It was a warm late-spring day in 1999. I sat in my office with a venture capitalist, my lawyer, and my son. The sun beamed in the patio outside my office. We talked about Palo Alto Software and its web subsidiary bplans.com. At one point the VC said:
You wouldn’t be an attractive investment for VCs. You’re too profitable.
I chuckled. I thought it was a joke. We’d grown sales in four years from less than $1 million to more than $5 million annual sales. We had to be profitable because we had no outside money.
That’s no joke. It’s like the Oklahoma gold rush, a land grab, and the assumption is that if you’re profitable, you’ve stopped too soon. You should be spending more to build traffic.
(Note: this is the third of a 10-part series listing my revised top 10 business planning mistakes. The list goes from 10, the least important, to 1, the most important.)
It’s just too damn bad that so many entrepreneurs assume to start a business you do a plan, get financed, and then you start. As if the goal of the plan is getting financed; and as if the getting financed is the win, regardless of financed how and by whom and on what terms.
And that’s a big mistake. You should choose investors as carefully as you choose a spouse.
Contrary to the myth, winning the investment isn’t always a win. Getting investment from the wrong people isn’t a win. It’s a recipe for disaster. Marrying your company with incompatible investors can turn a dream into a nightmare. And yet so often when you talk to entrepreneurs they seem to think that just getting that investment is the same as winning the race. Find somebody to say yes and you’ve succeeded.
Not all good businesses make good investments for outsiders. Investors need exits in 3-5 years, while lots of good businesses aim for forever, not just 3-5 years. And entrepreneurs often want independence, while investors usually feel like bosses. They are owners. Some of the best businesses are bootstrapped, meaning they don’t get outside investment. They use their own funds, or early sales, and they grow more slowly but without requiring other people’s money. And some successful businesses are financed by loans, which increases the risk, but doesn’t dilute ownership.
I say let the nature of the business, and the goals of the entrepreneur, determine the financial strategy regarding investment. Some businesses simply can’t sprout without healthy amounts of outside investment. Others have no good reason to even think of investment. And most are in between, with investment a matter of what the owners ultimately want. And there is what I’ve called the Startup Sweet Spot, the natural right level of financing for the startup, based on what it actually needs to develop right, which may or may not require outside funding. As in the diagram here to the right, the plan estimates the ideal startup costs level, and if funding for that isn’t available, then you revise the plan.
The correct goal of the planning process is to help the entrepreneurs determine what their startup really requires, and to help them look at options for growth, so that they can decide whether or not they even have something that will interest investors. And, if they do, then also of course whether or not they want investment. Then, if the entrepreneurs decide they want or need investors, then the planning helps communicate the business to the investors, and that becomes a starting point to deciding whether or not the founders and the investors are compatible.
Jeffrey Moskovitz added an important comment to my big mistake post from last week:
I read an blog yesterday, written by someone I respect, who asserted that investors know and even EXPECT that projected sales and profits will be overstated. Aware of this expectation, the entrepreneur plays the game by inflating the numbers, fully aware that the investors will give the numbers a “haircut,” and everyone will be happy.
Jeffrey didn’t think so and I agree with Jeffrey. Emphatically agree. The idea that everybody winks at inflated numbers is a really bad idea.
My view on this hasn’t changed at all, even as years passed and I moved from entrepreneur seeking investment to angel investor reviewing business plans as part of an angel group. Here’s the way the process works, step by step:
1. Is the sales forecast believable?
Sales forecast credibility is a matter of several factors: understanding the market, size and structure of the market, selling process, channels, decision making, and so on. Granularity is really important, like the details of distribution, margins, buying points, actual names of potential buyers. Real sales already made, letters and testimonials from customers or distributors, are also important. Real Web forecasts, page views, conversion rates, and so on, are important.
If the sales forecast isn’t credible, then investors lose interest in the rest of the numbers in the plan. An unbelievable forecast voids profitability, cash flow, and supposed future valuation and investor return. The process stops.
It is true that a dumb forecast doesn’t necessarily kill potential investment. If there’s good product-market fit, scalability, defensibility, growth potential, management team, and so forth, then bad numbers are forgivable. But a bad forecast is a huge negative.
2. If so, then is profitability believable?
One of the most common errors in business plans, almost pervasive, is unbelievable profitability. As soon as projected profits go over industry averages, I disbelieve the rest of the numbers. In some rare cases (one that I posted about here Monday) entrepreneurs have real justification of those high numbers. But those are uncommon. Most of the time, it means the entrepreneurs don’t understand the business. They’ve underestimated expenses.
Even without researching the specific industry, no industry averages profits much higher than 10%. Most are closer to 5%.
If profitability isn’t believable, then I stop reading the numbers. I have no interest in cash flow or future valuation if profitability is off.
3. If so, then is cash flow believable?
Only if both sales and expenses are believable, do I look at cash flow. Does the cash flow plan recognize the impact of industry and accounts receivable? Does it show the need for investment?
And from there, to be honest, I’m back looking at larger factors, like product-market fit, management, defensibility, and scalability. I still don’t put much stock in what the business plan says the investors will get as return on investment. ROI and IRR projected out five years is an academic exercise, not a real decision factor.
Question: I’m in the process of writing an Internet startup business plan to present to prospective investors. The site isn’t live so I don’t even have a basis for speculation with respect to the financials. I would essentially be pulling numbers out of the air. Being that the Internet business as it pertains to advertising revenues is so mercurial, is it feasible to present the plan without having the financials included? If not, how can I make more realistic financial assumptions?
My answer: No, you won’t get anywhere presenting a business plan to investors without financials. I’m glad you asked me instead of just moving ahead with that idea.
Every new business, including a website business, has to be able to present a reasonable forecast if it’s going to hope to get an approval from outside investors. And it can never be “pulling numbers out of the air.” The assumption is that before you start a new business you have some idea how it’s going to work, based on some experience. If you have no idea, no investor wants to even share the same elevator with you.
In this case, the website business, you need somebody on your team who can project website traffic and sales based on real experience with search terms, search engine optimization, Google ad words and its competitors, conversion rates, and so on. Your traffic doesn’t get pulled out of the air, it’s a function of what you plan to do and what you plan to spend. Know your key search words and the traffic those words and phrases get for others, right now. Know reasonable conversion rates. Make estimates based on real assumptions about real variables.
This seems so strange to me. My business plan marathon has turned up several plans calling for way more money than the plan itself says it needs. How can that happen?
For example, a plan calls for $3 million investment for 2010 and its projected cash balance at the end of 2010, and again at the end of 2011, never goes below $2.5 million.
Why would investors ever say yes to that? They’re being asked to take money from their bank account and put it into some startup entrepreneur’s bank account instead; and there it sits. Unused.
That’s just strange. Sure there’s uncertainty, but don’t tell investors you want their money in your bank account. Do a “use of funds” table if you have to, and lay out where the money is going.
And if it’s in the cash balance at the end of the year, then you didn’t need it. Revise your plan. Sure, a reasonable cushion is fine, but I’ve seen a bunch of them this year, asking for money that ends up all, or mostly, in the end of year cash balance. That doesn’t work.
There’s supposed to be a match: the investment is as close as possible to what the company needs to grow on. The money is your best guess on what you need to spend to launch the company. It doesn’t sit in the bank.
If your business plan cash flow has disproportionate ending cash balances, then the fix is obvious. You should be asking for less money from investors. You’ll suffer less dilution.
Yes, I know, there are people out there advising entrepreneurs to seek more money than they think they need. That’s not horrible advice, if you have the kind of startup that can pull those amounts in. But hey, please, don’t insult your readers’ intelligence: show the money being spent on growth. Don’t show it in your projected cash balance.
True story: at one of the business plan contests I’ve judged (and I won’t say here which, or when) one of the contestants was challenged by one of the judges:
“But why do you need $600,000,” he asked? “Your plan doesn’t support that.”
“Oh, I know that,” the entrepreneur answered, “that’s peace of mind money. I need a cushion in case things go wrong, so I can sleep at night.”
The room went silent. After a pause, one of the other judges said the obvious:
“So you’re asking us to write you a check from our money so you can put it in the bank as your money?”
When two clear big winners in the high-end startup world disagree on something as basic as lean vs. fat startups, I’m fascinated. First, because both of them have a lot to say to the rest of us. Second, because it illustrates, once again, how much of startups and entrepreneurship defies rules of thumb and generalizations.
In The Case for the Fat Startup, Ben Horowitz tells how he burned hundreds of millions of investor dollars while building up Loudcloud/Opsware for a stunning $1.6 billion exit in 2007 when it was acquired by Hewlett-Packard. Clearly, this was a huge win. It’s a hall of fame story. And he makes raising a ton a money one of the keys to success (I’m quoting):
As you listen to the virtues of the lean start-up–lightweight sales, light engineering, and so on–keep the following in mind:
If you are a high-tech start-up, your value is in your intellectual property. Don’t stare at your spreadsheets so long that you get confused about that.
You cannot save your way to winning the market.
The best companies can raise money even in this market. If you are one of those, you should consider raising enough to wipe out your competition.
Thin is in, but sometimes you gotta eat.
Fred Wilson, founder of Union Ventures, a big winner as professional investor, and an eloquent blogger, answered that post with Being Fat is Not Healthy. He says:
The very best investments that I have been involved in established product market fit before raising a lot of money. That’s how Geocities did it. That’s how Twitter did it. That’s how Zynga did it. That’s how every single one of my top twenty web investments in my career did it.
I have to admit, I like the lean option better, but then most of the companies I’ve built or helped to build were bootstrapped. And times have changed, too, so what Horowitz is calling “fat” isn’t really an option very often. But the dialog doesn’t stop there. Horowitz came back and responded with The Revenge of the Fat Guy. He makes two points back:
Product market fit isn’t a one-time, discrete point in time that announces itself with trumpet fanfares.
My experiences [with Loudcloud/Opsware] are highly relevant to other entrepreneurs. In fact, they are more relevant than Fred’s pattern matching.
Ouch? Pattern matching? Really. Read the Fred Wilson post, see if that’s fair. Also ask yourself whether he’s really guilty of underestimating the time it takes to get the product-market fit. I can’t resist adding this quote from the Fred Wilson post favoring lean. It rings true to me:
In short, since I started investing in the web in ’93/’94, I have invested in about 100 software-based web companies. And the success rate of fat companies versus lean companies is stark. I have never, not once, been successful with an investment in a company that raised a boatload of money before it found traction and product market fit with its primary product.
The rest of us, meanwhile? I think we have to admit, the debate is pretty much moot for the rest of us. There might be a few dozen people around who can still raise hundreds of millions of dollars based mainly on their name and track records. Ben Horowitz and his partner Marc Andreessen are two of them. But I’m not; and, no offense, but the odds are you aren’t either.
I hate it when people push issues way too far, diluting their points by overextending them. Stretch your generalization net too far and you catch a lot of innocent fish along with the sharks. Do that and you kill your own argument.
For a great example of that, Jason Calacanis’ rant against startups having to pay to pitch investors. You can click here to read it. He’s very angry at businesses charging startups fees of thousand of dollars to pitch investor groups. I agree with him. I also dislike most (but not all) of the mostly-web-based listing services that charge startups hundreds of dollars to list themselves somewhere were investors will see them.
By the way, for a rant-free and more balanced discussion of the same problem, click here for Lora Kolodny’s summary on NYTimes. com.
But my beef with Jason’s rant is his total lack of distinction between thousands of dollars as a pay-to-pitch fee, charged by for-profit middle-men companies, and the normal fees of tens or hundreds of dollars charged by angel investment groups as part of the pitching process. That’s like apples and oranges. And the oranges are getting smeared with the bad apples.
I read, cringing, as Jason and his followers (in the comments) seethe with anger at entrepreneurs being forced to pay anything, in any context, to present to investors. And that’s way off base. You simply can’t lump these pitch predators and their big fees with the hundreds of angel investment groups and community organizations that charge tens or hundreds of dollars to cover real costs. He’s got so much sound and fury, without making some important distinctions. It’s scary.
Let’s take a real-world case, one that I know well. I’m a proud member of a local angel investor group that charges the startups who enter our annual business plan competition $199. We’re not exploiting anybody. Not one of us ever sees a dime of the entry money. It goes to support the costs of the event, including the location, coffee and such, collateral. It’s controlled entirely by the organization itself, a collection of non-profit civic groups trying to contribute to small business development in our local area. Where’s the harm in that?
While a few of Jason’s commenters hint at this kind of distinction, the general feel is about as friendly as an angry mob with torches and pitchforks.
So there’s the problem. Generalize that pay-to-pitch is exploiting startups, and you make the world harder for well-meaning groups of investors that are giving startups a pretty good deal. So why not make the distinction, apply some gray tones instead of all black and white, and make a better point? Oh dear, all those nerdy pointy-headed distinctions are so undramatic.
Just to make sure, I asked a local entrepreneur, Nathan Lillegard, president of Floragenex, who describes himself as “as someone who has paid way too many fees to talk to people about my company.” He said:
“A truly dedicated entrepreneur finds just as much value in the experience of pitching as in the investment payoff. If an event, like the WAC can help startups improve their pitch, enhance their skills, and make at least one useful connection, then it’s worth a small fee to participate. If, on the other hand, all that the entrepreneur gets is a quiet crowd and no feedback nor chance to network, then I wouldn’t pay $1 for the privilege of talking to a room full of people with money. Caveat Emptor! It’s up to the entrepreneur to know that there is a cost to raising money and these types of events can be a very efficient way to meet lots of potential investors, just one of which can change their world as they know it.”
And if you’re a startup anywhere in Oregon, especially in the southern Willamette Valley, and you have an interesting business with a good chance to grow, and a real exit strategy, then pay no attention to that angry man behind the curtain, and please apply to pitch to the Willamette Angel Conference. And yes, it will cost you $199.
Every startup has its own natural level of startup costs. It’s built into the circumstances, like strategy, location, and resources. Call it the natural startup level; or maybe the sweet spot.
1. The Plan
For example, Mabel’s Thai restaurant in San Francisco is going to need about $950,000, while Ralph’s new catering business needs only about $50,000. The level is determined by factors like strategy, scope, founders’ objectives, location, and so forth. Let’s call it its natural level. That natural startup level is built into the nature of the business, something like DNA.
Startup cost estimates have three parts: a list of expenses, a list of assets needed, and an initial cash number calculated to cover the company through the early months when most startups are still too young to generate sufficient revenue to cover their monthly costs.
It’s not just a matter of industry type or best practices; strategy, resources, and location make huge differences. The fact that it’s a Vietnamese restaurant or a graphic arts business or a retail shoe store doesn’t determine the natural startup level, by itself. A lot depends on where, by whom, with what strategy, and what resources.
While we don’t know it for sure ever — because even after we count the actual costs, we can always second-guess our actual spending — I do believe we can understand something like natural levels, somehow related to the nature of the specific startup.
Marketing strategy, just as an example, might make a huge difference. The company planning to buy Web traffic will naturally spend much more in its early months than the company planning to depend on viral word of mouth. It’s in the plan.
So too with location, product development strategy, management team and compensation, lots of different factors. They’re all in the plan. They result in our natural startup level.
2. Funding or Not Funding
There’s an obvious relationship between the amount of money needed and whether or not there’s funding, and where and how you seek that funding. It’s not random, it’s related to the plan itself. Here again is the idea of a natural level, of a fit between the nature of the business startup, and its funding strategy.
It seems that you start with your own resources, and if that’s enough, you stop there too. You look at what you can borrow. And you deal with realities of friends and family (limited for most people), angel investment (for more money, but also limited by realities of investor needs, payoffs, etc.), and venture capital (available for only a few very high-end plans, with good teams, defensible markets, scalability, etc.).
3. Launch or Revise
Somewhere in this process is a sense of scale and reality. If the natural startup cost is $2 million but you don’t have a proven team and a strong plan, then you don’t just raise less money, and you don’t just make do with less. No — and this is important — at that point, you have to revise your plan. You don’t just go blindly on spending money (and probably dumping it down the drain) if the money raised, or the money raisable, doesn’t match the amount the plan requires.
Revise the plan. Lower your sites. Narrow your market. Slow your projected growth rate.
Bring in a stronger team. New partners? More experienced people? Maybe a different ownership structure will help.
What’s really important is you have to jump out of a flawed assumption set and revise the plan. I’ve seen this too often: you do the plan, set the amounts, fail the funding, and then just keep going, but without the needed funding.
And that’s just not likely to work. And, more important, it is likely to cause you to fail, and lose money while you’re doing it.
Repetition for emphasis: you revise the plan to give it a different natural need level. You don’t just make do with less. You also do less.
There was a nice piece in Small Biz Labs yesterday, in which Steve King notes that you should have a business plan whether or not you expect investors to read it. He offers this summary in that post:
In my opinion, the best way to prepare for the pitch process is to develop a business plan. Preparing a plan organizes the entrepreneur’s thinking, requires going through all aspects of the business and helps to identify important issues facing the company.
You are in a group of angel investors talking with entrepreneurs looking for funding. Or you are in a group of venture competition judges giving feedback to teams after the judging is over. The entrepreneurs listen intently, nod, they’re understanding, and then suddenly one or more of their faces change, crestfallen, disappointed, cheated. Something that was just said triggered an immediate reaction:
But we put that in, they say, because so-and-so (the last angel group they talked to, or the judges of the last contest they entered) recommended it. We specifically changed our plan to accommodate feedback. And now your feedback is in exactly the opposite direction.
I see it a lot. I’ve seen it for years in the judging of the venture competitions. Lately I’ve seen it in reviewing potential angel investments.
For example, one that comes up a lot is whether you go for the broad sweeping expansive view of future market potential, which some groups like and other groups tag as lack of focus or realism.
I like focus myself. Keep it manageable. Narrow targets. Getting to $5, $10, $20 million in three or five years, but more in control. More realistic.
A lot of other judges want to see a bigger pot of gold at the far end of a more distant rainbow. “How do you get to hundreds of millions?”
So they go for big, because the judges say so. Then the next time, it’s “but you have too many targets; you’re doing too much.” And then there’s that look again, the disappointment. We’re supposed to do what the last judges suggested.