Startups and angels: Along the way to success

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.

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.

Helping Startups Get Growing

A lot of us  seem to continually be asking how to help early stage entrepreneurs get going.   

Of course, we expect early opportunities to be incomplete.  They often have a compelling product concept, but most of us are not deeply knowledgeable about the specifics of a proposed market and often, truth be told, the venture isn't either. 

Lately, I've been talking to technology entrepreneurs who want to be able to spin-off an idea - a very difficult task, to be sure, but not impossible - look at all of the technology transfer coming out of universities.   (A Tech Transfer VC I know, tho, always says, "No garage science," meaning non-academic inventors carry a high risk of not knowing the scope of the science, and therefore can get blindsided.)

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Here's an article from the Milwaukee Journal Sentinel about a local company with a spin-off idea: Brandt Innovative Technologies.  It strikes me that a perfectly legitimate investor position is "the problem is that Brandt isn't focused on (this product.)"   After all, if an angel sees him or herself primarily as a screener, then the investment opportunity skill is primarily about interpreting plans and making judgments about levels of risk and reward.  Most of the angels I know think that way. 

Now I have yet to talk to Kurt, but I think there is an alternative way for an investor to approach ideas like this.

If the idea/venture "checks out," why not treat it more like a technology transfer opportunity?  Can angels help put together the components required for it to be successful?   That's a tall order - the angels need a lot of talent and a darn good rolodex.  But it's also one way to develop deal flow and use the skills and talents of the people in the network. 

Perhaps early stage pre-investment incubation belongs somewhere else; our group's track record has been so-so in trying to help companies get going.  But it is an approach worth thinking about.   

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. 

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. 

Managing Personal Spending

The common secret weapon of successful startup entrepreneurs…manage personal spending to reduce cash pressure. 

In the very early stages of a startup, cash is always in short supply.  And, regardless of how the company is financed – through large customer contracts, friends and family money, angels, venture capital, or all of the above, more cash on hand is always better.  And it is almost never enough.

But, the one consistent finding about entrepreneurs is that they can successfully manage the burn rate at home.  In addition to successfully building a business, they have the ability to limit their personal spending and take salary pressure off the nascent venture.  Until things start to accelerate, this skill provides months of cushion.

Early on this means saving to be able to forego salary for the exploration phase; sometimes it means working on the venture at night and on weekends.  Modest salaries are usually next. 

The result is that the entrepreneur is in a much stronger position from every point of view - customers, employees and investors.

Compensation for Entrepreneurs

What’s a fair compensation plan for an entrepreneur (or CEO) with investors in his company?

I’d like to see an entrepreneur who is committed to the enterprise in more than words.  To me, that may include, based on the particular situation:

1.    Leaving all of the start-up cash in the company as equity, rather than carrying it on the books as debt, or trying to pay it from investment proceeds.  (It’s certainly OK to pay yourself back if you don’t have investors.)

2.    A salary package that is at least 15% to 25% below market for similar positions.  As the venture becomes it is important for the team to receive year-end bonuses from the board if and when cash is prudently available.  These milestones are usually agreed to in advance of the investment decision.

3.    Vesting ownership of stock over several years based on achieving goals.  There should certainly be latitude in the goals (worst - most likely – best) with vesting percentages tied to each.

4.    For CEOs who are not founders and therefore have a smaller equity stake,  a  carry on the upside that pays some sort of bonus based on sale price is a good idea.  I’d calculate these off of the IRR the investors receive.  For instance, after the investors receive a 50% IRR, the CEO would receive 10% to 15% of the profits thereafter with the balance distributed to investors. 

The general idea here is to align the interest of all of  the people in the deal.  The founders and managers have significant upside opportunity and a proactive structure by them makes this part of the investment decision much smoother, especially when this is a first time venture for them. 

As the venture starts to meet milestones, cash compensation issues become much easier.  It is terrific to be part of a success in which everyone succeeds.

Tips for talking to investors

If you find yourself presenting to investors, here are a couple of tips.  These are in addition to market opportunity-competitive matrix-deal issues, which I assume would also be covered.  These are the items I hope will be covered because they present me with a comfort level that will lead to a partner-based relationship with you, the entrepreneur.

1.    Understand the principle of risk reduction and its role in your business.  Explain how, since the beginning of the company, you have identified the critical risks that you face and how you have successfully and quantifiably reduced or eliminated them.  “Reduce the biggest risks with the smallest dollars,” is the underlying idea.  Tell me that the next level of funding will reduce specific, measurable risks quantifiably beyond the value of the investment.  This is your added value.  Identify the next level of funding, if there is one.  Tell me what they would consider to be the biggest risk reducers.  Explain how you will get there.   A lot of “why this is a great product” in place of this kind of thinking makes me nervous.

2.    Understand the testing concept as it relates to reducing risk.   Show me that you have thought about these critical risks and have ways to test them swiftly, accurately and cheaply.  The most probable outcome is that the product will need tailoring or even alterations.  That’s fine when it’s swift, less fine when it’s six months and $100,000 later. 

3.    Explain your valuation in terms of others in your industry/market/stage.  While I suppose there is a place for a breakthrough idea by a first time entrepreneur that’s a good bet at $12MM preval, I have yet to see it.  It’s a shame to see a potentially good idea dragged all over town because the entrepreneur is peeing in the well.  If you have a good grasp of comparables for your industry and stage of business that’s great and will make a more interesting conversation.

4.    Do have reasonable skin in the game expectations.  Don’t show up looking for a $250,000 salary and the repayment of the $100,000 of working capital you’ve put in the company up until now.   If you do ask for this you may as well ask for a ride on the investor’s flying pig, as well.

5.    Know your audience. If your product is a new surgical appliance try not to get into a knowledge debate with the surgeon in the audience.  Work hard to inform yourself of who is in the audience.  Talk to their expertise; engage them in discussion. 

6.    Pass the “Congruity and Integrity” test.  Bet that someone in your audience will know everyone you’re referring to.  If they are interested in your business, they’ll make those calls.  Better to understate.  Modesty isn’t a virtue for nothing.   

The Useless NDA

"Why," I get asked all the time, "won't you sign an NDA?  Are you going to steal our idea?

This dialog is in full swing in a conversation started by Brad Feld.  Here is Feld on "Why VC's Don't Sign NDAs".

I'd add that in adddition to creating entanglements, they suck up an inordinate amount of time and effort for no benefit.  I can't think of a single good reason to consider one.

Getting Over The Capital Hurdle

"My question is how you get over the capital hurdle when you have a product that straddles the fence between the need for Angel Investors and VC money and your friends and family cannot get you over the hump?" -- Bob

This is a complex question.  Let's just say that Friends money might be up to $100,000 or so; angels might go up to $500,000; and VCs really are going to start at a minimum of $5MM.

So, there is a gap between angel amounts and VC amounts.  So Bob is right in that there really is a kind of no man's land of 1MM to 5MM for many entrepreneurs who have a legitimate ability to use professional investment in their business venture.

One solution may be to try and derive the important milestones that the "next" investor will consider to be critical.  This makes the assumption that the entrepreneur can make progress spending small amounts of money that demonstrate viability and create interest in some way.

This involves a conversation with an investor that addresses the question "What would I have to achieve for you to invest?"  Possible answers might be prototypes, market tests, potential customer testimonials, or some combination of these and other factors.

  In other words, the entrepreneur wants to spend the least amount of money to eliminate the highest risk as perceived by the next investor in the company.

This is important because it will allow the entrepreneur to value the company more highly in the next round because the next round investor will value the reduction of risk that has occurred. 

By taking these risk reducing steps in increments, and assuming that the market is attractive to investors, the entrepreneur can achieve her goals.

For the first time entrepreneur, this will often mean starting with a bootstrap or friends and family model, or a combination of the two, to create some credibility for the product concept.

The other thing to think about in this situation is - can the entrepreneur reach the returns required by venture capital investors?  An extremely shorthand version of that is 30X the original investment in 5 years or less.  If the business has the potential to reach that level, great.  If not, staging investments in smaller amounts may work better.