Gauging Fund Raise Strategies Based On Market Dynamics
Economics is not what I liked as a teenager and I honestly believed that being in technology would provide me with an escape route away from what I felt was the most boring subject on earth. Off course that was not the only reason I choose to be in IT. But the irony of it all is that economics is what drove to me reach a consensus on all my critical decisions and drove my most successful strategies in business. I was not thinking economics at face value, although I relied heavily on its concepts all along indirectly. I learnt things the hard way, as I was too bold a technologist to admit faith in normative sciences and too confident an entrepreneur with a ‘curve jumping’ idea. In the end, the only curves we jumped were the work around our mistakes that could have been avoided in the first place. Here are some excerpts, I learnt as an entrepreneur and now in the venture space, which will help shed light on structured arguments before funding your business plan from a market perspective:1. Difference between a Fundable Vs. an Investable Business Plan: You will often hear VC’s loosely talk about the ‘fundability’ of a business plan. Fundability, in its true sense, is a secondary aspect of an investment, which means whether or not your business plan needs money to get to your next milestone. In a way, everyone and everything that sounds cool is fundable. The question is whether your idea is worth investing in, in order to yield exponential early returns on an exist or sustain consistent high-growth returns over the life of the firm. Looking at your competitors (if you don’t have one you are probably in the wrong space as there is a reason why no one else is attempting what you are) growth rates and yields for their investors in addition to their profitability, market share and product maturity is key. Talk about how your idea will increase that growth rate and yield curve significantly, at the same time, bringing value to the market. Keep your friends close but your enemies closer.
It is not very attractive even if you want 1% of a $50 Billion market but the rate of return and growth is around 2% annually. The investor does not want to wait for 8-10 years to see his 10x return. He can re-invest the money 3 times over in that period and make a lot more. Think about market sustainability. Your current market is $50Billion – says who? And if it is true, how long will it last to be $50Billion? We don’t care what Forrester, McKinsey or Gartner have to say. The typical cycle to exit, whatever the strategy, is between 3-5 years for technology funds. If your business can’t make money in that period, re-visit your product or service strategy. There are off course, exceptions to the rule in rare cases.
Let’s face it; the investor is not looking to loose money even if you are going to save a million lives. In that case, you should talk to a philanthropists if you idea is just looking to ‘fund’ itself.
2. Angels vs. Institutional Funds – No Silver Bullet: Let’s say you work out of your parents garage, have no experience building companies and neither are you a ‘serial’ entrepreneur. You have no patents, no connections within the VC community in your area and no concept of economics. But you have a real idea that will change the way we live, or something that we call a ‘disruptive technology’ and you want to put it in practice in an area where you think it will have the best applicability. I’d be a liar if I told you to go either way – angels or VC’s. There is no sure fire road to debate this dilemma.
Angels, in certain markets, seem to take higher risks than VC’s as these guys typically provide seed stage financing. VC’s are also no longer interested in funding you for $150k. But angels are not as risk adverse as the VC’s, who are diversified in their investment portfolio, so chances are the angel intricately involves himself in the business than your average VC, as you may be, his only investment. On the other hand, if your idea requires a $5M seed investment, it is unlikely that you will achieve that via angels. Lastly, a VC fund life is limited (5-7 years) but angels have their own money thus, there is no legal implication and urgency to show performance within a given period. Then there are GP’s (General Partners) in VC firms whose LP’s (Limited Partnership arrangement) allows them to invest outside of their firm affiliation as independent investors. All these could be good things or bad for you. Lastly, make sure you don’t approach angels who are clueless about your idea.
E.g. a rich real-estate developer or a wealthy widow (not sure where that came from) investing in your IPSEC security profiler for IIS authentication technology on 802.11x protocols is probably a bad idea. They would neither understand the product or what the heck you do and why it takes 5 years to get their return, nor will they be able to make introductions to relevant people. Instead, they will be a bottleneck for you to run your operations smoothly and a hindrance to seek additional rounds of financing. VC’s always see who the first investors are and what is their credibility. On the other hand, show the real-estate developer your idea of a transparent wall built from cheap chemical composites, and you will be a rich man very soon. As we used to say in the 90’s: “If Context is king then content is King Kong!” In other words, don’t get desperate for cash. Plan ahead but just in time to market your product and with just the right people.
Ultimately, your fund raise strategy depends on the person who is interested in giving you money and understands the potential implications for your application and your market, believes collectively in the idea and can help you get to the next level rather than pushing his own agenda on the table. VC’s, from my experience, act as if they are interested in the product but seem more concerned over exit strategies and valuations and tend to structure your company in the best interest of the investment. With zero experience, most entrepreneurs typically do a friends-n-family round, gain some traction with development & a pilot site and look for additional capital either via an iBank or through Broker Dealers. If you are a complete geek, get an outside partner with previous successful start-up experience, but not a family member and hire a good lawyer with IP & start-up practice.
In the end, a successful investment is not necessarily a successful product. Selling ‘honest-hype’ is an art, which almost seems a pre-requisite for a large M&A or an IPO deal.
3. Self Validation: Before you seek cash or even write a business plan, ask your self these questions, as it is likely that most suave investors will know and expect answers to these directly or indirectly:
b). Think about your solution. See if it solves a need that is unmet or is being met in an ineffective way.
c). Who are these people that are trying to address this unmet need? (They could be potential M&A targets).
d). Is my idea tested before? Did it fail and if so, why? (Some markets and solutions choose their battles).
e). How long ago was this idea tested, if at all? (The 1960’s or yesterday)
f). Am I the first one to think of such an idea? Am I a genius or a duffus? (Remember: Geniuses are very rare)
g). Is my idea a theory or can I display hard evidence of its functionality in some form?
h). If I have money, will I be able to build a prototype that actually works outside the lab?
i). If so, how fast can I build & test it & how sustainable would it be? (Cant sell something that breaks after 1 use)
j). Can you display the real functional value add from the prototype minus the hype?
k). If this is not an end product, how easy it is to integrate it with other mainstream products?
l). If this is the end product, how easy it is to make it in large quantities? (Forget margins & profitability at this point).
m). Do you have any scientific, legal, commercial or individual subject matter expert validate your claims?
n). How defensible is the idea? Can anyone duplicate what you do somewhere in India or Russia?
o). How patentable is the idea? Are there any existing patents around your idea?
p). Lastly, look beyond your geographical boundaries to other countries for research.
If your answer to any 3 of the above is “It may be tough” or “it is difficult to answer . . . “ or “It is complicated to explain.. “ or “I don’t think I have any competition” or “It will take me 10 years to built a prototype” or “I am a genius . . . “, take a hike. We like realists. You will not be funded and I will end the conversation with you in 5 mins. So will 99% of my peers in this business. Sorry – we take risks, but calculative risks. These questions are my data-points to make those calculations. Besides, we have 50 other business plans we need to take a look at that may really change the world we live in. Forget ‘perception play’ and ‘lifestyle solution’ and ‘revolutionary’ talk. That’ll come if you even have a brand. Think about your product & the size and nature of your market. If you develop an oral pill that will not require intake of food for days, that’s revolutionary. If you show me a pill that removes warts or wrinkles (there are 18,679 products in US, Canada & Europe addressing this issue), you are out.
4. Yield Curve Equations: Not that you need to be an ace economist, but follow the investment pattern. Most top law & asset management firms publish M&A & investment reports that are freely available on their website. E.g. If funds are putting their money in long-term fixed-income investments (less money more risk), that may be an indication of a slumping economy, where interest rates tomorrow may give lower rates than today. These funds thus depend on currently prevailing yields because future yields may be significantly less. This is called Inverted Yield Curve where maturity dates in the future yield less returns than those with a shorter maturity date. This may dictate your exit strategy and may help you construct a favorable pre-money capital structure or where you look for cash. It may even help you decide your market segments.
One of my favorite topics is the debate of using IRR (Internal Rate of Return) on your financial projections. I generally tend to disagree with the use of IRR despite its appeal. The assumption that interim and all cash flows will be re-invested at the same or higher rates seems be an inaccurate way of calculating yearly yields (unless there is no cash-flow which will make IRR accurate), especially when you discount or avoid the use of your annual cost of capital altogether. IRR also assumes that your current and future business plan will be exactly the same – which is never the case. Your product strategy, as a start-up, is a moving target. The level of attractiveness on your model may not be the same as what you have now or vice versa, thus your cash flows will never be re-invested at the same rate 3 years from now. Not to mention you may not generate the same level of cash flow. But if you do use this analysis, factor in valuations, annual CapEx and sales projections. Avoid the use of percentages in IRR calculations and hope that you are not off.
5. The Valuation Game: Most VC’s ask entrepreneurs what they think their business in valued at. After all, you need to put the worth of your business in dollars. The fact of the matter is, this question is so inane; it is almost meaningless to even discuss it more than a ‘good-to-know’ information during your presentation. Based on your liquidity and prior investments, and sometimes even with cash at bank and strong P/E ratio (Price to earnings), you may think you are valued at $(X)Million but market forces may decide that based on what your competition is valued at, the rate of return they currently yield, the future value of investment (either from the original investor or someone else), the legal and procedural complications that involve your product to reach maturity (HIPPA, Sab-Ox, etc), etc, your current valuation really should be $(X-2)Million. You are a start-up. You have no credibility on earnings yet. In reality, in subjective terms, it is impossible to put a figure on your company. Investors usually have a ‘liquidity preference’ on the term sheet that allows them to exercise their shares and sales money before you can. This can be bad of you don’t read the fine print close enough. Find out what the investors sweet-spot is in terms of deal-size. Find out the current market capitalization of the industry you are serving. Lastly, ask the investor where he wants to see his money go after 5 years? There is a difference between a ‘flip’ and building a real corporation. Your strategy as an entrepreneur who wants to pursue either paths should and will dictate your valuation terms.
In the end, it is an execution play, however defensible and disruptive the technology. If you cannot put yuor ideas in practice and cannot leverage that practice to wide use, you will not as succesful. Be honest to yourself and to the market and build a company to last.
posted by Janak Joshi @ 3/16/2006 01:33:00 PM
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