BootStrap Busters: Critical mass.

If you want to bootstrap a business, beware of “bootstrap busters” – challenges that make bootstrapping more difficult. Let’s start with “critical mass”.

Let’s say you want to launch a business that involves bringing together buyers and sellers. That could be an auction model, like eBay, StubHub, or Sotheby’s, or a classified model, like Monster.com, Craigslist or Match.com. If buyers come, and there aren’t enough sellers, the buyers may leave and never come back. And vice versa.

How do you resolve this dilemma? Maybe you’ll spend money on marketing early on, to reach a critical mass of buyers and sellers quickly. Or perhaps you’ll make the service free for a while instead of collecting fees. Either way, you’ll probably be operating at a loss, which is rough when you are bootstrapping.

Media businesses have similar challenges. Want to launch a magazine, online community, or email newsletter? You’ll need to build an audience of a few thousand people before you can generate revenue from advertisers. That can take a lot of time, effort, and/or money. Either way, you probably won’t be generating positive cash flow for a while.

Bootstrap busters like critical mass aren’t insurmountable, of course. I’ve seen plenty of examples where scrappy entrepreneurs reach critical mass without raising capital. Just be sure you know what you are getting yourself into, and that you have enough patience and / or resources.

BootStrap BootCamp 2

This is the second in a series of posts following a BootStrap Bootcamp I ran in NYC in July.

Should you bootstrap your venture?

Before answering that, I’d ask you this:  Do you have a choice? If you haven’t  launched a successful startup before, don’t have a stellar track record within the industry you are pursuing, and don’t have a strong network of angel and venture capital investors, you might find it very tough to raise capital. Even if you can do it, it might take you nine months or longer to scrape together your funding. That’s going to be a long, painful process.

But what if do have the ability to raise capital. Should you always do it?

Pros:

• You’ll be able to pay your rent without eating into savings
• If you budget properly, you’ll know you can keep the business going for some period of time
• You’ll probably be able to move faster
• You may find it easier to sleep at night – at least when it comes to your own personal risk

Cons:

• Once you raise capital, you have to a responsibility to someone else. That means you’ll have to consider their interests when you make big decisions, which means you probably won’t have as much flexibility. For example, if you decide to change your business model, you’re going to want to get your investors to agree it’s the right thing to do. Even if you’ve only sold a small stake, you don’t want pissed off investors for a multitude of reasons (e.g. You need their help, they can make life difficult for you, etc.). That also means, you’re reputation with future investor prospects will be on the line.
• If you’ve got the money, you’ll spend it. That’s just human nature. The flipside of this is that if you don’t have the money, you’ll probably do more with less.
• Even if you have great contacts, it can take months to raise capital. Your time might be better spent operating your business.

StartUp valuation 101

If you are raising capital, be prepared to tell investors your proposed deal terms. Terms can get very complicated, especially with venture capital investors, but I’ll stick to the basics in this chapter, since most of you will be raising capital from friends, family, and / or angel investors.

Whether or not to put deal terms in your pitch deck is a matter of style. I often prepare a backup slide with deal terms, and pull it out if the pitch is going well, or if the investors ask for it. The mechanics are as follows:

1. How much is the company worth today? (“pre-money valuation”)
2. How much money are you looking to raise? (typically enough to get your company through at least 12 months of operations)
3. How much will the company be worth the day after you raise the investment? (a.k.a., post-money valuation)

Let’s try some simple round numbers. Let’s say the company is worth $1 million today, and you are raising $500,000, so the $1 million it’s worth now plus the $500,000 cash from the financing will make the company worth $1.5 million. That means the investors as a group will be putting in $500,000 of the $1.5 million post-money valuation, so they will be buying $500,000/$1,500,000, or 33% (a third) of the equity ownership in the company. 

The toughest part of this calculation is determining the pre-money valuation. I recently helped a client establish a valuation for his startup, and thought I’d discuss the topic a bit here. He hadn’t raised capital before, and his instinct was to value the startup based projections of future cash flows (i.e. Net Present Value analysis). That can work for a going concern, but startup valuations are typically derived by looking at comparables, meaning recent valuations of other startups being financed. 

As I write this, most seed-stage round valuations tend to range from $500,000 to $2.5 million. Factors that determine where a startup falls along this spectrum include:

• Quality of the team. Have they founded successful businesses before, and made money for investors?
• Stage of development. Is this an entrepreneur with a business plan and nothing more? Does she have a prototype developed? Paying customers? 
• Size of the opportunity. Is this a company that could, in theory, become a $10 million business or does it have the potential to be $100 million business?
• Sweat equity implications. If the valuation is too low in relation to the amount raised, the management team may own a very small stake. That’s bad for you as an entrepreneur, because you won’t have enough incentive to make the sacrifices necessary to build the company. It’s also bad for investors— they want you motivated to work hard to make the company valuable, so you both make money when the company is sold.

After considering these issues, my client and I came up with a target pre-money valuation. Our number was $1.5 million. His goal is to raise $500,000, so he’d be selling $500,000 / ($1,500,000 +$500,000), or 25% of his equity to the new investors.

Like any good entrepreneur, he was concerned about giving away too much equity, and thought he should try for a $3MM pre-money valuation. It took a bit of discussion, but I convinced him otherwise. Of course, I want the best for my clients. But if he walked into a meeting with a sophisticated investor with a valuation that’s out of line with what’s happening in the market, he could lose credibility, and blow the deal. If he were to convince an unsophisticated investor (e.g. a family member) to take the higher valuation, he could have a different problem… Down the road, if he took money from a venture capital firm, they might strike a tougher bargain, in which case (depending on terms) the unsophisticated investor could suffer significant dilution.

Slide 11: Funding

Hooray! You’re almost done with your business plan pitch deck. At this point, you’ve made a persuasive case for why there’s an attractive opportunity, and why you have the right vision and team for capitalizing on that opportunity. Now it’s time to close the deal (that is, if you are raising capital).

This slide should explain how much capital you need now, and in any future rounds. If you did not include a slide with details on your monthly financials during your seed round, provide a “use of proceeds” here, which is basically a chart showing that if you are raising $1 million, you’ll spend 30% to develop your technology, 25% on marketing, etc.

Then explain where the capital gets you. In other words, show what milestones will you hit, and when, facilitated by the money you’ve raised.

Next, discuss your exit strategy. Tell investors how you think (not promise) they’ll make a profit on their investment. If that strategy is to build something valuable and sell it to a larger company, explain just what you need to build, and who is most likely to buy it. A good way to do this is to look at recent acquisition activity in related markets. Be sure to look at (and think through) why companies made acquisitions. Were they looking to buy talented management teams? Hot, up-and-coming brands to add to their stables of mature brands? Relationships with distributors? Advanced technology?

Also, look at how the acquiring companies valued their acquisition targets. Their methods of valuation will help you predict what your company might be worth. Financial buyers might have bought a company for a price equal to some multiple of cash flow or profit (e.g., eight times earnings). Big companies with efficient sales and marketing processes might see a small company differently. Maybe the small company is growing their sales very quickly, but is barely eking out a profit. The big company might focus on some multiple of sales (such as 2x sales) because they know they can boost profits when they increase efficiencies. Finally, see whether there seem to be critical hurdles required before companies get acquired. Maybe in your industry, the last few companies acquired had recently hit $10 million in sales. That could be a “magic number” you’ll need to reach before companies consider buying you.

Why bootstrapping matters

Why should you care about bootstrapping? The vast majority of new businesses are financed via bootstrapping, not from angel investments[1] or venture capital funding[2]. In fact only about 3% of companies that seek angel funding actually land investments[3], and the odds are even tougher for companies seeking venture capital.

 

 

 

 

 

 

 

 

 

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[1] http://www.angelcapitaleducation.org/dir_resources/for_entrepreneurs.aspx

[2] https://www.pwcmoneytree.com/MTPublic/ns/moneytree/filesource/exhibits/MoneyTree%20-%20Q2%202008%20final.pdf – Startup, Seed and Early Stage investments.

[3] http://angelsoft.net/industry/

Seek out smart money investors

In general, always seek out “smart money” investors—people with expertise, experience, skills and the willingness to use them to help grow your business. These investors can provide far more than just a check. They can help with strategy, provide business development leads, help you find and screen employees, drum up customers, suppliers, and more. Investors who have been successful entrepreneurs themselves are particularly beneficial. They know what it takes to start a new business, and will be both helpful and understanding.

A few years ago, I started a business with the goal of selling advertisements and promotions on milk containers. The first step was to secure the rights to the space on the milk containers—effectively little billboards in supermarkets and on kitchen tables. I had zero experience in the dairy business, so I sought out investors with experience in the industry, and gave them extra equity options to serve as advisors. One such investor was a man named Stanley. I remember going to my first meeting with a dairy producer, and nearly getting laughed out of the room. I flew out to a rural Midwestern location for the meeting, wearing a suit that screamed “city slicker.” Somehow the dairy guy found out I graduated from Harvard, which was just the ammo he needed to mock me. “I don’t know how they do things up at Haaaahvard, but here, we….” Ugh. Next time I brought Stanley (and I left the suit at home). He spent the first 20 minutes of the meeting shooting the shit with the dairy guy. He found tons of common ground, like conferences they had attended, people they knew, and problems they had faced. He had the right accent, the right look, the right lingo. When it was time to discuss the deal, the dairy guy was open-minded and eager to explore our opportunity.

Rounds of financing

Startup Capital. Most entrepreneurs begin with money of their own, and/or money from friends and family. At this stage, people tend to invest because they know/trust/love you, so they are not going to be as tough on your business plan as others. They will also be “patient capital” — they’ll be happy to make a profit on their investment, but they probably won’t be too upset if it takes longer than you expect. These rounds are typically less than $100,000 in total. Be sure not to take money from anyone who can’t afford to lose what they put in, and always make it clear that many things can go wrong, and that they could lose their money. This startup capital is typically used to the company prepared to launch its business by designing a product, creating samples or prototypes, and/or conducting market research. Some companies can get all the way to profitability using startup capital. Others must move on to the next stage.

Seed Round. Many companies seek outside[1] capital in order to build their businesses. This stage is typically called a “seed stage,” and most entrepreneurs get seed stage capital from angel investors.[2] Angel investors are people who invest their own money on an amateur basis—as opposed to venture capital firms, which invest money in funds, on a professional basis. Each year, angels invest about $26 billion in more 57,000 companies,[3] more than 10 times the number of companies venture capital firms back each year.[4] Some angels invest alone, and others invest through groups.[5] Their levels of sophistication can vary widely; those in groups tend to be the most savvy, which makes them tougher to persuade but also more valuable. Most angel rounds are below $1 million. The investments can be used for many different purposes, but in many cases they are designed to get a company to the point where it has a product or service up and running, and enough paying customers to prove that their concept works ( “proof of concept”).

Series A Round. Companies that need significant amounts of capital after burning through their seed funding often seek funding from venture capital firms (“VCs”). For the average entrepreneur, VCs are tough nuts to crack.  First, you’ve got to have the right background. Yes, VCs sometimes invest in unknown, first time entrepreneurs, but there’s usually a back-story. More often, they invest in teams led by seasoned entrepreneurs with track records of success. Next, you’ve got to have the right idea. VCs take a portfolio approach to investing. Let’s say a VC invests in 10 startups. Most of them will fail, or experience mediocre performance, in which case they’ll get merged or shut down. Maybe one in 10 will actually succeed. For that reason, each of the 10 companies must have the potential to be a home run—to sell for $100 million or more, or make the equivalent from an IPO (remember those?). Oh, and it’s got to happen in three to five years.

Also, each venture capital firm has a specific focus. They invest in companies in particular industries or locations, and focus on certain stages of development. Plus, VCs tend to make larger investments than angels – typically more than $3 million, though there are some exceptions.

If you pass all those hurdles, be forewarned that raising VC can take a long time (plan on four to five months or more), and that their terms tend to be more aggressive than angel terms. Their pre-investment research or “due diligence” also tends to be much more thorough. Last but not least, you generally can’t just waltz into a VC firm—you almost always need a personal introduction.

Before approaching any angel, angel group or venture capital firm, do your homework. Know what they’ve invested in previously, and how those investments have performed. Know what types of investments they like to make now, which could be different from just a few months earlier. Know the backgrounds of the key players. And be sure you meet their investment criteria before you waste your time and theirs.

 

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[1] Outside meaning beyond an entrepreneur’s capital, and that of his / her friends and family.

 

 

 

 

[2] A small number of VCs invest in seed stage ventures.

[3] http://wsbe.unh.edu/files/2007%20Media%20Release%20-%20Lori%20Wright.pdf

[4] Compared to angels, VCs place much bigger investments in far fewer ventures.

[5] One good way to find these groups is to visit www.AngelSoft.net

When the economy gives you lemons, open a lemonade stand

Just read an article in Forbes about the state of early stage venture capital investing, and it’s not pretty. Shocker. Among other things, 60% of early stage VC funds aren’t making any new investments. I haven’t seen any recent data on the state of angel (amateur) investment activity, but it’s probably not looking rosy either. Still, keep in mind that the vast majority of early stage companies are financed by investors themselves, and their friends and family. 

Call me crazy, but I think there’s a silver lining in all this. 

• Survival of the fittest. Fair-weather entrepreneurs are sprinting for the exits, but those choosing to stick it out are more likely to have the kind of tenacity and resourcefulness that drives success.
• Bootstrapping rules. If you don’t have a lot of investment capital, you are forced to do more with less…. to make smarter decisions, and focus on cash flow. Need to raise outside capital? Prove you’ve can get traction first (e.g. build your prototype, grow your user base, close distribution deals, land some paying customers…). That’s the way it should be. See my post on boostrapping for more.

Valuation

I just helped a client establish a valuation for his startup, and thought I’d discuss the topic a bit here. He hadn’t raised capital before, and his instinct was to value the startup based projections of future cash flows (i.e. Net Present Value analysis). That can work for a going concern, but startup valuations are typically driven by comparables, meaning recent valuations of other startups being financed.

At the time of this post, most seed-stage round valuations are between $500K and $2MM. Factors that determine where a startup falls along this spectrum include:

• Quality of the team. Have they founded successful businesses before, and made money for investors?
• Stage of development. Is this an entrepreneur with a business plan and nothing more? Does she have a prototype developed? Paying customers?
• Size of the opportunity. Is this a company that could, in theory, become a $10MM business or $100MM business?

After considering these issues, we came up with a valuation. To be more specific, a pre-money valuation, or the value of his company today. Our number was $1.5MM. His goal is to raise $500K. So how much do his investors get? The math is pretty simple. Take the value of the company before the investment ($1.5MM), add the amount of the investment ($500K), and you have a post-money valuation ($2MM). The investors get $500K divided by $2MM, or 25% of the equity.

Like any good entrepreneur, he was concerned about giving away too much equity, and thought he should try for a $3MM pre-money valuation. It took a bit of discussion, but I convinced him otherwise. Of course, I want the best for my clients. But if he walked into a meeting with a sophisticated angel investor with a valuation that’s out of line with what’s happening in the market, he could lose credibility, and blow the deal. If he were to convince an unsophisticated investor (e.g. a family member) to take the higher valuation, he could have a different problem… Down the road, if he took money from a venture capital firm, they might strike a tougher bargain, in which case (depending on terms) the unsophisticated investor could suffer significant dilution.

Have thoughts on valuations of early stage companies? Please share them below.

Process of raising capital

Here’s another chart I’ve found helpful for UpStart clients… It shows a typical process for approaching and raising money from investors. Of course, many investors will require multiple meetings and due diligence steps, but the general progression tends to look like this: