Beware bad partners bearing cash

I met with a successful consumer products entrepreneur today, and he told me how he spent the past few months unwinding a partnership–complete with legal costs, wasted time, and frustration.

Long story short, he took investment capital from a wealthy person with nothing to do and a desire to be involved in running the business. That person proved to be a lousy operator and awful partner. The story made me cringe, not only because I’ve heard it before, but because I made the same mistake many years ago.

I know, I know, you need capital now to start–or preferably to grow–your business. But be very careful about mixing investors and partners / employees. Think about whether you need to fill a specific role on your management team. Then profile the skills and experience of your dream candidate for that role. Before you even consider having an investor fill the role, be sure they are a great fit, and that they’re someone you know very well , trust, and want to work with every day.

4 things you should NOT say to potential investors

1. “I really don’t want investors meddling in the business.” I heard this beauty from someone who asked me for an introduction to an investor. Needless to say, the conversation stopped there.
2. “Our financial projections are conservative.” Puhleeese. You’ve got revenue of um, zero, now. And within three years you’ll have $x0,000,000. Sounds very conservative to me.
3. “I’ll send you my pitch deck.” NOOOOOO. Send a 1 page synopsis. You should present your pitch in person, or at least via web conference.
4. “Before I tell you the basic idea, I’ll need you to sign an NDA.” If you think your basic idea is the true source of the value you’ll create over the next 3 – 5 years, you’ve got bigger problems. It’s (nearly) all about how well you’ll execute.

Working through the numbers on ownership

One of my clients is raising a seed round of financing. Of course, she’s a smart cookie, and bootstrapped her way to some impressive results before raising the money. In case you go about something like this, I’ll show you how the ownership structure gets impacted.

First, she starts with some (arbitrary) number of shares – or units if it’s an LLC.

Then she issued some more units to key employees and advisors.

After that, she raised the round. The price per share is simply the pre-money valuation divided by number of shares before the round ($900,000 pre-money valuation / 10,640 shares = $85.59 per share). The investors put in $250,000, so the company issues an additional 2,956 units to them ($250,000/$85.59 = 2,956).

Everytime the company issues more shares, the previous owners are left with a smaller fraction of the total shares (barring anti-dilution provisions). They are effectively “diluted”. However, as long as the valuations keep rising, they’ll own a smaller piece of a bigger pie, so the value of their ownership will increase.

16 questions to ask yourself when planning a business

Here are questions I ask my clients when helping them develop business plans to raise capital:

1. What are your goals for the business? Is there a revenue number you’d like to hit? Do you want to sell the business, and pull out some amount of personal wealth? Do you have other motivations (e.g. fame, press, a bridge to other opportunities, etc.)?
2. Who is on your current team, and why are they uniquely qualified to execute your plan? As you expand your business, what are the key management roles you’ll need to fill? Have you identified candidates for those roles yet? Do you know what the cash / equity compensation will be?
3. Do you have recent data on the size and growth rate of your industry? What are the key trends driving the business?
4. What customers will you be targeting? Can you prove that they’ve got unmet needs
5. What will be your unique positioning within the market?
6. What businesses most closely resemble the one you will build? Do you have data on how they built their business, including the evolution of their product lines, distribution, and revenue
7. What will your product offering consist of, and how will it evolve over time – including categories and price points?
8. What’s your marketing strategy?
9. What are the unit economics of your business? What does an average sale look like in terms of revenue and variable costs? What’s your break-even volume?
10. What’s most likely to go wrong with your plan, and how can you prevent it from happening? How have similar companies failed / what obstacles did they run into?
11. Who are your competitors? How are they doing? How will you differentiate yourself from them?
12. What are the next phases of implementation? What tangible milestones will you aim for in each phase?
13. What have you accomplished to date that helps prove you are capable of executing against your plan?  That can include:  the team you’ve built, distribution channels and performance in those channels, revenue, branding, etc.
14. To what extent have you projected your future revenues? Expenses? Team structure? Distribution?
15. How much capital are you raising in the current round? Where will the money get you? How will you spend it? Will you need additional funding? When? How much?
16. What’s your exit strategy? Who will buy your company? Why? What will they pay? What transactions can you point to that lend credence to your exit strategy?
17. What is the valuation of your company today, and the basis for that number? How much equity are you willing to give up to new investors in this round?

Lottery vs. venture capital

I was just reading in Crain’s that only 19 companies in the NY-metro area closed early-stage venture capital funding last quarter. 19!!!

That got me thinking, are you better off playing the lottery? The numbers aren’t apples to apples, but just for fun, consider this:

• 1,600 people per year in the U.S. win at least $1 million in the lottery.
• 483 companies raised seed stage VC funding in 2008, and another 1,072 got early stage funding.

Not far off!! So, unless you’re sure you’ve got the right stuff (e.g. team with previous startup wins, chance to generate $100 million+, significant traction to date, a network of vc contacts, etc.) – stick to bootstrapping or angel funding through your early stages.

Bootstrapping pointers

A friend and business parter, Beth Schoenfeldt, from Collective-E, just asked me a couple questions about bootstrapping for a webinar we’ll be teaching about bootstrapping on October 20th (lemme know if you want to participate: david @  upstartadvisors .com). I thought you might find the Q&A helpful:

Beth: Can you name any big brands that were originally started by bootstrapping?

David: Apple, YouTube, Facebook, Yahoo, Google all got traction via bootstrapping before raising significant outside capital.

Beth: What are a couple great ways to get services or products for less?

David:

• Hire less experienced employees with raw potential. Train them yourself (but avoid giving them inflated titles). Bring in top talent later.Use freelancers where possible – especially for one time or part time needs.
• Forget the pr firm. Instead, wse social media to create your own voice to the public, via blogging, Facebook, Twitter, LinkedIn, etc. Establish yourself as an expert, and develop a rapport with bloggers and journalists so they reach out to you when they need your POV.
• Syndicate. Tap into other properties with audiences you’d like to reach via guest blogging, active postings on message threads.
• Barter. Find products or services you can provide with minimal / zero cost, that other companies may find valuable. Got an email newsletter or website that makes money from advertising? Give away some of your inventory (better yet, unsold inventory) in exchange for products or services.

Beth: What if you have bootstrapped it for a while now and feel stuck, any suggestions?

David: You can always raise capital after boostrapping. In fact, it’s often better to bootstrap your way until you’ve made significant progress (e.g. revenue) BEFORE raising capital. Having that traction will make it faster and easier to raise money, and usually lets you keep more equity.

Anatomy of a vc funded startup

More insight into the Mint deal, and how the stages of financing and growth play out in a venture-backed model from Christine.net:

The straight shot: Why should you raise money, and how much?

• Step 1: When you’re ready with an Idea: Raise $100K from friends and family, and use it to build a prototype.
• Step 2: Once the prototype is done: Raise < $1M in seed capital, and get into market with an alpha launch.
• Step 3: After that initial launch has traction: Raise $5-10M, and use it to prove/scale the model.

Garage Phase: What are the costs and milestones?

Here’s how MINT spend its $100K of garage money:

• Founders: $30K/year living expenses
• Engineering 1st hires: $30-50K/year
• Office: $400/cube/month
• Tech: $10K
• Legal: Deferred payments for 0.50 – 0.75% of company

Roughly, 2 founders + 1 engineer/contractor = $150K/year burn. This gives you 6 – 9 months of runway before you need to raise a seed round.

In order to get that seed round, you’ll need to understand your competition, and come up with projections. Everyone knows this will change…but you need to show your thinking around it anyway. As an example, MINT originally projected $30/user/year for lead-gen and CPA. (Aaron noted that the company is pretty close to this today. But this is the exception rather than the rule.) Know how the business model works. People do X behavior and it turns into $Y income, add up those $Ys and it’s a $Z business. If you can walk people through these assumptions convincingly, you’ll get that seed round.

Seed Round: What are the next costs and milestones?

• Salaries: $50 – 90K/year ($450K/year for 5 people)
• Overhead: +20% ($100K/year)
• Legal: $25K + $2K/month ($50K/year)

MINT.com raised $750K in its seed round to cover these expenses for 12 months, which is about how much time you’ll need to develop into the Series A stage.

What model do you build next in order to raise the Series A? Testing and learning from your seed model, show user growth, retention, COGS, revenue per sale/user, and profit. The accumulated loss is how much you need to raise, and a well-though funding strategy combined with an understanding of (hopefully good) business economics is what will speed the Series A process along.

Series A: Now what?

• Salaries + Overhead: $200K/year/person
• COGS: Varies, but even one-time expenses magically add up to $150K/month
• Legal: $10-50K/month

Total burn for a 30-person team: $6M/year. Naturally you don’t start out burning this much, as it takes time to grow the team. However the numbers work out, your goals should be the same: Get profitable within 2 years. Raise the capital you need to do this without much distraction.

If you want to raise more after this in order to grow more aggressively or extend otherwise, your success in achieving those first two goals will speak for itself.

Economics of an exit

Just read an interesting article on Silicon Valley Watcher, describing the economics of a vc-backed exit:

“…Here’s how the math works against EVERY employee at an overfunded startup – take the mint deal for example: $170M exit (maybe $70 or so is future perf related so that leaves $100M), even without liquidation prefs, the employees get basically nothing. $40mil VC = maybe 60% of the company, 20% for the founder CEO, 3% each for the next 5 guys. That leaves everyone else sharing $5mil to vest over the next 4 years. And even that’s skewed for a few people. So with the biggest VC exit of the year, the employees are basically vesting a $20k annual bonus. gee thanks. Huge VC rounds are only good for people who own big, early, preferred chunks already.”

Of course, that kind of exit is pretty rare, especially lately. And usually there are a few founders splitting that 20%. Plus, of COURSE there are liquidity preferences up the wazoo, so the pie gets reduced (VCs get their investment amount off the top, or sometimes 2x that amount, before the pie gets divided among them and the others).

BootStrap BootCamp 1

A few weeks ago I ran a workshop at SOHO House called BootStrap Bootcamp. I thought I’d share a few of the key points over the next few posts.

First, what is bootstrapping? In general terms, it means pulling yourself up by your own bootstraps – or relying on your own efforts and resources instead of getting help. In the world of entrepreneurship, it tends to mean launching a business with limited capital investments.

There are a few flavors of this, though.

-A team funds the first phase of a startup by themselves, hits their milestones, and then raises outside financing.

-A team funds the first phase of a startup by themselves, and doesn’t need additional financing

-A scrappy team that starts and grows a company on a very tight budget – never investing or raising money. One common flavor of this is to use customer payments to finance growth

Don’t bother planning, if you are Kevin Ryan

Ok I feel the need to comment on this video, in which Kevin Ryan says he doesn’t believe in business plans. First, Kudo’s to Kevin. He’s built some incredible businesses, including Doubleclick, which he sold for over $1 billion, and Gilt Group, which is crushing the new private online sample sale model, with over $100 million in revenues in its second year. I’ve also had the pleasure of meeting Kevin (over foosball, of all things) and he comes across as being super bright, intellectually curious, and very personable.  And not too shabby at foosball either.

My guess is Kevin (and his team at AlleyCorp) puts more thought into the key elements of a startup opportunity than he lets on. But my issue is not with Kevin, actually. It’s with how some people seem to be reacting to his comments.

Kevin believes in launching companies with his own funds for the first 6 months or so, to get a sense for whether they will succeed. That’s bootstrapping, essentially, which I rave about ad nauseum. But Kevin has something most bootstrappers don’t – a big pile of money. If you share Kevin’s advantage, you can probably afford to use his ready-fire-aim approach. If not, be sure to think through the basics. Don’t spend months running doing research and analysis up the wazoo, but at the same time, don’t sprint blindly down what could be the wrong path. As with many things in life, seek a balanced approach.