Category Archives: Venture Capital

Is Your Startup Positioned in The Funding Gap?

Nice post by Bill Payne called The Funding Gap on the Blog. Here’s the summary:

It is clear from this table that Friends and Family, Angel Investors and Venture Capitalists provide 95% of the capital for new ventures. Friends and Family typically invest a few thousand to perhaps $10,000, and only a small number of investors provide more than $50,000. Angel investments range from $100,000 to $1.5 million with a small fraction below and above this range, while venture capitalists fund rounds of investment from $4 million to $100 million with a few above and below this range. So, generally, these three major sources of capital are complementary, not competitive.

After examining the details, he draws the bar chart below, showing the funding gaps he identifies.

Clearly, there is a funding gap between $25,000 and $100,000, and another capital gap between $1.5 million and $4 million. This simply means that there are fewer investors who are willing to provide investments in these two capital gaps than for rounds of investment larger and smaller than these two ranges. To elaborate, seldom can entrepreneurs accumulate $50,000 from Friends and Family, while angels are infrequently willing to provide as little as $75,000 for new ventures. In the gap between $1.5 and $4 million, angels only occasionally fund rounds larger than $1.5 million, while VCs are hardly ever interested in investing less than $4 to $5 million in startup companies. In fact, we estimate that less than 200 investors in the US are routinely investing $2.5 to $3.5 million in entrepreneurial ventures.

bar chart

Interesting discussion. I think I see this in the real world. And what do you, the entrepreneur, do about it? Here’s what Bill says:

So, how should entrepreneurs use this information? Clearly, new companies need to design their achievement milestones with the capital food chain in mind. For example, entrepreneurs who anticipate needing $4 million to achieve positive cash flow need to carefully plan to hit important milestones with perhaps $1 million, and then plan to raise two additional rounds of $1.5 million to eventually achieve positive cash flow. What might these milestones be? Milestones are accomplishments that demonstrate the viability of the business; hence, they increase the valuation of the company. Depending on the company, important milestones may include being granted a patent, receiving a 510k FDA approval, completing a prototype, receiving positive customer feedback on a beta test, achieving first revenues, hitting the goal in annual revenues of $1 million, etc.

(image: from

You Can Take Your IRR and Shove It

In pitches and presentations everywhere, bright young entrepreneur tells cynical skeptical investors, usually with great pride and flourish, about their fabulous IRR for their great new startup. I get a gag reflex.

IRR stands for internal rate of return. You can check wikipedia or investopedia for what that’s supposed to mean and how it’s calculated. It’s supposed to compare cash spent on an investment, over several years, to cash that comes back, which spits out as a percentage. The higher the IRR, the better. They teach it in business schools. It’s kind of an MBA parlor game. It has some very limited usage in comparing past performance of investments, if you can hold all the definitions stable; think of it in a large company context, corporate investments, and corporate budgets.

IRR in a business pitch insults my intelligence. It depends on projected sales, costs, expenses, financing, investment, and some hypothetical valuation at some hypothetical time some years in the future. That, by definition, is a crock. Show me the projects, yes. Show me Sales, costs and expenses. Show me cash flow. Go ahead, guess at a future valuation, what the heck. I’ll look at how the assumptions come together and realism, or lack of it, on how the pieces mesh. But the IRR, which summarizing multiple layers of uncertainty as one single percentage number, is totally irrelevant at best, and downright annoying when entrepreneurs act like a projected IRR actually means anything.

And it gets worse, too: there’s the widespread misunderstanding that angel investors and venture capitalists have IRR targets. There’s the unspoken but felt thought: “jeez, what do these investors want? They turned down an IRR of 105%!” And you’ll see people, all over the web, asking what kind of yields they have to give to interest investors. What are the targets?

Talking of IRR if a projected shows me only that you’re too close to the academics. Investors will look at your plan, your team, your product/market fit, and your projections; and they’ll decide what they guess about your future. Stop sooner, before you get to IRR. Let it go.

Long-Term Successes Don’t Leave Out Investors

For an investor in a startup, return on investment is as simple as writing a check now and depositing some related money later.  And since startups are risky, you’d expect to hit big when you win because you’re so much more likely to lose. Does that make sense?

So when the angel investor writes a $50,000 check today to invest in a startup, getting $100,000 back out of it five years later is not bad – it’s slightly less than 14% per year return – but it’s not spectacularly good either.

After all, that same investor could buy a cool car or put a down payment on a vacation condo instead. Or she could just leave that money in a bank with decent interest and have $70,000 in five years without risking losing it all.

But here’s the counter-intuitive catch: What happens if the $50,000 creates a healthy and happy company that grows and becomes independent and never creates any liquidity for its investors? The founders don’t want to get bought, and the stock market doesn’t accept it for a public offering, so the early investors are stuck with a share in a long-term business. Growing businesses don’t generally produce dividends, so that $50,000 investment is stuck.

The return on investment of a $50,000 check that never produces a deposit is way less than zero. Getting $50,000 back would be a zero return. Getting nothing back is – well, let’s just say it’s bad. Real bad.

All of which I post here to explain this statement:

Investors are more interested in companies that will be bought. Not in long term companies.

That’s not exactly what I said last Thursday in my session for Dun and Bradstreet Credibility Corp; but it’s close enough.  If you’re curious you can click this Youtube link to go directly to seven minutes into the interview where I was was saying that.

Investors appreciate long-term success as much as anybody. But a long-term successful company finds a way to reward its early investors. Maybe that’s through subsequent rounds, a partial liquidity event, a buyout, or some other instrument. But you don’t leave investors stuck in your company with no way to exit.

When my business confronted a situation like that, we practiced then what I’m preaching now: we bought our investors back out of the company.

Mark Suster: Be a Line, Not a Dot

This morning I added Mark Suster’s Both Sides of the Table to my blogroll here because his post Invest in Lines, not Dots reminded me that I’ve been meaning to include his blog for a long time. His idea here is something everybody should understand.

His single line chart here,combined with his title, makes the point extremely well.  As a startup looking for investment, you need time to become a line. You start as a dot:

The first time I meet you, you are a single data point.  A dot.  I have no reference point from which to judge whether you were higher on the y-axis 3 months ago or lower.  Because I have no observation points from the past, I have no sense for where you will be in the future.  Thus, it is very hard to make a commitment to fund you.

So instead of that, Mark suggests, you need time to communicate progress:

For this reason I tell entrepreneurs the following: Meet your potential investors early.  Tell them you’re not raising money yet but that you will be in the next 6 months or so …  Hopefully by then you’ve made good progress.  You’ll be able to give them an update on key hires, pilot customers, key tech innovations – whatever.  Keep these interactions low-key and short.

Do you see the dots vs. lines concept in that? I think it’s one of those great concepts that seems obvious, but only after you’ve heard it. I also really like Mark’s emphasis on entrepreneurs and investment as a long-term relationship. Here’s his conclusion for entrepreneurs:

you might be pumped up with that super quick round done at a high price.  But just remember that raising money is a bit like Ireland in the 90′s – no divorces allowed.  I know VCs and sophisticated angels can be difficult, slow and price sensitive, but I also know that in tough times unsophisticated investors can be a right pain in the arse.  For some companies – they become deal breakers on further funding rounds.  By definition if somebody is investing in you as a dot (limited thought, limited due diligence, maximum price) they are a dot to you, too.  You can’t really know them in 2 minutes yet you’re letting them own part of your business.

That’s an excellent post. Go read the original. He has several additional line charts, and great advice.

How Much Money Do I Need for My Startup?

It’s an obvious question. And if you’re looking for startup investors you’d better be able to answer it well, and quickly too. No wandering eyes. No doubt. If you’re doing a pitch, have a slide for it. And be specific.

I liked this from Ben Yoskovitz’s Instigator Blog on Use of Funds:

most descriptions of “use of funds” are incredibly generic and standard, typically involving the following: hire key personnel, product development, sales & marketing. Hhhm…the phrase, “No shit Sherlock…” comes to mind.

And on the other hand, there’s this about that, from Perfecting Your Pitch, by Guy Kawasaki’s Ventures:

It should be clear from your financials what your capital requirements will be. On this slide you should outline how you plan to take in funding—how big each round will be, and the timing of each—and map the funding against your key near-term and medium-term milestones. You should also include your key achievements to date. These milestones should tie to the key metrics in your financial projections, and they should provide a clear, crisp picture of your product introduction and market expansion roadmap. In essence, this is your operating plan for the funds you are raising. Do not spend time presenting a “use of funds” table. Investors want to see measures of accomplishment, not measures of activity.

So go figure. There are two opposite points of view from two good sources.

I’m amazed, meanwhile, how often I see people pitch startups to investors without having a good answer to that question. I expect an instant answer, without hesitation, and if it’s a slide deck there should be a slide.

And that doesn’t mean that anybody necessarily believes what you say. It’s all educated guessing. But details add credibility. And if you can’t answer that question, what do you think your audience is thinking?

There is a standard way to calculate starting costs.

  1. Make a list of the stuff you need to purchase before you start. Include expenses like early salaries, cleaning up the location, developing the website, packaging if relevant, prototypes … it’s a collection of educated guesses, of course. It’s just guessing, but how can you not do it?
  2. Do your projected first year cash flow. Estimate sales, costs, expenses, and payment lags from business customers, your own lags paying your vendors, plus what you need in inventory. If this isn’t a cash deficit, recalculate. In real startups it almost always is.
  3. Add those startup costs with the deficit spending, and that’s what you need from investors.
  4. Reality check: if that calculated amount is way too much, investors will laugh at you, go back and change your plan. Spend less. Look for the startup sweet spot.
  5. Double reality check: if you can spend less, maybe you can do it without investors. There are other ways to get money. But even in that case, don’t you want to have a good idea of what it takes?
  6. Triple reality check: if you’ve got a high-end high-tech startup, looking for serious angel or VC investors, give them a break and show spending the money on things that make for growth, excitement, virality, sizzle. If you don’t know what that is, rethink your plan.

(Image: mgkaya/

Angels vs. VCs on Business Pitches

Over the weekend I caught Business Insider’s Five VCs Explain What They REALLY Think About Your Pitches. It’s a great post, gathering points together from discussions with several high-end VCs. If you’re looking at venture capital, read it. Business Insider

Part of what they said reminded me that angel investors and VCs have a lot in common. For example, these important points:

  • Keep it short.
  • Avoid buzzwords.
  • Answer questions quickly without getting defensive.
  • Be a good storyteller.
  • Know the people you’re pitching.
  • Don’t forget the financial info.

I’m pretty sure all of the 30+ investors in my local angel investor group would agree with every one of those. I particularly like the three about answering questions, telling stories, and not to forget the financial info. Those three are critical.

Some of the other points, however, remind me of the differences between VCs and angels. For example, the VCs say introductions matter:

The person introducing the entrepreneur is a big deal — if [the VC quoted] doesn’t trust the referral, he won’t even take the meeting.

Our group, in contrast to this, looks into every submission we get. Introductions aren’t required. Some of them don’t get past a quick read of the executive summary, but I think most angel groups are similar. We’re going to read the executive summaries, at the very least. And we invite submissions. Every plan submitted before March 31 is considered for our May investment. Some are not considered very long — like less than five minutes — but still. Introductions don’t matter. The plan does.

Two other points probably depend on the group, the particular angel investor, and the moment. The VCs said:

  • Think big or don’t bother.
  • Forget saving the world.

I don’t think those points are as true for angels as for VCs.VCs are investing other people’s money, mostly institutional money, and they’re paid to do that well. Professionally. Angels, on the other hand, are investing their own money. Maybe that makes a difference. It does to me. Angels invest smaller amounts, generally, and at an earlier stage, generally. Maybe that’s why sometimes we’ll consider a not-so-big deal, and sometimes saving the world, or not, makes a favorable difference.

That’s my opinion, anyway.

True Story: Why We Bought Out Our VC Investors

It started in 1999. We had already grown Palo Alto Software from zero to more than $5 million in annual sales in five years, without investment. But valuations had gone crazy, and our site was already getting millions of visits every month. So we decided to look for venture capital to grow the company and sell it.

The boom seemed temporary, and we decided to take advantage before it waned. We had a sense of a very large open window that was going to close.

But we were too late. We signed a deal early in 2000, just a few weeks before the dot-com bubble burst. Very quickly we saw our web properties, which had been worth tens of millions of dollars, settle into more realistic valuations. And more realistic wasn’t interesting to us. We didn’t want to sell the company for what it was worth in 2001, based on sales multiples. We had wanted to sell it in 1999, when valuations were based on website traffic.

Which left us and our investors with incompatible goals. They wanted to flip the company, while we wanted to build it, grow it, and keep it.

We liked our investors. They believed in us, wanted the same thing we did, and offered useful suggestions. They were smart, honest, and respectful. But we ended up with minority owners who wanted only to sell the company, and we no longer wanted to. So we negotiated a deal, and bought their share back from them. That was in 2002.

The buy-back deal wasn’t easy because we’d spent the money to grow and didn’t keep it liquid. But we didn’t want minority investors to be trapped in our company with no hope of a near-term liquidity event.

It all worked out. We still see them on occasion, and they are still friends. But it is one good example of a case in which you don’t want incompatible goals in the ownership of your company.

Are You Planning to Sell Boxes or Hours?

All of these are just “in general” points. There will always be exceptions. But still, it’s good to understand the huge difference between service businesses and product business. Selling hours has advantages, but selling boxes does too. And there are huge differences, things I think you need to understand.

My wife and I spent several years working on converting our business planning business to “sell boxes, not hours.” It took a long time, but eventually that worked. But we started with a service business, and it was only after several years of that business that we started to convert it to products. Here are some of the standard tradeoffs.

  1. Service businesses take less capital to start. Particularly professional service businesses, like consulting, graphic design, landscaping, bookkeeping … you don’t have to buy products to sell, or materials to build products. You need credentials, yes, and a computer, and in most cases a website. But you’re not worried about design, prototypes, packaging, inventory, channels of distribution, and all that.
  2. Service businesses are harder to grow. With a product business you sell more and you make more money. Succeed with online marketing, open up a new channel, and you can build more of those things. Product businesses usually – obviously not if a lot of hand labor is involved – scale up. On a classic service business, though, to double sales you have to double your payroll. That’s what investors call a “body shop.” Classic service businesses can be great businesses for the owners and workers, but they’re rarely good investment opportunities for outside investors.
  3. Investors like Product businesses. I’ve been spending a lot of time lately looking at pitches for our angel investment group, and evaluating businesses for some major business plan competitions. Investors like product businesses because you can lever up, and scale. And you can sell a product business – the whole business – to somebody else. And you can make sales while you sleep. And of course, to make this perfectly clear …
  4. Investors don’t like service businesses. It’s the body shop problem. The assets walk out of the door every night. The assumption is that they don’t scale. Sure, there are exceptions.
  5. Web service businesses act like product businesses, without the inventory drag on cash, or the problems of physical distribution. A web service can scale up, if it’s designed correctly, and go from 100 to 1,000 to 10,000 without needing a lot of hand labor or human intervention.

So what? I think it’s good to know. Service businesses start up all the time with only a few thousand dollars of initial investment. All you need is that first good client, and off you go. There is less risk. It’s easier to get from nowhere to covering costs.

But if you want to go big-time, or if you want to build a business you can sell, build products or web-based services.  Sell boxes, not hours (or a web app).

(Image: Quang Ho/Shutterstock)

Not the Customer’s Job to Know What They Want

There was a nice short video on TechCrunch the other day, quoting Mark Zuckerberg, John Doerr, and two other industry leaders on how much the iPad has changed “everything.” I picked it up because of what John Doerr says near the end.

The video snippet I’ve embedded here skips directly to my favorite part, at 2:45, very near the end, as John Doerr talks about Steve Jobs saying what market research has done for the iPad. Jobs says:

It’s not the consumers’ job to figure out what they want.

I like that. As we turn increasingly to polling and research for answers, the problem is that people don’t often say what they really think, and quite often don’t even know what they really want. One kind of leadership, to me, is leading people instead of asking people. You take a guess. When you guess right, you win big. Guess wrong, you lose.  Is it possible that this is also called entrepreneurship? What do you think?

Why Market Numbers Are Like Patents: Good, But Not To Be Believed

I was enjoying Chris Dixon’s Size markets using narratives, not numbers when I realized his point is a lot like a point I like to make about patents:

good to have, but not to believe in

On sizing new markets, with startups looking for investors, Chris says:

The only way to understand and predict large new markets is through narratives. Some popular current narratives include: people are spending more and more time online and somehow brand advertisers will find a way to effectively influence them; social link sharing is becoming an increasingly significant source of website traffic and somehow will be monetized; mobile devices are becoming powerful enough to replace laptops for most tasks and will unleash a flood of new applications and business models.

That makes good sense to me. He adds:

For early-stage companies, you should never rely on quantitative analysis to estimate market size. Venture-style startups are bets on broad, secular trends. Good VCs understand this. Bad VCs don’t.

I’m with Chris on this (although I like to call them stories, instead of narratives; just a matter of style). Markets are future developments that haven’t happened yet, and stories picture the developments better than data.

But even as I write that I realize that as a frequent reader of business plans, for judging and investment purpose, I also like the numbers. I want to see how many buyers now, or how many people who meet those criteria, how much money now, a certain amount of numbers to give me a sense of size.

Which takes me back to the patents reference: I realize the best is having them but not believing them. I want entrepreneurs to realize their numbers are more background than data. Show me what it could be, but don’t think it proves anything. And with patents, well, here’s what I wrote about that last March, in  10 requests from your business plan reader:

Show me your patents if you have them but if you do, show me something about how defensible they are (if at all) and make sure your projections include legal expenses to defend them.

Does that make sense? Is there a parallel there? Both are good to have, but not to believe in? I wonder how much of business planning, entrepreneurship, and startups fit into that same basic category.

(image: Sergej Khakimullin/Shutterstock)