A low burn rate is a pearl of great price.  It provides lots of options that high burn rates take away.  In Paul's words "Spend little, and work fast."

10.  ...vesting (of founders stock) is a way for founders to protect themselves from one another.  It solves the problem of what to do if one of the founders quits.

and also...

"If "near you" doesn't mean the Bay Area, Boston, or Seattle, consider moving.  It's not a coincidence you haven't heard of many startups from Philadelphia.  Or any humble California software guys.  Not everyone can be perfect.

The Best Advisors are Teachers

Several of the insightful comments I've gotten this week asks if I don't see a place for the business advisor in the entrepreneurial business.  That is, aside from lawyers and accountants, whose expertise is undeniably required in ventures, do I think the business advisor generally brings value to the venture?

The best advisors are teachers, I think.  This is a way of being.  By contrast, the advisor who wants to make decisions - or give strong advice and then sell it to the entrepreneur - is often a less than optimal fit in the venture.

We call on the entrepreneur to be decisive, to prioritize, to make decisions and test them, changing as required, all the while operating on 10% less than humanly possible. 

Into this very difficult and altogether human mix, enter the advisor.  If the entrepreneur has wisdom, she asks "why" all the time.  She uses her advisor to teach the why and the how.  She probably verifies the advice enough to advance some trust to the advisor.  She begins to build experience more rapdily than she would by herself.  The advisor who relishes the role of assisting the entrepreneur to grow stronger and more capable - and independent - is invaluble.

The strongest potential advisors operate from knowledge based on a broad set of real experiences - both successful and not.

If the entrepreneur, on the other hand, cedes decisions to the advisor, the venture is out of the entrepreneur's hands.  Making a decision to trust an advisor based on the entrepreneur's judgment about the advisor's ability, rather than on learning the decision making process, is a dangerous game.  And the advisor who likes the role of decision maker rather than teacher often makes the entrepreneur less broadly capable and more dependent.

That does not apply to every operational issue - but it sure applies to strategy and finance.   

More on Plan Development

This story "From Idea to Reality" appeared in yesterday's Milwaukee Journal-Sentinel about this blog and the "Growing Entrepreneurial Ventures" post.  This has become a hot topic; perhaps this might be going somewhere.

Finding Credible Help

I've once again had the opportunity to talk to a potentially great entrepreneur with lots of experience in his area of interest, and a credible idea that is really worth pursuing.  He's a scientist - a very good one, I think.

He admits to not being a business guy - tho he has grown a very nice business quite well for almost ten years.  And, as he starts to think about growing and expanding, he is facing the same challenge I see all too often in the Midwest - a dearth of people from whom to seek advice and experience.  (I actually had the same conversation twice today with two different entrepreneurs.)

How do you - the entrepreneur - figure out where the risks are in your plan, how to reduce or eliminate then, how to think about structuring, and what the most probable best course is?

Well, in the words of Bob Ryan, for one thing, "don't pee in the well."  That is, don't keep moving from one investor to another with a different version of the same plan tweaked and adjusted until everyone and his uncle has seen it and rejected it.  I blame this on weak "advisors" who have never actually done a startup and pass along self-serving (and usually fee-based) advice.  See this article from Guy Kingston, "When The Best Advice is No Advice."

And, do map the market.  Who might also be working on this, who is selling to these same customers, who are our natural partners, and competitors?  Have we used this logic based structure to figure out how big this market may be?  It doesn't matter if it's a $5, $50, or $500 Million market; but how we finance the business to grow will be almost entirely based on market size.  Don't think too big if the market won't support it, because you'll have a difficult time digging out from under the financing.  Don't think too small if the market will be big because you won't be prepared and will miss it.  I know that sounds a bit like Goldilocks and the Three Bears, but it is really true, nonetheless.

What's our plan for distribution?  (We used to call that sales in the olden days.)  I have yet to meet an entrepreneur who had sold a business who didn't say "I wish I had sold more." 

Launch, launch, launch.  If you are not at least a little embarrassed by your version 1.0 product you are probably launching too late.   We often over engineer while sales oriented companies grab the brass ring. 

When the risk-reward and timing is right, think carefully about what the investor's interests are.  Make some provision for the financing round after this one so everyone knows where they are going - together.  And present to the investors in a way that not only acknowledges their interests but sets up a partnership relationship that is good for everyone. 

And do map the advisors you need based on the skills you need in your advisory group, find people you trust, verify your instincts, then verify them again.

Here in the midwest (true others places too?) the number of advisors who have relevant entrepreneurial experience that can be organized and directed is awfully small.  Our angel group is now talking about helping startups, well, start up.  Kind of an incubator format with highly experienced folks. 

But, getting the right advice and the right commitment to an ongoing relationship not based on availability between other activities but rather on the needs of the business is critical.

Advisors have to be able to sell, to work their rolodex - and it had better be a good one - and to generally roll up their sleeves and be helpful.  Pontification is an overrated skill. 

I'd love to know what you think.

Looks like we've started something...

Yesterday's post drew several comments and a lot of traffic.  Seems this whole subject is a hot button.  This being a holiday weekend, I only wanted to post a link to the SBDC (Small Business Development Center) and keep the conversation going. 

The SBDC provides classes for entrepreneurs and business owners.  Take a look.

Another comment raised the question of advisor compensation, and yet another asked what the difference was between the idea I posted several days ago and more traditional one-to-many classes. 

I'll try and tackle these in the upcoming week.  Stay tuned.