The Confused VC Rule part II

In a previous post I walked through a bunch of generic questions VC’s ask that can alert the entrepreneur that the VC has no idea what you are talking about. Here’s a hilarious video that illustrates the point even further —

http://techcrunch.com/2010/10/05/stupid-questions-vcs-ask/

The Rule of 2

–> Take a startup’s business projections and multiply by 2, multiply by 2, and divide by 2. Successful businesses often require 2x projected capital needs, take 2x as long to reach the investment goal, and attain 1/2x of projected revenue.

This is my back of the envelope calculation whenever considering an investment in a startup. Let’s look at Company X:

COMPANY X

• Funding Request = $1,000,000
• Goal = Cash flow neutral in 18 months
• Annual Revenue 3 Years from Today = $16,000,000

Here’s what I do:

Apply the Rule of 2

• Money Company X will actually need = $2,000,000
• Goal = Cash flow neutral in 3 years
• Annual Revenue 3 Years from Today = $8,000,000

Keep in mind that this is often the result of a successful business and not every business. Successful means you are some small % of the 1% of business ideas that get to a point where there is a paying customer and real revenue. This is obviously not an exact science. The Rule of 2 is a good starting point, a good sketch. Given the Rule of 2, does the business still get to a point where a venture capital investment return is realistic?

Death by PowerPoint Rule

–> Refrain from sending PowerPoint presentations that have more slides than the number of minutes you have been given to present your business.

You may laugh, but this happens a lot. We typically give entrepreneurs 30 minutes on a 1st call to discuss the business and demo the product. This leaves plenty of time to ask a bunch of initial questions. Before the call we have received slides decks with 50+ slides that the entrepreneur suggests we “discuss in depth” during the call… oh boy

I recently realized that younger entrepreneurs that have been coached through leading business incubators like AlphaLab or TechStars get this right every time. Through these programs, entrepreneurs are trained to present their business in a concise, time efficient manner. These entrepreneurs continue to use this format when approaching angels and VC. A practiced and tight business pitch will go a long way towards getting a 2nd meeting and, more importantly, getting funded.

There are tons of “rules” out there regarding PowerPoint but most rules focus on overall, message headings, font size, etc. We all love to hate PowerPoint, but it is here to stay….this doesn’t mean that we have to overuse it!

The Zugzwang Rule

–> Most startups fail. Before failure, the company is often in zugzwang. Unlike in the game of chess, entrepreneurs can choose to “not move” and return the remaining portion of the investment to investors.

First of all, what is “zugzwang”? It is a German word for “compulsion to move” and is most often used in reference to chess. A chess player whose turn it is to move has no move that does not worsen his position is said to be in zugzwang. Every move will make his position in the game worse, and he would be better off if he could pass and not move.

The concept is best described through an illustration. In the picture below, Black is in zugzwang because he would rather not move. Unfortunately, it is his turn so he must make a move. A king move (currently on f4) would lose the knight (currently on g5) while a knight move would allow the white pawn to advance.

In this game, the black knight moved to f3, white moved to h6, black knight went back to g5, and the white king followed with a move to g6. Black is again in zugzwang. The Fischer game ended shortly because the pawn would eventually slip through and “promote” (become a queen).

I’m not a chess fan, but I love the concept of zugzwang and recently discovered the term in a Marketing class at Tepper School of Business. I instantly began to think how this concept relates to venture funded startups. I have seen this play out a few times but will illustrate with a fictional example.

_______________________

Cougar Enterprises successfully raises $1m from a prominent VC. Cougar is a dating website that aims to connect women in their 40’s to men in their 20’s. After 6 months in the market, Cougar fails to catch on in the marketplace. They have only 500 registered users and website metrics are worsening. A new competitor has emerged, Puma Enterprises, which is the same idea and has significant early traction (1 million users and exponential growth). Puma just raised $30M in financing and no one (including current investors) is interested in an investment in Cougar. Cougar has $500k left in the bank and is in zugzwang.

_______________________

Here’s are Cougar’s choices:

1. Stay in business, make your next move, waste a bunch of time, eventually you will fail and kill a relationship with an investor as they will make a $0 return
2. Realize you are in zugzwang, return the $500k to investors and start over with a new idea. A smart investor will respect this decision and may even be willing to work with this entrepreneur on his next venture

I have heard of  a few examples where entrepreneurs go with choice 1. This is VERY RARE. Startups will often take the business down to its last penny or enter “hibernation” before calling it quits. Investors typically have no legal right to recall a venture investment, so admitting zugzwang is up to the entrepreneur. Sometimes the best move is no move – return the money to investors and move on to your next venture.

Side note —> This can be a very contentious issue with investors and entrepreneurs so would love to get your thoughts/feedback.

The High Tide Rule

–> A rising tide raises all boats

A crucial element for venture capitalists in evaluating a potential investment opportunity involves determining total addressable market and the compound annual growth rate for the company in consideration.

In this analogy the tide = the market or growth and the boats = all the companies in the given market. Most investors have market size constraints (the business must address a market size of $xxx before considering an investment). But even more important, if the market (tide) is increasing at a rapid rate, all the boats (you and your competitors) benefit. Investors like big, growing markets.

There are many great ideas that go after smaller markets, and I’m not saying these are bad businesses. If you are looking for VC funding, however, make sure the market you are targeting is big and rising.

The Dangling Carrot Rule

–> Refrain from sending introductory e-mails to investors that reveal little or nothing about your business…with the hope that the investor will reply with a “can you send some company info?”.

Our VC firm receives dozens of cold business plans a month. “Cold” means we have no prior connection to the entrepreneur and have no prior knowledge of the business. These types of opportunities tend to be of lesser quality, but we approach them all with an open mind.

Implement the dangling carrot if you want to lessen your chances of getting funded.

Dear Investor,

I have spent 3 years and $1M developing this breakthrough technology!!! The market for this product is HUGE, and I am looking for capital to expand my sales and technology team. Would you be interested in funding my company? I look forward to hearing back. My business plan is available upon request.

Regards,

______

Most VCs claim that you must network your way into a VC firm – in other words, find someone who can personally introduce you to a Partner in an investment firm. I find this to be extremely arrogant and do not adhere to this rule. BUT, when approaching a VC in a “cold” manner, be sure you do your homework on the firm, prepare a nice email with a succinct description of your business, and refrain from using the dangling carrot.

The 1st Dollar Rule

–> Most successful early stage businesses have an anchor paying customer and have built a trust relationship with this customer. Getting to a trust relationship with an initial sponsor is key.

Ever been to a restaurant, dry cleaner, etc. and seen a plaque with a $1 bill inside signifying the 1st dollar of revenue that the business received? At first glance this can seem rather ridiculous, but just think how much work went into earning this first dollar.

It would be interesting to chart out the evolution of a business idea and what percentage of ideas transform into a business plan, the % of business plans that result a built product, and what % of these products get to a point where a customer is willing to pay for the product.

I bet it would look something like this.

Most ideas are forgotten or fail before any sort of business plan is developed – this is obvious. The less obvious point here is that many businesses build products and fail before they achieve $1 in revenue. They often give the product away for free with the hope that these free users evolve into paid users. I am not saying that this “free for now” strategy is always wrong, but the key point here is that most successful businesses have developed a key relationship with a customer that is willing to pay for the product.

This customer helps the startup in many ways. Since what the customer needs is not usually what the entrepreneur thinks the customer needs, this initial sponsor can help develop the key value drivers that future customers will desire. This sponsor can evangelize the business to other potential customers in the industry, help with reference calls for prospective customers, and provide real revenue to the business. A business with some revenue traction also looks much more credible to an investor and will often result in a premium valuation relative to a pre-revenue company.

The General Hosptial Rule

I will try to reserve Fridays for lighter venture rules, and I hope they are somewhat comical. Keep in mind, all of these “rules” come from real interactions. I have to credit my colleague Alan Veeck @aveeck for this one.

–> If, in your first phone interaction with an entrepreneur, you hear loud daytime drama TV shows in the background, and the entrepreneur crunchily eating chips in your ear, the chances for successful investment are low.

In addition, I’m told this entrepreneur was not eating your everyday light crunching potato chip, this was of the twice baked,  kettle cooked, extra crunch variety.

The obvious rule here is refrain from eating and cancel all background noise when talking to an investor. The implicit rule here is to pick a quiet location for important investor calls. I have noticed that investment calls when entrepreneurs are “on the road” – calling from an airport, hotel lobby, car, etc. are typically less productive interactions. Schedule important calls during times when you know that you will be in a quiet, private, comfortable location.

The Confused VC Rule

–> The harder a business is to understand, the lower its ultimate valuation will be.

Does an investor fully comprehend your business after reading a brief summary or after a brief conversation or is the idea mired behind technology jargon and acronyms? Is this business and value proposition easy enough for a 9^th grader to understand?

Hi Mr. VC, nice to meet you. Here’s how our technology works:

Here’s the truth: whenever you (the entrepreneur) talk about your business to a VC, the VC will always act as if he understands the business….we are very good at this. There are a bunch of canned questions that investors ask an entrepreneur to make it seem as if he fully understands the concept. Some of the more popular questions:

“How do you make money / What’s your revenue model?”

“Is the technology protected?”

“How many employees do you have?”

“How much money have you raised to date?”

“How much money are you looking to raise?”

If any of these are a lead-off question from a potential investor, more often than not he/she is having difficulty understanding the business. If you say enough to spark some initial interest there will be plenty of time downstream to dig into the details of the technology. Work hard on developing a verbal snapshot of the business that is concise, compelling, and super-simple because a confused VC = not your VC.

The Valuation Rule – Not Your Typical MBA Approach

–> Early on, a company valuation is a function of excitement and hope. Later on, a company valuation is a function of execution and performance

At Meakem Becker Venture Capital we invest mainly in early stage businesses. Early stage for our Firm = a team that is working full-time on the business, has built an impressive early version of the product, and has some early customer (revenue) traction. I am often asked how we value these early stage businesses since we have no historical revenue to make future assumptions, and projected revenue is, more often than not, nothing more than a cool spreadsheet filled with wild predictions.

People with heavy finance or business school backgrounds seem to be the most perplexed by the “excitement and hope” answer since these folks have been trained to value a business through strict quantitative methods (discounting cash flows to determine if the given project is a positive net present value project, etc.). Early stage venture investing is unique. While early stage VCs may do some financial modeling to determine the valuation of a pure early stage startup, a large part of the decision is based on the excitement surrounding the product, the founders, the market and the hope that the business will deliver.

After making an investment, we often work with our companies to develop a set of milestones. The valuation of a company in a future financing round depends largely on the execution and performance of these milestones which will vary depending on the industry. Execution and performance largely revolves around revenue targets, but other performance metrics are often equally as important (e.g. # of new customers, # of users, website growth, etc, etc).

After taking an investment from an excited and hopeful investor, be prepared to be given a set of company milestones…..be laser focused on achieving these milestones.