Inside the Mind of a VC
> Exit, Stage Right Know when and how to exit.
> FOIA? GOIA! (translation: Freedom of Information Act: Get Over It Already!)
> Why Syndicates Matter Who you want on your board when things go bump in the night.
> Wires Are, Like, So Twentieth Century Wireless technology lets developing countries leapfrog developed ones.
> The Pendulum Swings The hardware-software cycle.
> Whither PNW Venture Capital? No Way! Conventional wisdom in the local press is very wrong!
> The Price-Progress Paradox With so much money out there, why are so few companies being funded?
> Make a Plan You Can Make Almost no start-up ever makes its business plan!
> Sales DNA It's in the Genes.
> Avoiding A Bad Hair Day Understanding your potential investor.
> Two Frogs with One Hand Let your reach exceed your grasp.
> Needs vs. Wants Why the Venture Capital Industry Crashed
> Business Model Muddle Two revenue streams is a lot, three is way too many!
> Venture Capital’s Third Wave This party is just starting.
> Ax The CEO! How first time CEO’s can keep their heads!
> How Much Is Too Much Cash is like altitude in an airplane!
> Hocus Focus Do not try to catch two frogs with one hand!
> Venture Capital - To The Power Of Teams Your team determines your dream.
> Know Your Competition What do you mean you don’t have any!
> Numbers, Numbers! Your business plan is wrong! Get over it.
> Reach Out And Touch Someone! The vaudeville approach to product design.
> How To Buy A Venture Capitalist Choose your VC with more care than you chose your spouse!
> 5% Of A Huge Market Stinks! Dominant businesses dominate!
> What's The Big Idea? Leave your good ideas at home.
Once upon a time, the standard approach for a startup was to do its product development locally, then test early versions of its product regionally, then start selling its product nationally, and only expand internationally once domestic sales ramped up. Not any more! What was once a very simple and linear process of company formation and development has become a complex and parallel approach.
In today's global economy, many new firms come to life with international components operating not just at the same time as their domestic colleagues but before. If you are working in the wireless arena, does it make more sense to do your product definition in Seattle or in Scandinavia? If you are an enterprise software company, do you want to develop your product in Beaverton or Bangalore? If you are a company in the medical field, will you do your first clinical trials and sales in the US, or get an earlier start in Europe? Will you join forces with your first strategic partners in Kirkland or Korea? Will you set up manufacturing in the Silicon Forest or in Singapore?
Let Your Reach Exceed Your Grasp
To start a company with global reach, you need to reach out. To grasp the complexities of business that has dimensions far beyond the shores of North America requires a mind set, not just an operating plan. It means that everyone on the founding team needs to appreciate how hard it is to start a company with far-flung activities, but at the same time how necessary it might be.
All this puts a premium on experienced management from day one. We are delighted to back first time entrepreneurs and young management teams - but if you are trying to keep a development team in India in synch with a business development person in Helsinki and a product marketing group in Redmond - you'd better not be trying that for the first time. In fact, you'd be better off not trying that at all.
But Don't Try To Grasp Everything All At Once
As the proverb on the wall of my office says, "Do not try to catch two frogs with one hand." There are just too many moving parts to that scenario. Just because there are compelling reasons to start a business with the goal of global reach doesn't mean you have to reach everywhere at once. It means you have to reach where you need to reach, when you need to reach there.
A smart approach is to focus on doing the things you have to do well first, and do them in the place they are best done, before moving to the next pad in the grand global lily pond. If that means you send a team to Europe to spec the product while the developers slave away at their keyboards in Seattle, so be it. But if you think you can do that and manage a software team in India, and a fledgling domestic sales force, while trying to raise a round of funding from VCs cross the USA - you are probably going to fall prey to the fate of the proverbial frog catcher, and wind up empty handed.
Domino To Dominate!
Trying to find the right balance between global reach and keeping things under control is a tough task, and a problem for which there are no simplistic solutions. Perhaps the best way to think about it would be to imagine you are setting up a huge set of dominos. As you build the design, you are wise to leave some holes in it so that an accidental bump doesn't have the whole thing trigger before you are ready. In the world of startups the same technique can apply. While building your initial core activities you can extend your reach with small efforts by small teams who are not just physically remote but also kept organizationally remote. You might hire a very experienced person to handle what needs doing in Europe or Asia. But you must have the discipline to not let them drag the whole organization towards them, until it is time to put the dominos in place to connect them with the main enterprise. By then they should have built their own set of dominos that can be made to fall in sequence. That will make your company effective in the new domain and your enterprise ready to take its place on the global stage.
When done with the proper balance, starting your company with an international dimension makes perfect sense. Two of our OVP portfolio companies recently recorded their first revenues, from customers in Korea and the UK, respectively. However, in both cases, they were careful to focus their energies and their enterprises to make sure the first domino to fall was the one they chose to fall and for the right reasons. Now they have the opportunity to extend back to the US at a time and circumstance of their choosing. That's a good initial model for a long-term global success story. Ribbit!
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The last five years of the 1990s were the best years the venture capital industry has ever seen. Three major technology waves (Internet, broadband and wireless communications, and biotechnology) hit the beach at the same time, coupled with a buoyant public stock market and a booming economy. That’s as close to a perfect world as we’ll ever see. By the dawn of the new millennium, everyone wanted to be a venture capitalist. It looked like easy money, and for a time it was.
In March 2000, it all started to come apart. The public markets contracted, then crashed. The IPO window slammed shut. Those companies expecting the public markets to provide the cash necessary to cover their losses suddenly looked very naked. And venture capitalists suddenly looked not so smart. We went from cover stories of hubris to cover stories of debris in less than a year.
What happened? It was actually rather simple. It was not, as some have reported, only a matter of greed - not that there’s anything wrong with that! Nor was it a matter of speed - not that there’s anything wrong with that either. It was, in fact, a matter of need. Venture capitalists and the public forgot for a while that major successful new businesses are built neither on the fact that some new technology enables them to exist nor on the fact that someone may want them to exist. Companies thrive only when they serve a real, sustained, compelling need in the marketplace.
While it is easy to pick on some of the fallen e-tail stars of yesterday, they do provide good examples to prove the point. The Internet enabled a company to let you buy puppy chow from the comfort of your home. A few people may have even wanted to do so. But clearly there was no compelling need to do so. The shopping experience, product availability and consumer knowledge necessary to decide on dog food were all in good shape through existing channels. Whither Pets.com? The same could be said for gardening tools, diamonds, and a host of other retail items. There were no needs, only wants and greed, and so the ventures failed.
On the other hand, in some retail categories there was a need for a different model. In books, the selection was so overwhelming that the ability to "browse" on line made book-shopping a better and more convenient experience for many people. Hail Amazon! There is a similar story in consumer electronics, where a truly rotten retail experience with pushy yet unknowledgeable sales clerks allowed 800.com to carve out a sustainable on-line position. Both firms have their challenges, since retail is a tough business through any channel. But neither faces the insurmountable hurdle of trying to serve a need where there is none.
Many venture capitalists broke their own business models by trying to ride those easy-to-start businesses rather than truly needed businesses. But some VC firms were more selective. They chose companies where the potential customers were clearly crying for something new and better. In many areas that newness was driven by the need for new technology - such as optical networks, Internet-enabled commerce, wireless infrastructure, and biotechnology. In others it was the chance to break down old barriers between customers and suppliers - a la Ebay. Wherever these new businesses flourish, the common theme is that their product or service is needed, not just wanted, by their customers.
For venture capitalists who are licking their wounds sustained in the last 12 months, the message is clear. It is not back to the drawing boards, but it is back to basics. What worked well in the years leading up to the Internet bubble still works well. Find great teams, serving compelling needs, in explosive markets. Two out of three isn’t good enough. You need all three – every time.
For entrepreneurs seeking venture capital, the same rules apply. Even better, make sure your company is addressing not just a need, but a compelling need. So how do you tell the difference? When doing your research on exactly what product or service you are going to offer, ask your prospective customers this question: "If we bring this product to market, what other current area or project are you likely to draw dollars from in order to squeeze us into your budget?" If the customer does not know what he’ll give up to buy from you, you are still in the "want" category and have not yet made it to "need." If she tells you, "We don’t know where, but we’ll find the money," you’ve made it to need. If he says, "I can think of two or three projects we will defer to buy your product," you just hit pay dirt! Not surprisingly, those questions and answers come from what we ask in our standard due diligence on prospective new investments. Better you should ask them before we do!
The venture capital business crashed because it forgot what made it great. The industry is on its way back to health because it is now remembering. That’s good news, not just for venture capitalists but for entrepreneurs and their service providers as well. Also, recognize that the media is often late to the party. Eighteen months ago, things were not as rosy as they seemed. Neither are they as dire today. There has never been a better time than the present to start a company. Back to needs means back to basics. That benefits us all.
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One of the surest signs that a startup doesn’t have its act together, and as such is not yet ready to ask for serious venture capital – is a muddled business model.
In these days of Internet mania, the refrain often goes something like this:
"We are going to start a business to business portal on the Net. We’ll get lots of people to come to the site based on our unique content and information aggregation. Then we’ll capture their dollars through these five or six different revenue streams."
Here is the problem: As venture capitalists, we are forced to be not only students of startups, but students of the history of startups – the good, the bad and the ugly. Looking backward, we are hard pressed to identify any businesses, but certainly none in their early years, that can really develop five or six meaningful revenue streams at once. Those streams do not flow together to make a river, they make a muddle. What they say to us is the company does not yet know where the real value capture points are in the business, and as such is forced to throw a bunch up against the wall and hope some stick.
Remember a few years ago when the Net was young? Many startups said they would make their money with advertising. A few years later, people realized that only solidly established web sites such as Yahoo and AOL would be able to attract ads at significant dollar volume. Along the way, other companies tried subscription models where you paid for the right to access the information. Most died, while a few thrived. More recently, we’ve seen more transaction oriented models, where a site helps bring together buyers and sellers, and in making those markets, extracts a fee. There are many more business models being tried today, and more to come.
When it comes to business models, simpler is better. Even when breaking new ground in new markets, with no established business rules, focusing on a few points of customer contact and value delivery yields dividends. Avoid the muddle – narrow your model!
To many people, this is the golden age of venture capital. More money is being raised by venture capitalists, and more is being invested in startups, than ever before. While we all may enjoy the "paradise" we find ourselves in today, we also need to be cognizant of the waves of change that brought us to these shores. Those changes might hold the keys to what we should expect going forward.
The Brave First Wave
The first wave of Venture Capital began in the early 1970’s driven largely by some brave souls such as General Doriot at ARD, Charlie Waite at Greylock in Boston, Peter Crisp of Venrock in New York and Arthur Rock in California. They set out to raise risk capital from family trusts, and put that money to work largely in the nascent computer industry. The amount of money they raised, and put to work, was small. But the gains they made were substantial. However, they were helped along by one very significant change. That was the emergence of a public stock market that would support liquidity of new and largely un-proven companies. The rise of NASDAQ was a critical factor in the success of the pioneer venture capitalists. So, there were three drivers to the first wave – people, technology and liquidity. They sustained that wave for a decade.
The Brief Second Wave
The second wave of venture capital arrived in the early 1980’s, driven by a major change in the laws regarding how pension funds could invest their money. The ERISA statute was revised to allow for previously ‘risky’ investments in private equity to be covered by the ‘prudent investor’ mantra. Money into venture capital exploded! Pension funds put their stunningly large asset bases in play, and the cash bonanza was on.
This was coupled with a technology push brought on by powerful microprocessors and a new wave of software and networking technologies. In addition, both the medical device and biotech industries began to attract startup investment. However, this flood of money and technology was not matched with the third component – people. With too much money chasing too few good deals, and without the time to develop seasoned professionals to put the money to work wisely, returns for venture funds plummeted. The average return for all venture funds founded from 1981 through 1988 was in single digits! Investors would have been better served in T-bills! Therefore, the early 1980’s VC boom quickly gave way to the VC bust of the late 80’s and early 90’s. As the evidence of meager returns mounted, cash inflows into VC firms dropped dramatically. So, in turn, did the outflows to startups.
However, you can argue that this was not simply a matter of financial performance. The technology revolutions pushing new startups in the 1980’s did not have the longest legs in the world. The microprocessor spawned many new companies, but by the end of the decade, most of the rich veins had been mined. Software taking advantage of this new distributed computing power lasted longer as a startup phenomena, but by the early 1990’s a few software powerhouses emerged, stifling new entrants. Biotech proved to have a much longer gestation period than information technology, and the public markets got tired of playing venture capitalist.
In any event, the second wave of venture capital had two out of the three components necessary for sustained growth – liquidity and technology, but the lack of skilled people helped it crash on the beach, taking many investors out to sea in the undertow. It was all over in about five years.
The Big Third Wave
Unlike the second wave, the truly global inter-connectivity of the Internet, coupled with the pending move to high bandwidth to the home, opens up so many new business opportunities, and business models, that innovation should thrive for some time. Wireless technology is still in its infancy. While many people talk about the rise of the personal computer and local area networks as the dawning of the Information Age, I believe it is the rise of connectivity that heralds the real growth spurt. In addition, we will probably see a resurgence of biotech investing, as the long gestation period started in the 1980’s suddenly bears fruit at the start of the 21st century. With the final work on the Human Genome project coming out in the next few years – the possibilities are astounding.
Finally, venture capital now is attracting not just a few brave souls, nor just fresh faced MBA’s, but a cross section of experienced business and technology minds. That broad base of talent will provide the sustained human capital to take the risks, learn from the mistakes, and persevere.
Money. Technology. People. It’s all there. Ride the wave!
Here is a surefire bet: Gather together a bunch of entrepreneurs to talk about venture capitalists, and before long the conversation will turn to the issue of control. Here's the common refrain: "If we take VC money, the next thing you know, they'll be in control, and we'll be out on our ear." Now, try the reverse. Gather the VCs, and before long you'll hear something like this: "If we invest in them and we don't have the ability to take control, these young hotshots may run right over the edge of the cliff and take our money with them."
The problem, of course, stems from the following: Entrepreneurs often have mixed goals in starting a business. They want to deliver on a product vision, want to grow a major enterprise and make money, and also want to be the boss. Venture capitalists have only one goal: To make money for their investors and themselves. Sometimes, if the company gets off track and management doesn't seem able to fix it quickly, VCs want to bring in people who they believe can.
So, if you are the entrepreneur/CEO, how do you avoid this potential conflict point? First and foremost --perform. The last think a VC wants to do is change management. It is messy and risky and often leads to a washout of the previous round of investment. And no VC in his right mind wants to take the reins himself. We know how hard you work!
Venture capital boards are like normal boards, only more so! They have little time to spend developing management in the face of fierce competition and dynamically moving markets. They are much more ready to fix something that is broken or keep a rocket ship from coming off the rails. So--avoid the Seven Deadly Sins for CEOs. You'll find your venture capitalists supporting you every step of the way!
When was the last time you met an entrepreneur who looked back on his or her business efforts and said, "I wish I'd raised less money"? Better yet, have you ever heard of a company dying from being overcapitalized? But we still see start-up management teams proposing to skinny their way to greatness, raising just enough cash to make it if everything goes according to plan - in order to minimize dilution. This is patently unwise. In any business, but particularly a fragile startup, cash is like altitude in an airplane. If the engines start to sputter, you can never have too much. In a startup, you can be sure the engines will sputter, and sometimes they might even quit running for a while as you struggle with product, market, personnel, or other problems.
Double Your Money
One of the best pieces of advice we have seen for CEOs is this: Do all the spreadsheets you want until you think you have a rational model for the business. Look at the amount of capital those calculations call for, and then double it! From personal experience, I can say that this is a minimum approach. Years ago, I was involved in a very successful start-up. We put lots of attention on our financials that showed we needed only $600,000 to grow the company to $50M in sales. To be "safe," we raised $1M in the first (and planned only) round. Two more venture rounds and $9M later, we went public. We were off by more than ten times in our projected need for cash! If the VC money had not been there in a timely way, we would have gone bankrupt - even as we grew like topsy.
Today, we still see business plan after business plan with the same fundamental flaws. Planners assume that one initial financing will be all that is needed. They assume that all product shipment dates, pricing and margin assumptions, and inventory issues are certain. They assume that the business, in fact, can be planned. Here's a key news flash: "No start-up can plan its business." There are just way too many unknowns to have any degree of certainty as to what will happen next month, much less next year. What you can plan on is that things will almost certainly not go as you expected. A few will go better, most will go worse - or at least slower. There will probably be a few things you didn't think about at all that will rise up and surprise you. The only way to buffer yourself and your enterprise against those unknowns is to have enough altitude under your wings to coast for a while until you figure out where you are and what you can do about it. Again, that altitude means more cash, not less.
Dilutions of Grandeur
However, the issue of dilution still rears its head. You don't want to give up more of the company than necessary in obtaining funding. First, remember that 100 percent of nothing is always nothing. If you fail because you were undercapitalized, that ownership percentage is meaningless. Second, remember that a key risk to your business is financing risk. Even if you get initial funding, there is no guaranty that a second round will be available, or available under reasonable terms, or available from acceptable investors, even if you are making nice progress with your business. In our experience, the second round of venture capital is often the toughest to land.
But you still don't want to give up the whole company by raising too much in round one. So here's a possible approach - look for "value inflection points" in the growth of your company. For example: business plan written, team in place, product prototype available, beta sites installed, first revenue shipments, customers ready to serve as references, strategic partnerships in place, profitability, etc. Raise enough money in every financing to get you not just to the next valuation up-tick, but comfortably past it - allowing for inevitable slippage. Maximize your chances for success by raising far more money than you think you need at each step. Minimize dilution by handling your financing needs in a couple of rounds, each at a higher price with the value inflection points well proved.
Beware of VCs Bearing Gifts
The only counter to this argument is driven by the fact that today there are many venture capital firms with so much money in their pockets that they are out pushing more money at start-ups than those companies might actually need. Some "early stage" VCs are now saying their minimum investment is $10M! Not many start-ups need that much in the initial going. Aim yourself at firms that can push your thinking on how much money you should raise, but not on those that will push their need to invest onto your capital structure. A balance between your real needs for cash and your desire for minimum dilution is often the best outcome.
One of the most fundamental issues facing most startups, whether they are out looking for money, or out spending the money they have already raised, is focus. It is remarkable how just a small deviation from a laser-like focus on the critical issues for the business can mean the difference between success and failure. We like to say, "more startups die from indigestion than starvation", and it is true. Lack of focus manifests itself in a number of ways, during fund raising and then in operating the business.
The Bootstrap Trap
Many entrepreneurs come to us with a "bootstrap" model of growing the enterprise that looks something like this: "We will utilize this initial product/market to get the company started, while we do the R&D necessary to build the "real" product for the "real" market we find really attractive." This model may appeal to commercial bankers who care about how you are going to service their debt and other lenders who exist in a world where cash flow is king, but it strikes terror into the hearts of venture capitalists.
The single most precious resource any startup has is its people. The bootstrap model requires those people to serve two masters, today's business and tomorrow's. While we have all heard the story that today's business will take very little management time and attention, allowing most of the energy to be focused on the big future opportunity, we have seen compelling evidence this is a myth. In fact, what usually happens is that the pressure of today's products, customers, competitors, etc. is actually a full time job for management, leaving little time or attention to the true venture-fundable part of the business.
Most ventures fail even when one hundred percent of everyone's attention is focused on one and only one goal. What do you think the chances are when you split that attention? To those who say the bootstrap model "lowers the risk", we say "nonsense"! The goal is not to avoid the downside. The challenge is to achieve the upside. That requires everyone in the organization to get up in the morning with no uncertainty as to which master they are serving. Come to a venture capital firm with one of these two headed monsters (or even a three headed one as we saw recently), and be prepared to go home with your empty hat (or your head!) in your hands. Instead, chop off the extraneous business before showing up for funding. All of us who play this game are more than prepared to take great risk for great reward. If that means you have no revenues for twelve to eighteen months while developing your product, so be it. You can kid yourself into thinking the bootstrap model raises your valuation, since there is some provable revenue stream up front. The reverse is true. We don't want to pay for a business we don't want!
The Red Zone
Football teams know that a key to their success is whenever they get the ball inside the 20 yard line, they need to come away with at least some points on the board. Startup companies often do not understand this issue. It is remarkable how many times we see firms out blowing through their venture financing, with burn rates that give new meaning to the term, trying to do far too many things at once. They keep trying to advance multiple balls down the field from multiple distances from the goal line, rather than taking the obvious early leaders and driving them into the end zone.
Not only does this drive the finances of the company crazy, it also drives the employees crazy. Many get confused as multiple conflicting priorities, all for "critical" projects, hit their desks. For many people, it gets hard to know how they are going to be measured. The natural response is either to chase the priority of the moment, or to shut down all together. A far better approach is for the company to decide what things absolutely need doing to reach the next few milestones that matter most (revenues, financing, etc.) and then focus just on those.
We recently went through just such an exercise with one of our portfolio companies. They were in disarray after missing the sales forecast for the quarter, and were burning through cash at an alarming rate. Rather than sack the CEO or the Sales VP, we all sat down and tried to peel back the onion to find the core reason for the problem. It quickly became clear everyone had too many irons in the fire. In addition, there were some terrific strategic opportunities that were languishing while the sales force focused on meeting the short-term revenue plan. Development was running in at least three directions. "Operation Red Zone" was put in place, with dramatic results in less than ninety days.
If you want to raise money, focus! If you want to use it wisely, focus! Anything else is hocus-pocus.
What is remarkable, then, is how little attention entrepreneurs pay to this issue when thinking about starting a company and going out to raise money. More often than not, the product concept is the driver while the team and the market are just necessary passengers. For example, we see far too many business plans that go something like this: a few pages on the market, more pages on the product and/or technology, and as little as a page on the team members. Sometimes, the team is listed only by name and title - with no backgrounds given! Does anyone expect VC's to get excited about a set of names on a page? Would you hire a new employee that way?
Meet Our President
Not quite as bad, but close, is the startup plan whose founders come from fields far from the space they intend to address. "Our company CEO, R. P. Featherweight, has successfully grown his family cardboard recycling business to over 50 employees in 10 years. He leads a star-studded team of former plumbing rack jobbers ready to command a leadership position in worldwide Internet commerce, growing to $100 million in sales in three years." Don't laugh, we see business plans far closer to this than you might believe. Now this is not to say that people can not get brilliant product ideas outside their area of direct work experience. However, if they do, they had better be teaming up with folks directly in that marketplace to make sure they really understand the issues. Just as important, the speed of business today virtually demands a top rated Rolodex to be successful. If you have to build all of your key industry contacts, relationships and partnerships from scratch, you will probably be caught and passed by a later market entrant with a better set of connections. Hooking up with the right venture capitalists (and their Rolodex's) can help, but VC's help those best who can also help themselves.
Great Job, No Pay
So how do you go about getting the team before you have the money? How do you get great, experienced people to leave their comfortable jobs and step out on a limb with you with no visible means of support? Hmmmm… what an interesting test of leadership! No one said this was easy. As a founder, one of your key jobs is to have a vision so compelling that intelligent people will make what appears to be an irrational decision to follow you. Clearly, not all individuals are in a personal situation where they can expose themselves to that much financial risk, but some are. Others may be willing to commit on the condition of financing and be willing (under confidentiality) to let you use their names with prospective investors.
Even then, you may end up short a key executive or two at the start. That's OK! It is far better to have a hole on the organization chart, with a clear description of the experience and skills you are looking for to fill that position, than to fill the hole with a warm body with weak credentials. The wrong person in a key position sends out more negative messages about the CEO's ability than any other red flag. Again, VC's are more than happy to help find and recruit folks to flesh out the team. We are far less excited about having to first convince you it was a mistake hiring good old Charlie to fill the VP Marketing role, deal with removing Charlie from that position, and then start a search for a replacement.
Start With The Team - The Money Will Come
Examples tell the story: Arguably the two most successful startups in the Portland, Oregon area in the last fifteen years were Mentor Graphics and Sequent Computer. While the companies, their cultures, their products and markets were very different, they shared one common factor. Both came into being with complete teams of high-powered executives and individual contributors, all experienced in their areas. Both raised venture capital easily. Both became successful public companies - though not always via the path laid out in their initial business plans. Both teams were capable enough to take what they knew, learn what they didn't, and adjust accordingly. In the end, their venture investors were well rewarded, as were the founders. Not every startup can be a Mentor or a Sequent, but if you want venture capital, they provide good case studies.
Build your team with as much care and as much attention to quality as you plan to build your products. It will make raising venture capital much easier, and give you a far better shot at creating a substantial enterprise.
One of the most fundamental elements of any successful enterprise is its ability to serve a segment of customers better than its competitors. Therefore, any startup hoping to receive venture capital funding needs to be able to articulate how it is going to do just that. However, when we read business plans or meet with entrepreneurs, it is remarkable how weak their understanding of the competition is, and how narrowly the word competition is usually defined.
Your Product Is Not Better In Every Dimension
Most business plans have a competitive analysis section that highlights how that firm's products will be superior to all competitors. Some allege they have no competition. They are wrong! Others include a nice matrix showing feature comparisons where, amazingly, only the startup has a check in all the boxes - while other players are lucky to have half the boxes filled.
There are a number of problems with this approach. First it smacks of a naïve view of the world. Certainly you will need to have a substantial product advantage to break into a market, but are your competitors really that stupid and lazy? Many have probably been selling to your target market for years. Perhaps some elements of their products that you do not include in your matrix (or even in your product) are more important to customers than you know. Perhaps a more detailed analysis will show that there are multiple segments in your market. Some will clearly value the product attributes you offer. Others may favor your competition. That's O.K.! The better you know your customers, the better you know your competition. We are much more comfortable with a competitive matrix that shows where you have advantage, where you will be at a disadvantage, and why the segment(s) you are targeting make sense.
Your Product Is Not All That Matters
Even those business plans that do a good job on the product competition section rarely look at the more telling competitive issues of marketing, price, distribution and sales coverage, services, strategic partnerships and other absolutely critical elements of what a company needs to win. If you came out with a superior word processing software package - that beat Microsoft Word in every product dimension - do you think it would have a chance? Not likely! Companies that understand all the real world issues of competition are the ones that have the best chance to get funded.
As we look back on the companies we have backed that have gone public or been acquired at fancy valuations, there are a couple of telling constants. Sure their product strategy and execution was terrific, but in addition their understanding of how to beat the competition in a variety of ways was superior. By building multiple barriers to competitive attack, they were able to survive the occasional slipped product release or a competitor's surprise announcement. Startups that rely only on product superiority are very vulnerable.
Your Competition Is Broader Than You Know
I have a close friend in a venture-backed company offering software in the medical field. The team is terrific, the product stellar, the sales force first rate, the services group outstanding. Customers all agree this is something they need desperately. Yet this year the company is straining to achieve their growth objectives. How can that be? The answer is simple - Y2K. The hospitals and clinics that are desperate for my friend's software have a much larger problem - one that is draining all their capital budgets as well as their human resources. Those customers have to not only test and upgrade all their huge legacy software systems, they also have to test all their electronic instruments, patient monitors, anything that might have a year 2000 bug that could be life-threatening if not found in time.
This company's competition is not just other medical software players. It is anything or anyone that competes for precious capital dollars and the staff needed to evaluate, recommend, and rollout their products. Fortunately, my friend's company is very well financed and can afford to grow more slowly than they might like for a year or two until this problem passes. Most startups are not so lucky.
While the Y2K problem is well covered in the press, every new firm has to compete to get up their customer's priority list in order to get products purchased. It behooves all young companies to try to determine what customer projects and priorities are above them on the list. They are your competition too!
Finally, Think Of Your Stock As A Product
When you go out to raise money, you are approaching potential customers (investors) with a product (your stock). Just as you segment the target market for your products, do the same for your stock. Who is likely to buy and why? What are their needs, their buying patterns (previous investments made)? Those investors also have alternative places to put their money (other new deals). How do you stack up to the competition? The sale of your stock is every bit as critical as the sale of your product. Give it the same attention.
When it comes to competition, the more you know, the faster you'll grow!
A fundamental part of any startup's business plan is the financial section, which details the economics of the enterprise. We often see plans where at least half the pages are taken up by spread sheets showing everything from top line revenue growth to how much will be spent on office supplies in the year 2004. It is remarkable how much more emphasis entrepreneurs place on those numbers than venture capitalists do. The reason for that is simple. Venture capitalists know from years of experience that there are a couple of universal truths in business plan financials.
First and foremost, your numbers are wrong. All we do not know is how wrong they are, and in which direction (although we can guess!). We also know they are not conservative. Most new businesses, even those backed by sophisticated venture capitalists, fail. Even those that succeed usually take twice as much capital and twice as long as their founders (and financial backers) ever imagined. Therefore, to say a business can go from zero revenues to over $50 million in five years or less, and still be projecting itself conservatively is folly. It is also an insult to the intelligence of the investor audience. Little known fact: Our firm has backed over 50 startups, some of which have become terrific, valuable companies. Not one (that's right, not one!) ever made its initial business plan. Action 1: do a search and replace in your business plan for the word conservative!
Secondly, we know that most smart entrepreneurs are getting counsel from experienced accountants who give the following advice. They tell the startup that to get venture money, they need to show $50 million in sales by year five, and need to demonstrate a good handle on the financial needs of the business. While both are largely true, the way they get played out can backfire. Many business plans seem to work backwards from the $50 million number rather than building up to it. We see lots of examples of CEOs who can talk about that top line dollar number. Too many do not have any clue on how many product units have to be sold to reach that level, or how many customer accounts that translates into. They do not know what kind of sales resources will be needed and what the average sales per salesperson is required. There is usually no thinking on what the actual sales cycle is and why. In fact the entire plan is "top down" rather than "bottoms up". No business is ever built top down. It is built out in the marketplace belly to belly to customers while hacking away at competitors. Action 2: Go back over your numbers and build them from the bottom up, so they make sense. More importantly, look at that exercise as a way for you to learn more about what areas are key to your business success. If the numbers do not add up to a firm attractive to venture capital backers, better to find out now, and pursue more likely sources (corporate, angels, etc.).
The are a couple of real dangers with spreadsheets. First, they let you crunch out detail where detail makes little sense. Let's face it, you really have no idea what your budget for office supplies should be five years from now, nor does it matter, but a nice formula will provide you a number. Second, spreadsheets have this look of authority to them that makes people believe what is in them must be true. We see many startup CEOs who get passionate about defending their financials rather than defending the underlying tenets of the business. Finally, as the formulas you put in place in the early years play out in later years, they often become silly. You would be amazed how many startups think they will really have 40% operating profit margins in year five. Unless the product they are selling is an illegal substance, those numbers are very unlikely. Action 3: Your financials should be monthly for year one, quarterly for year two, and annually thereafter. Your income statement should pass this simple test: The key ratios a few years out should be no better than those of other similar companies in the public market.
Discounted Cash Flaw
The final indignity in business plans is when the entrepreneur takes the projected earnings over the life of the plan, calculates a discounted cash flow (at some arbitrary discount rate), and then proudly proclaims that result as the valuation of the company. This methodology has a number of flaws. First, since we already know the numbers are wrong, and more than likely aggressive, there is little basis to use them. Second, at what discount rate should we evaluate a business with a better than 50% chance of going bankrupt? Try discounting the numbers at 100% or more. The valuation numbers will shrink rather quickly! Finally, the ultimate value of the company has nothing to do with manufactured financial projections, and everything to do with supply and demand in the venture markets. Your company's valuation will be determined by what VCs are willing to pay - and whether more than one wants to play! Action 4: Put off valuation discussions until the fish is at least partially hooked. VCs spook easily, and have lots of other bait they can nibble.
Keep the financial portion of your business plan in perspective. Your chances of getting funding will improve.
A few months ago, The Money Trail focused on why 5% of a large market is often not appealing to venture capitalists. There was even some ranting and raving about the lack of value we all place on those large secondary market studies which all predict wondrous things for almost any new opportunity on the planet. Now it is time to drill down to the level of analysis that does make sense to VCs, and should make equally good sense to those startups desiring funding.
With apologies to AT&T, it is indeed right to "reach out and touch someone". In fact, you would be wise to interview at least twenty-five potential customers before finalizing the business plan you send out to investors. On the surface, this seems to be needlessly obvious. It is not. Of the over one thousand business plans our firm received last year, at least 90% did not pass this simple test. Plan after plan came in quoting grandiose macro market numbers, without any grounding in real customers or partners to validate the market size, the product requirements, or the business model. The entrepreneurs had not done their homework to determine if their product/market match had merit with the customers, and if that merit lifted the company above the noise of others competing for those customers' attention and dollars.
The risk from overlooking this fundamental work is clear. "If you build it, they may not come!" Just as dangerous, they may come, but be unwilling to pay the price you need to make this a profitable enterprise. More often than not, we see startups with very nice products fail because they did not understand the customer's needs in enough depth to produce a "complete" product offering. Often, the product needs to be supplemented with considerable training, installation, consulting, or connections to related or installed products. Missing any one of these can cause a customer to wait. To a startup, a delayed sales cycle means delayed cash flow, which can mean curtains.
Perhaps less important long term, but equally important short term, is the issue of your credibility with potential investors. There are few turn-offs as strong to a VC as the one where after a day or two of due diligence on your company, it becomes clear we know more about your potential customers and market than you do. While all VCs like to add value, none of us ever expect to be, or want to be, more knowledgeable than you are in this regard. In addition, the message that is sent is, "If these folks haven't done their homework with their customers, what other areas have they glossed over?"
I personally experienced the power of this approach many years ago while starting a high technology company of my own. You might call it the vaudeville approach to product specification. Our VP of R&D and I hit the road for scheduled meetings with potential customers, armed with a product presentation, blank overheads and magic markers (pre-PowerPoint days!). The first presentations did not go so well, as we were bashed and battered with the shortcomings of our product concept. After every presentation, we would stop at a roadside restaurant, update some of the slides and try again. After about ten meetings, the criticisms began to diminish. After twenty-five, we hit nirvana. The prospect said, "That sounds terrific, if you build it we will definitely buy it. By the way, we do not think anyone can build that, particularly a startup with limited resources." With that challenge, we went back to the engineering team to see if they could deliver. To their everlasting credit, they did, and the company became the success every entrepreneur dreams about. Just like the old vaudeville comedians, we had polished our act in the backwater towns before taking it to Las Vegas!
Most startups design the product, then build the product, and then sell the product. We first sold it, then designed it, and then built it. This customer-focused methodology remains a powerful paradigm. When it comes to the one shot you get at product success in a startup, it is crucial to have assurance you are on target.
Of course, there is an added benefit from this "reversed" process. You now have a good number of prospects with their fingerprints all over your product specification. When it comes time for selecting beta test sites, or making early sales, what better closing line than, "Hey, we heard you. Remember what you said was missing in our original design? Here it is!" In addition, you will have a due diligence list for the VCs that will both be sure to give you positive comments, and be broad enough to convince investors that there really are lots of customers eager to get their hands on your invention.
Most new ventures fail. Most new products fail. Most startups trying to raise venture capital fail to do so. If you want to maximize your chances of beating those odds, remember vaudeville. Reach out and touch someone!
Entrepreneurs Awake! These days, there is so much venture capital available that if you are out shopping for dollars, with a good story, there is a high probability you will get a positive response. Now what do you do? All along you have probably mouthed the words "We are looking for more than just money". Now you have the chance to prove it! Here is a guideline and checklist on how to buy yourself a top-notch venture capitalist. There are three areas you should probe in depth.
Most entrepreneurs relate to this one very quickly. They are eager to know what potential customers and strategic partners venture firms have lurking in their databases of contacts that can help launch the business. What is often glossed over is that there are many other areas where connections can be equally important as the business grows. Your investor's connections need to be helpful beyond the first Board meeting.
A venture capitalist should bring experience in both starting and growing companies from your size to well past the IPO point. This encompasses a host of issues, from follow-on financing to strategic thinking, from changing key management to hunkering down when things do not go as well as planned, from corporate partnering to liquidity paths such as public offering or acquisition. Do not settle for anyone who is going to run into some of these issues for the first time. New folks to the venture business are great. Just let them learn on someone else's deal!
Your venture investors need to be there when you need them, both with dollars and support. Therefore, staying power measures both the ability of a venture fund to handle follow-on financing (how deep are their pockets?) and their willingness to hang in there if times get tough (how long are their arms?). Beware of anyone who has not been through lots of bumps in the road with a number of startups. You do not want to learn how they will react when it is your company's future on the line.
For each question below, ask the venture capitalist to go beyond their response and provide a list of people to call to get a direct perspective.
One of the most common mistakes we see in business plans run something like this:
"Our startup, Hi-tech Corp., has developed a concept for a new product that will revolutionize the Internet market. You may know that over 40 million people are already connected to the Internet, according to DataGrind Research. We only need to get 5% market share to reach $100 million in annual revenues."
There is no faster way to turn off a professional venture capital firm than with a lead-in such as this. But wait, didn't we comment in the last issue of High Tech Advisor that VC firms are only looking for companies which serve large growing markets that will allow the company to scale to just this size? What's the problem? Actually there are at least three problems.
First, there is no such thing as the Internet market. It is not a market, but a technology infrastructure in which many markets exist. The same can be said of the wireless market or the medical device market or the biotech market. All of these "markets" are far too large and amorphous to have any meaning to a technology startup. If you do not understand your potential market, customers and competitors better than this, no venture capitalist will want to let you take their money and fritter it away finding out. This is analogous to the old line, "All we need is to have 1% of the people in China buy our product". China is not a market, it is a country. A market is a collection of people or companies with a specific set of wants and needs that may be met by a specific set of products and/or services. Now, if you have a product which fills a set of needs that everyone in China has, that everyone in China knows they have, and everyone in China has the money to buy -then China is a market.
Second, venture capitalists hate secondary market research. Most of these reports are far too sweeping to identify real markets, are far too optimistic in their growth projections (at least in the short term) and are far too expensive for anyone to actually buy! If a startup is relying on those numbers to prove its point, then we have to ask, "Do they really understand the business they are going after?" In addition, although there may be times you have evidence to the contrary, venture capitalists are not stupid (just misguided!). You should assume that at a minimum we do read most business journals and keep up on fundamental technology trends. The fact that the Internet is a major change agent is well known. Do not insult us with touting those huge but meaningless numbers. A much more persuasive argument might go something like this:
"Our startup, Hi-tech Corp., has developed innovative new software which solves a critical problem facing 2 million of the 40 million people who use the web on a daily basis."
You have already told us a few very important things with this statement. First, you have clearly identified a market within the Internet space that has a common set of needs (described in more detail in your plan). In addition, that market is a "heavy user" market and is therefore likely to feel more pain and be more ready to buy than casual users might be. It sounds as if you actually do have clear perspective on what you are setting out to do. If it is really 2 million users, it is still plenty large enough to get us to keep reading!
Now, we come to the third and most basic problem. Rarely, if ever, is 5% share of any market a good sustainable profitable position. Give me 30% of a smaller market any day. You may have read that Jack Welch at GE has a fundamental rule for that company. If they can not be number 1 or number 2 in a market, they get out. Jack is no dumb bunny! You can look at market after market and industry after industry, with the same results. The number one player in a market usually makes about one-half to two-thirds of the total profits in that market. The number two player often sees about half that. Numbers three on down are either marginally profitable or unprofitable. Unless a market is very fragmented, it usually takes 20% share or greater to be number one. Venture capitalists want to invest in firms that have the power to be the leader in their space, knowing that they can fall to number two and still be OK (unless the number one makes software in Redmond!).
The real issue here is simple. Understand your product and how it maps to customer needs and competitors well enough to articulate how you are going to carve out a leading position in a rapidly growing market. Then show how you plan to sustain that position. You will almost certainly find that the "market" you define is somewhat smaller than the pundits describe, but is far more real and reachable. In addition, you will have laid a foundation to growing a profitable, focused enterprise.
As we set off with this new publication, The Money Trail will try to address, explain and simplify some of the key issues surrounding the search for funding for new technology ventures. Along the way, we will attempt to demystify the venture capital process, and point out ways to increase the probability of you getting a favorable reception regardless of where you turn for financing.
So, to start at the beginning, the question is, "What's Your Big Idea"? It turns out this is much more than a rhetorical question. Professional venture capital firms receive many hundreds of business plans per investing partner per year. Most will actually fund only two to four projects per partner per year. If you are going to be the less than one-in-a-hundred to successfully run this gauntlet, you had better come armed with an idea that is more than just somewhat interesting. Now there is nothing wrong with a good solid business concept, which if executed properly leads to a modest-sized profitable enterprise. Such firms form the very fabric of American industry. However, they are not the ones to receive financing from professional venture capital funds.
Venture capitalists are looking for the chance to invest in companies that have the prospect to become major enterprises, generating many tens or hundreds of millions of dollars in sales over five to seven years. In addition, once those companies are established they will need to be able to command high enough margins to sustain explosive growth largely through internally generated cash flow. Those are very tough criteria. It is no wonder less than one percent make it through the screen.
Therefore, one of the very best things an entrepreneur can do is to conduct a brutally frank self-assessment of their business idea before darkening the door of the local VC. Clearly, a friendly but candid outside advisor (lawyer, accountant, banker) can lend a hand here.
So what if you do not pass the screen above? First, recognize that most startups get their funding from sources other than traditional venture capital. Private "angel" investors, corporate strategic investors and sales channel partners contribute far more to the financing scene than VC's do. For many of these other sources, your "Good Idea" may fit their profile quite well. If more entrepreneurs focused on what source of funding was most appropriate for them, before starting the financing dance, more would go home early with the right partner!
On the other hand, maybe you do have the germ of a Big Idea that still needs some more development before being ready for prime time financing. Perhaps you can investigate some other places where your technology might fit, or extend your thinking to reach a broader audience. In that case, another run through the six-question screen would be in order. Olympic Venture Partners has had some of its most successful experiences with entrepreneurs who came to us with a half-baked Big Idea, listened to our (and others) comments, went away, found the missing ingredients, and then came back and got funded.
Of course, when you are talking about new technologies serving new and often as yet undeveloped markets, it can be difficult to know up front how big your Big Idea really is. That is why venture capital is a risky business. After all the screening and due diligence, venture investors still strike out (e.g. lose most of their money) a third of the time or more. Less than a third of venture-funded projects ever come close to achieving the numbers in their original business plan. (so much for your "conservative" financials!). All this carnage after screening down over one hundred plans to make one investment!
However, if you do have a Big Idea, and you do take the leap for the brass ring and hang on, there is no greater thrill you can find in business!
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