1. Customers buy from you and perceive value

The question professional investors often ask is, “Will the dogs eat the dog food?” If you have an existing business where customers pay reasonable prices for your products and services and perceive value in the exchange, you have the foundation for a successful business. The absolute best source of capital for your business is satisfied customers. But if your company has strong proven customer demand and you need expansion capital to meet that demand, you’re in a highly attractive position to investors. For start-ups, the question is more difficult to answer until customer traction is achieved, and we’ll address this issue in a future post.

2. Your business generates strong earnings

Many start-ups launch with strategies to attract customers with free or low-priced goods and services. Of course, the company eventually has to generate profits to be successful, so prices usually escalate and more revenue streams are established. Most start-ups lose money for a while, and even well established companies lose money occasionally. If your business is not currently profitable, you need to demonstrate a clear and credible path to profitability. Investors are looking for proof of your company’s ability to maximize earnings while keeping the customer value equation in balance.

3. Your business is scalable

How much realistic growth potential does your business have? Is there a way to double or triple your revenues within a year or two? What will it take to make it happen? If you can demonstrate the scalability of your company, you’ll find more investors willing to talk to you. However, if you have a $1 million business today and can grow it to $5 million within the next 3 years, your deal won’t appeal to venture capitalists or angel investors, but it may be attractive to informal investors or commercial lenders. The type of investor will depend on how much your company can reasonably scale. Proof of scalability enhances your strength in the eyes of investors, even if it is on a limited or trial basis.

Start-up companies generally don’t have much evidence of these issues, but are often able to achieve it after a period of bootstrapping with a focus on generating the necessary proofs. Both investors and lenders respond well to business owners who have taken this approach.

Respectfully, I disagree.  Here’s why.

• There are about 300 angel groups in the United States at present.
• The largest angel group in the United States is currently Tech Coast Angels.
• Tech Coast Angels normally invest in about 10-12 new deals per year.
• Assuming 300 angel groups each invested in 12 new deals per year, they would fund about 3,600 deals per year in total.
• 57,225 companies received funding from angel investors in 2009, including follow-on investments.
• Based on these numbers, angel groups funded less than 10% of all angel deals in 2009.
• Angel groups are easy to find.  I’ve encountered people offering to sell lists of angel groups.  What a crock!  You can find the biggest and best list of them here for free.
• Because angel groups are so easy to find, they are often inundated with business plans from entrepreneurs clamoring for attention.  What happens when the demand for capital far outpaces investor supply?  Investors get a lot pickier.  Is this the perfect environment for an entrepreneur?

Solo angels and informal investors represent a far better funding opportunity for most startup and early stage companies.   Here’s the story the numbers tell.

• There were nearly 260,000 active angel investors in the U.S. in 2009.  An estimated 20,000 angel investors are part of organized angel groups, leaving a total of 240,000 solo angels. These solo angels were responsible for more than 90% of all angel deals funded in 2009, with an estimated total investment of more than $15 billion.
• Informal investors (including friends, family, and associates) invested in more than 4,000,000 deals in 2009.  They provided more than $70 billion in small business funding in 2009.

You can draw your own conclusions from these numbers; the math is pretty straightforward.

All that being said, raising money from solo angels and informal investors takes time, lots of work, and persistence to succeed.  Some professional guidance won’t hurt either!

How about having customers provide all or most of the necessary capital.

While this scenario may not be realistic for some companies, many companies can find practical application of this method in their approach to capital and customer acquisition. This is the essence of value creation capital.

The primary question is:

How lean can a company start and operate in order to attract paying customers with an early version of its products or services, thereby demonstrating viability, scalability, and fundability?

After a business has demonstrated these characteristics, it’s a lot easier to get funding, because the investment is less risky.

This idea is not new or uncommon. For many years 3-M has fostered a culture of intrapreneurship whereby small teams of technical and business people come together on a limited budget to develop and market new products. Some industry experts estimate that 30% of all large companies provide seed funds to finance internal entrepreneurship today.

Many entrepreneurs could take a page from this playbook for their own companies. In other words, start making money from a small investment in product development and marketing, consistently improve the product based on market demand and reasonable economics, and raise growth capital after establishing a respectable product, delivery and support team, customer base, and growth plan.

One of the key elements to this lean approach is focusing on the creation of “minimum viable products,” and then building a base of paying customers.  This approach has also been around a long time.  In the automotive industry, both Honda and Hyundai came to market in the United States with cars that could easily be classified as minimum viable products. They sold a lot of these cars at low prices, which provided revenue and a growing customer base on which they could continuously improve. Both car companies have a much better reputation today than they originally did, and they are still going strong, even amid global economic challenges.

I’ve worked with many startups that wanted to hit the market with a knockout product or service from the very beginning. Few have achieved their fully realized vision out of the starting gate. Many find that the perfection curve can be a real business killer for tender young companies with limited financial resources. I’ve experienced this brand of misery firsthand with one of my own startups, and don’t recommend it to anyone!

Venture capitalists and other investors are coming around to this way of thinking again – spend less upfront to develop products and customer bases, and then fund the winners that emerge.  It’s a simple lesson with major implications. It’s also a mindset and a strategic approach that can help you quickly and economically sift through many good business ideas to find a really great one customers love to pay for.

• Do you really need a business plan, and why?
• What’s the fastest, easiest and cheapest way to get one?
• Should you copy one for a company that got funded and edit it?
• Should you do it yourself or hire someone else to do it all for you, and why?
• Can you just start with an executive summary?

I’ve reviewed many websites, articles, software programs, videos, audio files, and books on the subject of writing business plans for raising capital.  Here’s what most of them say in answer to these questions:

• You need a business plan so you can effectively communicate your business to investors, employees, and other stakeholders.
• The fastest, cheapest, and easiest way to get one is to copy and edit one.  However, this is the least effective way to create a business plan.  You get out of the effort what you put into it.  It would be like trying to become a medical doctor by using someone else’s lab work and notes.   May I never visit a doctor thus prepared to practice medicine!
• Ditto on copying and editing a plan for a company that got funded.
• Most experts say you should write the business plan yourself.  Sweat it out, gain from the pain, pay your dues, and all of that.  This approach has merit, and you’ll become much more knowledgeable about your business.  But you’ll almost certainly waste a whole lot of time trying to figure things out on your own, learn lots of things that are useful and interesting but not yet critical, and probably have to do quite a few rewrites as you start showing it around.  If you can partner with someone who knows the ropes and is willing to work with you through the process, kind of like a personal trainer or a mentor, you can reduce the time it takes to create a solid business plan and be prepared to present it effectively.  I’m not talking about turning the whole thing over to someone else to create for you, but engaging the support of an expert who works with you to do it right the first time.

All this stuff is pretty straightforward.  It’s going to take time to create a business plan, and the clock is ticking.  So it’s the final question I primarily want to address.

Can you just start with an executive summary?

Many entrepreneurs, realizing that a business plan represents a significant investment of time, wonder if they could perhaps create an executive summary and start shopping it around while they work on the full plan …

In theory, it’s a great idea.  But most experts concur that this is not a good approach because you have not thought things through well enough yet, and so you’ll be communicating faulty information.

Well, I’m not most experts.

I believe you can and often should go with an executive summary first for a number of reasons.  With one caveat.  First you need to build a comprehensive financial model that tells the story of the business with numbers.  Then you’ll be prepared to start hanging words on the numbers, even in abbreviated form.

The benefits of this approach include:

• During the process of creating a comprehensive financial model, you’ll think through all aspects of your business, and see how they interrelate with each other.  You’ll have a clear picture of your key success drivers.
• After you’ve done the complete numeric creation, it becomes quite easy to start putting the story into words.
• A solid executive summary supported by a comprehensive financial model can be developed faster and at a lower cost than a complete business plan.
• This speed means you can start circulating the executive summary to generate interest in your business, and even start raising capital, while your business plan is in development.  I have many clients who have successfully followed this path.
• For startup businesses in particular, this is an economical way to test the waters to see how viable your business is and how attractive it will be to investors before you invest heavily in time and other resources.

The viability of this approach all comes down to one thing – how effectively you develop a comprehensive financial model before committing your ideas to words.

I provide for my family by helping entrepreneurs prepare for the capital raising process.  I’ve seen angel investors, venture capitalists, and trade associations strongly recommend that you should not hire people to help with your financial projections and business plans.  Obviously, I disagree with this recommendation, but I believe there are several basic principles that apply to entrepreneurs trying to raise money that we should all be able agree on, leading to mutually beneficial coexistence.

• Business owners must have a thorough understanding of their financial projections and business plans.
• Many new business owners have limited experience with creating detailed financial projections, developing effective business plans, and raising money.
• For business owners, time equates to money.

The Issues

If you hire someone to do everything for you, you won’t get the benefit of learning your finances and business model inside and out.

If you don’t have much experience with financial modeling, spreadsheets, business planning, writing, and experience in raising capital, it can take a tremendous amount of time and effort to get it right.

A lengthy learning curve can be very costly to you, as you spend less time in activities that can generate revenue and profit, and more time developing expertise in the capitalization process.  In my experience, even those who have done it multiple times often rely on help from others.

If your business has the potential to get funded by angel groups or venture capitalists, your preparations better be right on the mark, or your deal will probably not pass the screening process.  This is very difficult to do, especially if you’ve never done it before.  It’s like trying to hit a home run in your first at bat in the major leagues.

A collaborative effort between entrepreneurs and experts in the capital raising process can overcome all these challenges.  This approach has been proven to work effectively time and time again.

Elements of Effective Collaboration

In an effective collaboration:

• An expert walks through all the “nitty-gritty” details of a business with the entrepreneur, discussing ideas, strategies, tactics, plans, opportunities, weaknesses, and many other issues.
• The expert coaches the entrepreneur, and helps identify solutions to challenges and pitfalls to that specific business, which result in better projections and stronger business plans.
• The expert provides qualitative feedback on the information provided by the entrepreneur, something that does not come from books, websites, videos, or software.
• The expert works “side by side” with the entrepreneur to develop a comprehensive financial model and business plan, which are highly customized to each business.
• At the end of the collaborative process, the entrepreneur has been intensively schooled and tooled in preparation to raise capital.

If any of these elements is missing at the end, then the collaboration has not been fully effective.  If the expert does all the work, then the collaboration has not been effective, and the end result is an unprepared entrepreneur.  Intelligent investors will be quick to recognize the lack of preparation, and won’t invest.

Entrepreneurs:

• You do have to pay the price to get correctly prepared.
• You don’t have to do it alone, you just have to do it right.
• An effective collaboration is a proven, viable way to do it right.
• An effective collaboration can save you a tremendous amount of time and money.

A smart man learns from his own mistakes.
A wise man learns from the mistakes of others.
A fool learns from neither.

The answer depends on many factors, but I’d like to focus on what I believe are three critical aspects; 1) how well developed the revenue generation model is, 2) how reasonable the key financial assumptions are, and 3) how the management team views the numbers.

Revenue Model

Projections that are based on capturing “just 1% of the market” are the mark of a novice entrepreneur.  Projections of generating X million dollars of revenue in the first year will be greeted with questions about what the company will do to achieve that revenue volume.  The action plan for generating sales prospects and converting them to orders should be outlined and quantified in a good revenue model.

There are multiple benefits to this approach.  First, you demonstrate an understanding of the marketing and selling processes by which investors can assess your ability to oversee these key aspects of a business.  Second, you create an action plan that will be easier to implement upon funding.  And third, you generate leading indicators which can be used to manage the business.  This enables you to seek resolution to problems that arise before the company starts missing revenue targets several weeks or months later.  I believe the revenue model is the foundation for the entire business.  If done well, it will demonstrate your business expertise to investors, thereby engendering confidence and moving you toward funding success, as well as creating a useful tool that will help you manage the growth of the company after funding.

Reasonable Assumptions

In your financial model, the assumptions used should have a reasonable basis, something that is relatively easy to justify for a company at your stage of development.  For example, if you are a start-up, it would be unwise to use conversion rates or success factors of well-established competitors.  Your numbers should be reasonably lower.  Though it does not always work, I try to use assumptions that investors will acknowledge are reasonable after a brief explanation.

When talking with investors, “reasonable” is not a specific number, but rather a demonstration of your perception of reality.  Are you a pessimist, an optimist, a pragmatist, or a starry eyed dreamer?  As you explain your assumptions, investors get a read on you personally, as well as on the business opportunity.  What will they see?   In my experience, entrepreneurs that are pessimists and dreamers don’t generally get funded, and optimists have limited success.  Most successful investors are pragmatists, and optimistic investors generally have limited success.

Management Team View

Does your management team believe that your projections are cast in stone, are lofty goals, or are performances to manage by?  Clearly the best answer is the last.  Is your management team expecting things to go awry as you start to implement your plan?  The odds are very high that this is what will happen.  A solid management team that is experienced in dealing with such challenges (making lemonade from lemons as it were) can use a good projection tool to manage by.  Assumptions may change.  Revenue streams may be significantly altered or fall by the wayside.  If your financial model enables you to enter actual data in the place of assumptions, you can see what the effect will be on the business, and make appropriate course corrections faster and with better visibility.

Summary

Perhaps you noticed a common theme in this brief discussion about financial projections.  The exercise shows investors how you approach complex challenges, and how you view a good financial model as a flexible navigational aid rather than a definitive road map.  I like to use the analogy of a commercial jet flying from Los Angeles to New York.  Before departure, the pilot files a specific flight path.  During the flight, weather conditions, winds, and other issues arise that cause the plane to deviate from the flight path more than 90% of the time.  However, a good pilot can still arrive at the destination specified on time.  This is similar to the mission of the management team.  The development and presentation of a good financial model helps quantify a business while demonstrating the perspective and capabilities of the management team – a key factor in most investment decisions.

How would you respond?

• Smart money, of course!
• Dumb money, that’s why I’m talking to you.
• Which kind can I get from you?

The question is ridiculous, yet the issue comes up a lot. Money is inanimate, and is neither smart nor dumb in and of itself. The way entrepreneurs or investors manage and invest money can be smart or dumb, and this gets more to the heart of the matter. But before delving into this issue and its implications for entrepreneurs, let’s take a quick look at some definitions.

The term “smart money” is often used to describe investment capital from sources that also provide valuable expertise and contacts that will enable businesses to become more successful. This sounds like a smart idea, and I believe the principle is a good one. But the term is also used in other less useful ways, and not always explicitly. For example, a venture capitalist or angel investor may deem their investment as smart money, and infer that others who invested in your business at an earlier stage on an informal basis provided dumb money.

There are many elitists in the capital markets. But ultimately this doesn’t matter, and I’ll tell you why. I’ll also tell you what’s far more important as an entrepreneur looking for capital.

First, many of the “smartest” financial people in the world helped create the recent global economic meltdown. And even today, whenever they talk about the future, the only truth is “we don’t really know.”

Second, $18 billion (the same amount angel investors and venture capitalists each invested in 2009) was entrusted to Bernie Madoff by thousands of smart people.

Third, let’s compare the failure rates of companies that received angel investment, those that received venture capital, and the whole gamut of U.S. start-ups that survive at least 5 years. Perhaps surprisingly, the approximate failure rate in all cases is 50 percent!  While different studies report varying failure rates, these numbers reflect a reasonable average.

What does the data indicate about the value of so-called smart money?

Taken on the whole, it doesn’t seem to make much of a difference.

So what does matter for you, the entrepreneur?

YOU being smart.

Here are some tips to help guide you along.

• Bootstrap your company using appropriate capitalization solutions that don’t require you to go down the equity capital path.  Aside from banks, there are many other viable ways to grow a business by leveraging all available capitalization options.
• Smart entrepreneurs surround themselves with advisors, strategic partners, board members, employees, subcontractors, customers, vendors, etc. who bring expertise and contacts to the business. When you look at the big picture, you can get vastly more support from these resources than you are likely to get from your investors, though good participating investors can be very helpful members of your team.
• Investors who are also well-known and successful figures in your industry could be very helpful, if they take an active role in supporting you. There are many anecdotal tales of high profile experts that promised to help for a premium, but never did. Find out how active such investors will really be for you (check their references) before you take their money.
• Don’t take money from investors that are likely to become a problem for you later on. You can conduct due diligence on them by asking to talk to the owners of other companies they invested in.
• If investors are too “smart” you could end up in a dangerous situation where they can take over your business if you don’t meet certain performances on schedule. While this a a major concern for entrepreneurs, the reality is that it doesn’t happen very often. Most angel investors don’t want your business, don’t have time for it, and would rather support it with help from time to time rather than taking it over. Onerous terms and conditions proposed by an investor should flag you to perform due diligence on the investor, and talk to your trusted business advisors before committing to do a proposed deal. This is the path of the smart entrepreneur.
• Develop a strong financial model of your business built on leading indicators that will help you manage the business from the beginning of the marketing and sales cycle. Show it to experienced advisors you trust. Refine it until you completely believe in your ability to achieve these numbers. Don’t start trying to raise money until after this has been accomplished.
• Expect that you’ll have to do a major overhaul of your business model within a few years in order to ultimately succeed.
• Know that a smart entrepreneur can make just as much with so-called “smart money” as can be made with “dumb money.” So focus on being a smart entrepreneur. That’s something you have a lot more control of.
• Don’t be a smart aleck, that’s not the same thing as being smart. You’re unlikely to succeed with Tip #1 if you’re a jerk. I’d like to be able to say that jerks are also more likely to fail, but I haven’t seen any reliable numbers on that issue yet . . .

• They have a limited amount of time they can devote to looking at new opportunities because they are very busy people.
• They often receive dozens of funding requests per month.
• Every entrepreneur has a business plan and a private placement memorandum, but the format and quality of these documents vary wildly. There is little consistency, and as a result, it takes longer to find and digest the key information they are looking for.
• Investment decisions are rarely made without first developing a personal level of trust with an entrepreneur. When starting from scratch, this takes valuable time.
• Business valuations and deal terms offered by entrepreneurs are often based more on enthusiasm than reality.
• After investing all the time to sort through and finally find an attractive deal and develop a level of trust with the entrepreneur, it may take another 40 hours to conduct proper due diligence on a deal.
• Due diligence also costs money for background and credit checks, legal review and document preparation, and much more.
• After funding a deal, the statistics for success are not encouraging. 5 out of 10 businesses invested in will fail. 4 out of 10 are likely to survive but provide little return on investment. Only 1 deal in 10 is likely to be a home run. That home run has to make up for all the other losses incurred, and still provide a reasonable overall return.
• A down economy adds a whole new layer of risk, as successful exits through acquisition or public offering become fewer in number.

Even with all of these challenges, accredited investors still invest in deals. Smart entrepreneurs recognize that the key to capitalization success is making it easy for investors to address all these challenges.

I understand.  I’ve been there myself.  I’ve worked with many clients on a similar path, and have seen hundreds of business plans in much the same vein – one which ultimately yields little gold.  I’ve also worked with many companies in the process of “doing it right.” In other words, they approach the business and its capitalization on the basis of staged development.  These companies are born with a focus on economical proof of concept.  They learn to crawl through the early stages of customer acquisition, revenue generation, product or service improvement, and support infrastructure build out. Then they demonstrate their ability to walk by successfully scaling both revenue and production capacity.  Lastly, using their proven approach and infrastructure, they run hard to keep up with the demands of significant growth.  These businesses have a much higher probability of success, and represent greater financial returns for investors of all kinds.

Here are some statistics from U.S. Census data that reveal the near myth of the hundred million dollar startup, and some of its smaller kin.

• There are typically more than 500,000 new companies founded each year in the United States.
• Approximately 80,000 new companies founded each year project annual sales of $10 million or more within five years.
• The number of new companies founded each year that achieve $100 million or more in annual sales within six years is 175.
• The number of new companies founded each year that achieve $50 million or more in annual sales within six years is 474.
• The number of new companies founded each year that achieve $10 million or more in annual sales within six years is 3,608.
• The odds of starting a company that achieves $100 million or more within six years are 3.5 in 10,000.
• The odds of starting a company that achieves $50 million or more within six years are 9.5 in 10,000.
• The odds of starting a company that achieves $10 million or more within six years are 72 in 10,000.

These odds are not well known, though many investors suspect something like this to be the case. This is a major, justifiable reason why experienced investors are reluctant to believe massive projections from a startup company. If you want to learn more about reality versus myth in the arena of business capitalization, I recommend The Illusions of Entrepreneurship and Fools Gold? The Truth Behind Angel Investing in America, both by Scott A. Shane.

The truth is you don’t become a $10 million or a $50 million or a $100+ million company by getting fully funded in the startup phase.  Instead, you raise enough capital to support you from one development stage to the next, and earn your way up the revenue ladder.  This is reality. The exceptions to this rule are few in number.  As Mr. Spock of Star Trek would say, it is not logical to assume that your business is the exception.  Are you willing to gamble millions of dollars of your own money and several years of your life on these odds?  There is a better way, and that’s what we specialize in.

Here are some questions to help guide your thinking on the subject.

• What is the fastest and best way for me to capitalize my company in my current situation?
• Is there a phased capitalzation approach that would best meet my needs?
• How much is my company worth now?
• How much could my company be worth in a few years if it achieves its financial projections?
• What kind of deal should I offer that will be fair to me and attractive to investors?
• How much of the company should I expect to sell to investors for the money I need?
• What is the most ideal capitalization structure for my company so that it will be appealing to investors?
• Do my current financial projections help or hinder my ability to raise capital?
• Are the assumptions built into my financial projections reasonable, defensible, and properly described?
• Are there any red flags in my financial projections that need to be resolved?
• Will investors believe I am looking for the right amount of money?
• What are the weak points of my company, and how should I address them?
• Does my business plan address the right issues in the right ways to attract capital?
• What is the right amount of information to include in my business plan?
• What is the most effective way to use my business plan?
• What is the best way for me to find and approach potential investors?
• What is the most effective strategy for presenting my opportunity to potential investors?
• How should I respond to challenges and objections raised by potential investors?
• How can I motivate interested but uncommitted investors to put the first money into the business and thereby catalyze my whole capital raising process?