Startups and angels: Along the way to success

Due diligence: An Entrepreneur's Perspective

Due diligence by an investor, seen from the entrepreneur's point of view, is all good.  Really.  Here is an opportunity to really learn a lot about your business prospects and gain perspective.

Yes, of course, some investors will use this process to see "how much they can get" and be impolite about it.  Fewer than you might think, tho.  And my advice is always "walk."  Money is only money but business ideas - good ones - are harder to come by. 

So think of this as a process of learning - about your venture from a new perspective - about the investor(s) - and about building trust.

The investor is asking if you are trustworthy.  If you have the capability to run this venture.  If you understand when the venture may need new leadership.  (By the way, this issue will always arise.  Talk about it in an open way.  If the entrepreneur agrees to some sort of leadership strategy it'll probably be in the deal terms.)

She also wants to know if you understand the market dynamics for your proposed business, and if you have thought deeply about eventualities and alternatives.  If the entrepreneur is always selling, beyond a certain point this makes investors uncomfortable.  If they have been around, they have all seen deals that had hidden facts, or that were interpreted rosily without providing the investor the benefit of the information.  Our friends in the VC community, of course, will learn an industry fairly well, and will engage experts as well, so as not to miss something.

It is disarming and refreshing when an entrepreneur explains the risks and the plans to reduce or eliminate them, upfront.  The single most important factor for an investor should always be the people and their quality.  The basics - integrity, fiduciary responsibility, and so forth - go without saying.  Next, I suppose, comes a firm grasp of the facts of the market and the competitive environment.  The willingness to be forthcoming and both seek to present the venture and seek investor advice are next. 

Each question, each discussion, each exploration always has two purposes.  One is the content of the question being discussed; the other is the quality of the entrepreneur in their demeanor and response.

At the same time the entrepreneur has the opportunity to see the investor in action.  And to compare the terms and conditions being offered with what the investor has said.  If the entrepreneur cannot get an equal sense of a straightforward and fair relationship developing, ask more questions.  Have more discussions.  If you don't like what you hear, walk.  (Of course, make sure you've gotten some third party you do trust to make sure you understand all of the terms before you decide they are unfair!)

If you do see a straightforward and fair relationship evolving, work as hard as you can to build mutual trust.  And enjoy the success that will follow. 

Thinking about pricing

When mapping a market, it's important to study pricing strategy.  This seems like an obvious comment.  Of course, everyone understands that somewhere in the equation there's revenue, whether directly or indirectly. 

I'm amazed, though, how often companies get it wrong and then are slow to react and change.  Here are two examples.

1.  Don't price where there is no value.  We tried to buy some software recently that the vendor wanted to price on the basis of third party uses, a category of activity uncontrolled by us.  In addition to an unlimited liability, the vendor wanted to charge the third party visitors a fee, which isn't standard in this business.  It seemed like a universally bad idea.  The vendor stuck to this model through beta and launch.  People bought the software but grumbled about the pricing idea.  Eventually, the vendor abandoned the pricing model when initial users started canceling subscriptions.  Now that information was available right from day one.  The customer comments were entirely negative.  And now, the vendor has spent a lot of money communicating not just a product but a price.  What will it cost to re-communicate?  And how long will it take?

2.  Price competitively by reducing costs.   We have another company that has "a better mousetrap," a manufacturing technology device.   The price for the current product in the market is about $750.  Our fully loaded cost is coming out at about $65 (!).  We can be in the market at $750 and be great -- and have lots of room to move if there is any need.  Think of what leverage you lose if your cost of goods is OK but your expense structure adds hundreds of dollars to the fully loaded cost.  Yet, companies add expenses every day without thinking about what those expense additions do to pricing flexibility.

Pricing strategy is a big topic.  We communicate to customers and competitors by how we price, and it is not simple to change.

Calculating Market Share

Early growth companies - good ones - focus on sales.  A lot of effort goes into making sure the product is what customers want.  The entrepreneur thinks hard about all of the components that make the buying experience just what the customer wants.

To make sure the company isn't overlooking opportunities, or to begin to understand the boundaries of the "served market," do a little math.

I always ask entrepreneurs, when they are in a selling opportunity, how often their product is appropriate for that particular situation - right features, right price and terms, and so forth.

Let's say the entrepreneur's answer is "75% of the time."

OK, now, I ask, what's your success rate?  How often, when you have the right product, do you get the order?

Once again, the entrepreneur says, "75% of the time." 

So, then, the company's market share must be about 55% of the market.  (75% right product x 75% success rate.)

Well, no, says the entrepreneur.  I sure wish it was. 

Well, why not?

Because the company is not present in the vast majority of the opportunities available.  If it participates in 5% of all opportunities to sell its product, its market share is more like 2%.

Taken at face value, this means the entrepreneur should begin searching for every opportunity. 

That's one interpretation.  And, depending on the geographic constraints of the company and the market, it may be the right one.  It's also possible that our market is smaller than we had thought, and we should target our efforts in a smaller geographic area to improve our presence.

Presence can cost a lot of money - or very little.  If the company sells to hospitals, it is possible to know every customer in every geography.  It will still cost quite a bit to maintain enough knowledge about every hospital to be able to be present in most sales opportunities.

In some businesses, we rely upon advertising and communications as a way to ask the customer to tell us when there is a selling opportunity.  Sometimes this is the only practical way to do it.

In numerically smaller markets, with relatively fewer customers, moving to a proactive program to find sales opportunities - whether with a CRM application for a sales force, calling programs, email, or the like - can yield dramatic results by taking a great product and success rate and putting it in front of an expanded customer base. 

This is a simplified view of one product of course.  More on the subject of more stuff to the same customers another time.

The Sound of One Hand Clapping

The sound of one hand clapping:

1.  Telling a customer you are busy--when you aren't
2.  Telling a VC you have another term sheet -- when you don't
3.  Telling an investor the round is 80% subscribed -- when it isn't
4.  Telling a potential business partner you are close to signing with his competitor -- when you aren't
5.  Telling an acquirer you have another offer -- when you don't.

Real Applause ("Bualadh Bos" in Irish, in case you wanted to know) sounds like this:

1.  Being busy and prioritizing work based on customer criteria -- and raising prices
2.  Having two termsheets and politely discussing the situation with each VC to seek not only the best terms but also the best relationship.
3.  Having a round oversubscribed and allocating fairly to all participants.
4.  Having a choice between two partner opportunities and working with each to understand the mutual benefits in each deal.
5.  Having a choice between two acquirers and working to keep each party fully informed.

The difference is not just integrity.  The sound of one hand clapping always carries with it the potential for disasterous results, based on the lack of a real alternative in a critical situation.  It is possible, I suppose, to cross a freeway blindfolded, but even if you've done it, it's a bad habit.

But, if you have worked hard to generate alternatives, then you are doing a great job leading your venture.  And, in most cases, everyone will applaud your diligence and integrity in each of these situations.    This is obviously a lot better than trying a shortcut based on illusion. 

And, if you cannot generate appropriate interest from two - or more - parties, perhaps it might be time to ask why.

Increasing the Probability of Success

I frequently surprise myself about how enthusiastic I can get when looking at a startup or a strong business idea.  While I won't admit in public to thinking "can't miss," I suppose I've come close.

And it's always a mistake to think that way - even when things go well. 

An idea is just the beginning of a venture.  Successful prototypes are just one more step along the way. 

Here's a practical way to think about "reducing risk" in a startup in a bit more detail.

Consider the major areas of what has to work (after a successful prototype) for the business to be profitable.  These are the "killers" that if for whatever reason they do not work, the business dies.  For example:

Pricing (P)
Manufacturing (M)
Distribution (D)
Success in beating competition (C)
Ongoing next generation research (Re)
Retaining key employees (Ke)

...and so forth.

Now,  assign a probability to your team's ability to make each area work - getting it right.  For simplicity here, say they are each 90% probable.  Multiply all of those probabilities to get to the overall probability.

Do the math.   (.9P) x (.9M) x (.9D) x (.9C) x (.9Re) x (.9Ke) = .53

So the "can't miss" in reality is closer to 50-50.

Every success or failure can be checked against this kind of matrix. 

Consider what happens if an otherwise workable model can't be easily distributed and, in our example, distribution success is only 50%.  Overall success probability drops to 29%, but, aside from that, it becomes evident that anything we can do early on to reduce the risk in distribution is early money very well spent. 

This makes it evident that the work spent in planning to avoid the "Death Star" scenario in each area is required to assure success.  Another way to think about this process is to get the right team in place whose experience can move through this process rapidly.   Read Bill Sahlman's "How To Write A Great Business Plan" in the July 1997 edition of Harvard Business Review .

(If you don't think that experience is so important, next time you need a surgeon, ask if there's an intern available for a cheaper rate.)

Said another way, if the probability of distribution success changes to 100% because of your planning (a signed partnership agreement might be an example), the probability of overall success rises to 60-40. 

I am making a case both for planning and for experience in the venture as a way of raising the probability of success.   Give it a try.

Investing in Outliers

Why is Fly Wheel Ventures in New Mexico?  In the most recent audioblog series of The University at Buffalo's CFI Institute, Trevor Loy of Flywheel Ventures explains.  Listen here for the five minute version.  The full conversation is also available there. 

Where Should Your Startup Funding Come From?

"It is easier for an entrepreneur to win a lottery than it is to get startup capital from a VC."

--Bill Bygrave,Babson College, at the National Association of Seed and Venture Funds.

Bygrave is Frederic C. Hamilton Professor for Free Enterprise at Babson College. He is a principal researcher for the 2002 Global Entrepreneurship Monitor (GEM) and director of the Babson-Kauffman Entrepreneurship Research Conference.  So he should know. 

When asked if there were VCs in the audience, one (John Nice, Venture Investors) raised his hand.  "You're irrelevant, Bygrave told him.  You can go now."

The point of this comment, of course, is the funding gap that exists between the need for startup capital and the ever increasing trend of investors of most stripes - and virtually all venture capitalists - to move upstream to larger investments in later stage companies.

Most startup funding - and almost every startup by definition spends money on something that it did not earn in the anticipated business - comes from friends, founders, and family (and some would add "fools" to the list!)  That's most as in 99% +. 

So where should your startup money come from? 

Where you get it - from whom - is vastly more important than the terms.  Savvy investors can help a company grow - dramatically.  Unsophisticated ones not only become a drag in some cases, but almost always lose faith over time and become impediments to future financing. 

Consider what happens when your otherwise good venture cannot get reinvestment from original investors.  New potential investors worry about why.  Or, worse, if the early guys want to sell to the later guys, that really makes the new buyers nervous. 

From whom you get startup funds is always more important than the terms.