Category Archives: Pitching to Investors

What Time and Money Investors Expect from Startups

Wise Mountain Gorilla 2When we talk about investors, we usually mean financial investors, but what are time investors? And what do they expect? Let’s explore the motivations behind being an investor in general and the difference between those that contribute time and those that contribute money.

Traditional financial investors include angels, venture capitalists, friends and family, banks, and so on. Time investors include mentors, staffs of accelerator programs, and the founders themselves. Some (but not all) time investors may be financial investors. Some (but not all) financial investors may be time investors. At a high level, all investors focus on achieving maximum return while minimizing (or at least moderating) risk.

What Investors of Time Expect

I’ve mentored many dozens of aspiring entrepreneurs and their startup companies. Personally, I do it for a very simple reason: I like seeing people succeed, and if I can contribute in any way, big or small, toward that success, I feel great. I expect nothing from my mentor time investment other than personal satisfaction of making a difference. In those occasional cases when the founders/officers believe that I can make a much longer-term contribution to the company (and I have available time) and they offer me a position as a member of the board of directors or advisors, then, I always prefer equity and/or options over cash compensation; that’s to better align all of our personal goals with the company’s goals.

I’ve been in executive positions in 5 startups . . . and counting. Some have been great successes and some miserable failures. I learned far more from my failures than my successes (although Iearned far more from my successes than my failures J). Good mentors should not be afraid to admit their failures; others can learn from the patterns of underlying mistakes.

All investors expect some type of commitment from founders/entrepreneurs. Whereas financial investors usually expect entrepreneurs to devote full-time to the startup, time investors (who are not also financial investors) are more likely to understand a founder’s need to balance life’s commitments.

What Financial Investors Expect

To no surprise, financial investors are primarily interested in financial returns. Investors want to know what their internal rate of return (IRR) will be for a given investment. IRR is the compounded annualized rate of return.

The IRR an early startup investor will achieve is a function of many factors, including:

  • The rate of revenue growth (usually a function of the market size, “excitement” of products offered, strength of the marketing campaign, alignment of products with a significant pain felt by customers, and competition). The faster the growth, the higher the IRR.
  • The profitability of the company.
  • The level of merger and acquisition (M&A) activity in the space. This contributes to how quickly and how likely the company will experience a liquidity event.
  • Typical multiples for the industry. When a company in this industry is acquired (or has a public offering), the acquirer (or the investment banker) will value the company. That valuation will be some multiple of revenues and some multiple of profits. The averages differ greatly based on the industry. See “Determining Future Valuation of a Startup.”
  • The likelihood that the company will survive until a liquidity event. This is a function of many factors including the experience and knowledge of the team. Only 50% of startup companies survive 5 years; see “Eight Seemingly Harmless Things You Should Never Say to Investors.”.
  • The likelihood that later investors will not severely dilute earlier investors with high liquidation preferences. See “Liquidation Preferences and Avoiding Dilution.”

As a result of the above factors, it is no surprise that investors in startups companies like to invest in

  • High growth companies
  • High M&A industries
  • Industries with high multiples
  • Teams that include experienced entrepreneurs or new entrepreneurs who have been through intensive accelerator programs.

Summary

Ultimately investors have goals that they need to meet and all entrepreneurs must demonstrate that they are the best horse to back. Those that can clearly articulate why investors should invest their time and money are demonstrating that they understand every element of their startup and their environment and have the knowledge needed to succeed.

About the Author

Alan DavisDr. Al Davis is a mentor for Creative Startups in Albuquerque and Santa Fe, NM and was formerly a mentor for startups in the Colorado Springs Technology Incubator. He has published 100+ articles in journals, conferences and trade press. He is a passionate world traveler and has visited 8o countries.

He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He was a founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003. He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting and optimizing their business strategies. Click on the following to see a short video on Offtoa:

Botswana Truck

Are YOU a Good Risk to be an Entrepreneur?

During the past 30 years, hundreds of people have asked me, “I’ve got this great idea for a product. All I need is funding. Will you help me?”

As I search through online forums, I see similar pleas over and over again, “I have this great idea for a new app. Will you help me build it?”

Kickstarter and similar venues are full of great ideas that need money.

Let’s assume that you have a great idea. Will adding money be sufficient to create success? Or are there other ingredients that make a business successful? The answer of course is that building a profitable business requires more than a great idea and money!

It includes attributes of the market, the industry, your background and skills, and the rest of the team’s background and skills, to name just a few. But let’s focus right now on just YOU.

Are you a good risk as an entrepreneur? Do you have what it takes? Should others have the confidence in you to bet their money on you and your company? Here is a list of qualities that experienced investors will be looking for from you.

1. Are you 100% committed?

Assuming that you are looking for others to invest their money in your business, they need assurance that you are completely committed. After all, when things get tough (and they will), you should not find it easy or comfortable to simply walk away from the business.

To demonstrate commitment, you need to show you have some kind of skin in the game. This can be done in many ways. For example, quitting your day job. Taking out a second mortgage on your home. Putting your retirement savings into the venture. Using personal credit card debt to partially fund the company. Working 60 hours a week for the new company while working your day job.  All of these demonstrate commitment.

If you don’t show commitment, you don’t have what it takes, and you should not be surprised if others see you as a poor risk.

2. Do you surround yourself with excellence?

Startups require an enormous breadth of skills. As an entrepreneur, you need to be confident enough in yourself to bring on board your team the absolutely very best talent that compliments your skill set. You do not have all the skills necessary to run a company by yourself. Nobody does. Whatever talent you are lacking (e.g., law, accounting, sales, marketing, engineering, product development), you need to hire the absolutely very best!

If you are afraid that hiring somebody “better than you” will somehow erode your position, you probably don’t understand the role of a corporate founder. If you are afraid to hire the best, don’t expect others to invest in you. You don’t have what it takes.

3. Are all the requisite skills covered?

In the previous section, I talked about the fact that no single individual can possibly have all the requisite skills to run every aspect of a company. So what are these requisite skills? Among others, they include:

  • Product development
  • Sales
  • Marketing
  • Accounting
  • Finance
  • Law
  • Leadership
  • Manufacturing
  • Quality control
  • Operations

And each of the above has multiple dimensions that sometimes require multiple individuals (unless you are fortunate to find individuals whose skill sets span the dimensions). For example, within marketing, there is SEO, website development, marcomm creation, lead acquisition, branding, and so on.

Of course, some of these areas are easily outsourced (e.g., law and accounting). And others can easily be deferred until the company grows.

If you are going after serious investor funding (e.g., from angels or VCs), you will need to have all these areas covered, or at least make it clear that you understand that you will need to quickly fill any vacant positions.

4. Have you or your team “been there before?”

Experience running a startup arms you in a way that cannot be replicated by books, mentorship, and research.  These are important too but experience is the best teacher. Regardless of whether that company was ultimately successful and not, certain patterns repeat themselves in every company. Investors do not like seeing their money squandered while first-time entrepreneurs learn lessons.

If you are a first-time entrepreneur, you might think that you have no chance to secure funding. That is not at all true. The solution is to build your team and make sure the team includes individuals who have been there before. Consider “having been there before” as just one of the many diverse set of skills one needs on the team.

Personally, I served key roles in two startups. First I was a non-founding, vice president for a company that eventually had an IPO. Second I was a founding member of the board of directors for a company that was acquired by a publicly traded company. By the time I launched a startup as the CEO, I clearly had “been there before” even though I had not personally been the founder or CEO of either of the two earlier companies.

5. Are you a proven leader?

You may be the perfect founder for a company, but may have none of the skills required of a leader. In such a case, you might want to serve as the chief technical officer (CTO) for the company and allow somebody else to run the company.

You will still be a significant shareholder, but the company will be more attractive to investors and you’ll end up with a smaller piece of much larger pie than a large piece of a very small pie.

6. Are you motivated by the right things?

Outside investors (as well as potential colleagues) are going to be assessing what motivates you to start a company. It has to be for the right reason. Or at least it must be for a reason that is compatible with the investors.

Some of the likely wrong reasons to start a company are power and ego gratification. A good reason to start a company is a sincere desire to satisfy a customer problem. Wealth creation might be okay if it is not the only reason, and it isn’t just for yourself.

I remember asking the founder of my first startup company what his goals were; he responded, “I plan to become very rich, and I hope as many people as possible become very rich along with me as we endeavor to solve the problems that the customers have” I like that!

Summary

Many aspiring entrepreneurs who lack funding blame investors (or lack thereof) for their failure. In many cases, however, these individuals have at least two options:

  1. They can improve their chances of funding by changing their own skills, attributes, and attitudes.
  2. They can figure out how to bootstrap their businesses. By doing this they expend their energies slowly growing their businesses instead of complaining about the lack of funding.

If you have what it takes to be an entrepreneur, the next step is to create your pro forma financial statements. If you want to learn how to generate pro forma financial statements automatically from your business assumptions, check out www.offtoa.com.

About the Author

Alan DavisDr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., a SaaS company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money? If you’d like to verify that your great business idea makes financial sense, sign up for www.offtoa.com.

 

Startups: When Will You Be Profitable?

When Profitable PhotoAs the founder of a startup company, you should be able to determine when you will be profitable. But how can you do that before you even start?

The answer is you need to make some assumptions. In fact, you need to make many assumptions. It is very important to record all these assumptions because during the first few months of your company, you will have to create experiments that validate whether or not these assumptions are true.

So the first step in determining when you will be profitable is recording all your assumptions. See my earlier blog, What Assumptions Does an Entrepreneur Make, for a sample list of such assumptions.

The second step is to create a pro forma income statement based on those assumptions. If you are not familiar with what an income statement is, see my earlier blog, Seven Things an Income Statement Tells You.

The third and last step is to examine the row of the income statement labeled EBITDA (Earnings before Interest, Tax, Depreciation, and Amortization) from left to right looking for the first entry that is positive. If that entry is in the second column, then the answer is you will be profitable in the second year of your business. If it is in the third column, then the third year, and so on.

Most startups are not profitable in their first year. This is because of high starting expenses, as well as the inevitable high cost of goods sold associated with low volume sales. So, if your assumptions show you as profitable in year #1, you may want to rethink your assumptions. And if you are seeking investment capital, I can assure you that investors will look more favorably upon your enterprise if you show realistic numbers, not overly optimistic ones.

 

ABOUT THE AUTHOR:

Alan DavisDr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.
Photograph of CoverIf you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money? If you’d like to verify that your great business idea makes financial sense (and also as a tool to transform your assumptions into financial statements), sign up for www.offtoa.com.

Mine

Five Fatal Flaws in Financials

One of the first and most important steps to take before you launch your startup company is to create pro forma financial statements to verify that your company makes financial sense if all the assumptions that you are making end up becoming true.

The three pro forma financial statements we will be referring to are the income statement, cash flow statement, and the balance sheet.

Three types of “financial sense” can be derived from the above financial statements:

  • Fatal flaws: These are conditions in your financial statements that indicate that the company cannot survive. These are the subjects of this blog.
  • Universal non-investible flaws: These are conditions in your financial statements that make it highly unlikely that any right-minded investor would consider investing in your endeavor. The presence of universal non-investible flaws implies that the company could survive but will not produce extremely good financial returns.
  • Situation-specific flaws: These are conditions in your financial statements that may or may not preclude good financial returns, depending on the specific industry or unique situation.

Fatal Flaw 1. Negative Cash

The bottom line of every column of the monthly cash flow statement is always labeled “Cash at End of Period.” It tells you (based on all the assumptions you have made about your company) how much cash you will have in your company’s bank account at the end of every month.

No entry in this row can be negative.

If some column has a negative value in this row, you must do something to your assumptions prior to this month, for example (these are just four of dozens of possibilities),

  • Get a loan
  • Raise money in an investment round
  • Sell more product
  • Spend less money (on expenses)

What you cannot do is just launch the company and hope that things will work out. Hope is not a strategy. The fact is many things will change once you launch, but you have to at least start with a plan that has a fighting chance of working.

Fatal Flaw 2: Negative Gross Profit

Near the top of every column of the annual income statement will be lines for

Revenues
– Cost of goods sold      
Gross profit

Gross margins indicate how efficient the company is at acquiring and using raw mate­rials for its products. Different industries tend to experience radically different gross margins based on (a) inherent cost of goods sold within those industries, and (b) level of price competition.

Your company can tolerate a negative gross profit in its first year while you figure out pricing, find best suppliers, and hone manufacturing and internal processes. However, by year 2, you had better have a positive gross profit.

New companies rarely emerge in industries where gross margins are low. Reasons should be obvious: investors will likely not see a return on their investment based on an ROE calculation.

Here are some ideas on how to increase gross margins:

  • Decrease cost of raw materials. This is the most straightforward method to reduce cost of goods sold, and yet it is the most dangerous because of potential to adversely affect product quality.Some ways are: (a) find alternative suppliers, (b) replace expensive components with less costly substitute components, especially when customers are unlikely to perceive the difference, (c) use less of a raw material in your product, and (d) purchase in larger volumes
  • Outsource, insource, offshore, or onshore. Find the lowest cost source of doing tasks while still maintaining acceptable levels of quality.
  • Increase prices.
  • Change the product. If your product cannot be sold profitably, consider selling a simpler product that solves fewer customer problems and price it lower. Or consider selling a larger product that addresses more customer pains and price it higher. Or maybe you should rent or lease the product instead of selling it?

Fatal Flaw 3: Insufficient Cash from Operations

The top third of the annual cash flow statement captures cash flows in or out of the company that result from the core business of the company. The bottom line of every column of this top third is always labeled “Net Cash Provided (Used) by Operating Activities.” It tells you (based on all the assumptions you have made about your company) how much cash the company’s business is generating without the contributions of loans, investments, or sales of property.

Almost all startups experience negative cash from operations for the first few years. During this time, they rely on infusions of cash from external sources such as investments or loans.

However, a successful company must at some point be self-sufficient; it must be able to sustain itself with being on life support.

It is possible that a high-growth company with a huge market could plan to stay on a high-growth trajectory for many years and continue to need capital infusions to fund its growth. So, I guess the best way to describe this fatal flaw is to ask if the cash from operations would be positive if the cash from financing were set to zero.

Fatal Flaw 4: Current Ratio Less than One

On the annual balance sheet, divide current assets by current liabilities for each year. This current ratio gives you a pretty good indication of whether your company will be in a condition to pay off debt when it becomes due.

A value less than 1.0 indicates that the company is going to have problems, although there could be short-term fixes for short-term problems. As your company evolves, your current ratio should become (and remain) above 1.2.

If your current ratio is less than zero, it means your current assets are negative (current liabilities can never be negative), so this is equivalent to fatal flaw 1.

Fatal Flaw 5: No Profit

Near the bottom of every column of the annual income statement is a row labeled “EBITDA,” short for earnings before interest, taxes, depreciation, and amortization. You can think of it as the company’s profit (without some of the “noise”).

Most startups experience negative EBITDA for the first one or two years, and that is okay. In fact, it is highly unlikely to have positive EBITDA during those first few years.

However, by year three or so, EBITDA should be positive, and stay positive for the remaining years.

Summary

Although many dozens of potential problems can be detected in advance by examining the pro forma financial statements, the above five conditions are easy to detect and are almost always fatal for your company if not fixed. If you find them to be present in your company’s financial statements before you launch, don’t launch! Instead, fix your plan.

After you fix the plan, and know that it is possible to succeed, then launch the company. It is always good to start knowing that failure is not guaranteed.

ABOUT THE AUTHOR:

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money? If you’d like to verify that your great business idea makes financial sense, sign up for www.offtoa.com.

Mouse Trap

Eight Things You Never Say to Investors

When you approach potential investors about investing in your new company, you should avoid certain expressions. They are traps that you either make you look weak, or from which you will have a difficult time extricating yourself. Here are some examples.

1. “I have no competitors”

Everybody has competition, even if they offer a substitute product. A sophisticated investor will be turned off immediately if you imply you have no competition.

Every startup launches because its founder has thought of something new. It is either

  • a new product or service, or
  • a new market for an existing product or service, or
  • a new way to deliver an existing product or service.

But just because you have thought of something new doesn’t mean you have no competition. You provide products and services as solutions to customers’ problems/needs/pains. Ask yourself, “How do people satisfy their problems/needs/pains currently?” Even if the answer is “They don’t,” then the status quo is competition!

Let’s look at some examples:

  • A new 3rd generation canine cancer-fighting drug. The competition includes: (a) less effective 2nd generation cancer-fighting drug, (b) not treating the dog (could be cost effective), or (c) pain killers for the dog to enhance quality of life.
  • The first online gourmet recipe ingredient store. The competition includes: (a) general on-line merchandisers like Amazon, and (b) storefront sellers of gourmet food.
  • The first allergy clinic franchise embedded inside of physician offices. The competition includes: (a) standalone allergy clinics, (b) allergists, and (c) physician assistants and nurse practitioners specializing in allergies.
  • The first online bookstore (i.e., Amazon). The competition includes all the brick and mortar bookstores.

Bottom line: just because you are the “first” does not mean you have no competition.

2. “All I need is your money; not your opinions”

Investors, whether angels or venture capitalists, usually consider their business acumen to be of considerable value to their portfolio companies. When you make a statement like this (or imply it through your actions) you will likely alienate the investors sufficiently so they will not invest.

3. “My time is worth as much as your money”

During an investor pitch, investors will often ask “how much money have you raised to date?” They want to know how much cash has been invested in the company so far. All founders devote enormous hours in birthing their companies, but labor hours just don’t count.

Yes, you can and should offer to work for no cash compensation (this could be a factor in encouraging investors to invest), and yes, you can suggest that you will accept options in lieu of such compensation. This is all good.

But don’t go into a monologue explaining how your time is worth $100,000/year, so you have thus far invested $100,000 into the company by working for a year without salary.

4. “I will guarantee you an X% return on your investment”

“Danger! Will Robinson. Danger!” You cannot guarantee anything to your investors. You are selling them securities in return for their payment and the terms of this transaction are spelled out in a written subscription agreement.

When you state that you “guarantee” such a return, you are inviting a class action law suit from investors if such a return is not delivered. Do not do this! And the limited liability of the corporation will likely not protect you as an individual (or your personal assets) from claims by the investors.

5. “This is a risk free investment”

By their very nature, startups are risky. The graph to the left shows the survival rates for startup companies, and emphasizes that the rates have been the same regardless of the year they were started. Notice that only 50% of companies survive for 5 years or more.

But even ignoring the data, making such a statement is foolhardy. You have an obligation (legally and ethically) to potential investors to understand and spell out all the risks involved in investing in your startup.

And your attorneys, when they draft your subscription agreements, will insist on including a clause that spells out the likelihood of total loss of the investment.

6. “All I have to do is build my product and the customers will come”

This is a classic statement made by engineers without any marketing savvy. By saying it, investors will know you are a geek. Only three ways exist to create revenue:

  • You can “buy” a customer. That is, you can spend resources (usually money) to raise awareness of your product, you can pull or push leads to you, and you can spend more resources to convert those leads into customers.
  • You can convince existing customers to buy more, or buy more often, or not stop being your customer.
  • You can encourage existing customers to convert non-customers to become customers.

That’s it! Nowhere in this list is “Build my product and  customers will come.” Creating and growing revenue takes work. Plain and simple. Investors know that. If you don’t know that, you will be seen as naïve, not street smart.

7. “We’re almost out of cash”

The timing of raising capital is always a challenge. If you wait too long (e.g., you get close to running out of cash), less respectable investors could take advantage of your situation by delaying their decision to invest until you are desperate and you may end up being forced to accept less-then-ideal terms.

On the other hand, if you solicit investments too early, company valuations might be lower than you would like, and you may end up having to sell a larger percentage of the company to raise necessary cash. No perfect answer exists, but unless you are about to hit a major valuation-changing milestone, I would err on the side of too-early rather than too-late.

Whatever you do, don’t ever suggest to the investor that you are desperate for cash; that will invite even scrupulous investors to make lower offers. The best advice is manage your company so you are never desperate for cash.

8. “The market is so huge; all we need to do is capture 1/10 of 1% of it.”

This might sound impressive to you, but it doesn’t to the seasoned investor. Investors want to invest in market leaders; they want you to have a large percent of some market. Market leaders lead. Market laggards lag.

Successful startups first focus on penetration of relatively narrow vertical markets; it is called the “rifle shot.” Such an approach enables you to target your desired audience with a marketing campaign designed specifically to their particular pains.

Bragging about a “huge market” and the sufficiency of a tiny capture to “make millions” demonstrates that you don’t understand the dynamics of focusing. It sounds like you are going to take the “shot gun” approach, one that usually results in failure because of overly broad messaging.

In summary

Investors are much better at negotiations than you are; after all, they do it over and over again, and you do it rarely. They have heard all the “lines” before and they can see through BS immediately. They also know how to take advantage of your vulnerabilities if they desire to.

I have a few other cautionary bits of advice. They don’t fit into the category of “never say these,” but they are close:

  • “It will be easy to steal customers from competitors because they provide such terrible customer service.” Competitors may in fact be providing terrible customer service, but never underestimate the power of inertia. Many customers would rather stick with a known, but poor, service provider than venture into the unknown.
  • “Our key differentiator is a great user interface.” Sorry, but every new startup claims that it will provide the greatest user experience. You might actually plan on doing so, and you might even be able to do so, but because you sound like every other entrepreneur, your claim will be summarily dismissed.

 

ABOUT THE AUTHOR:

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money?

“Clippesby drainage pump – overgrown door” © Copyright Evelyn Simak and licensed for reuse under Creative Commons License. Original photo from Geograph Project.

wordle

What Financial Statements Investors Expect? Why?

You want to start a company and you want to fund the company by raising money from investors. What financial statements will potential investors expect to see?

Let’s talk about what they expect to get from two key phases in securing investment. The first is known as an “investor pitch”. This is a short presentation you deliver to investors about your great business idea.

The second is known as “due diligence”. This is the process investors use to convince themselves that investing in your idea is a sound undertaking . . . or not.

1. Financial Statements During Investor Pitch

If you are interested in attracting investment money from traditional sources such as angel investors or venture capitalists, they will expect you to make a short presentation to them, usually somewhere between 10 and 20 minutes.

Much of that time will be devoted to conveying the problem or pain you are addressing and your unique approach to solving it, but toward the end of the presentation, an entrepreneur usually includes three slides on financials:

  • Key Assumptions
  • Key Financials
  • Cap Table

Key Assumptions.

This slide lists the primary assumptions that you have made that drive the financial results to be shown on the following slide. Include only the most important assumptions.

This is an opportunity for you to demonstrate to investors that you understand what factors are the most critical to your business achieving its financial goals.

Here are some examples, but don’t use these; use the ones most important for your business:

  • Customer acquisition cost < $100
  • Average order size > $350
  • Annual increase in our cost of goods sold < 7%
  • By year 2, we will be able to negotiate ‘net 60’ terms with suppliers
  • Annual customer attrition rate < 20% (i.e., retention rate >= 80%)
  • We will be able to attract an effective VP of marketing for $75,000 plus a 10% equity stake

Key Financials.

This slide captures the most important data from your financial statements on one slide, without requiring a microscope.

Once again, this is an opportunity to demonstrate that you understand what is important. [Here’s one hint: omit cents!] Although the exact selection of data will vary based on the type of business, a good start is 5 columns (for 5 years) and 8 rows showing:

  • Number of units sold (or perhaps number of customers)
  • Annual revenues
  • Cost of goods sold
  • Gross profit
  • Expenses
  • EBITDA
  • Net cash from financing activities
  • Cash balance at end of year

If cost of goods sold is not important to your business, omit it and gross profit. Include a metric or two if you want to demonstrate something critical to your success, e.g., revenue/customer. Many entrepreneurs replace parts of this table with a graph. Here are two examples:

Example I shows key data from the income statement; none from the cash flow statement.

Example II shows key data from income statement graphically; with investment rounds highlighted in text boxes.

Capitalization Table

This slide shows the investors exactly what you are offering them. It shows how equity is distributed among shareholders currently, and how equity will be distributed among shareholders after the current stock offering. You can read more about how to create and interpret a cap table in How to Read a Cap Table: Advice for Entrepreneurs.

2. Financial Statements During Due Diligence

The investor pitch is designed to whet the appetite of the potential investors. If it succeeds, the investors will engage in an extensive process of discovery called due diligence. Its goal is to uncover all material facts.

They will ask questions, do research, and examine documents to determine the true state of the products, technology, competition, market, industry, personnel, financials, sales process, contracts, and relations with suppliers, partners, and customers.

Part of that due diligence process will include careful analysis of past performance (if any) and pro forma financial statements. This will include:

  • Income Statement
  • Cash Flow Statement
  • Balance Sheet

Income Statement.

Monthly for the next two years, and annually for at least the next 5 years.

This enables investors to determine:

  • Revenues and profit at the time of an expected liquidity event, so they can calculate a likely return on their investment
  • Revenue growth rates to determine if they are reasonable
  • Gross and net profit margins to determine if they are similar to other companies in your industry
  • Percentages of revenues being spent on R&D, marketing, and so on, to determine if they are similar to other companies in your industry.

Whenever anything seems unreasonable, investors will ask for clarification and/or explanation. You can read more about the income statement in Seven Things an Income Statement Tells You.

Cash Flow Statement.

Monthly for the next two years, and annually for at least the next 5 years.

This enables investors to:

  • Verify that the company is not going to run out of cash
  • See if you understand the need for sufficient cash cushion to handle unforeseen circumstances
  • Determine how many more investment dollars you will need to raise in the future
  • Learn what loans you will be making
  • Determine what fixed assets you need to purchase in order to conduct the business.

You can read more about the cash flow statement in Four Things a Cash Flow Statement Tells You.

Balance Sheet.

Annually for at least the next 5 years.

This enables investors to:

  • Quickly calculate current ratio and net working capital, to determine if you will be able to stay afloat
  • Compare accounts receivable as a function of revenues to industry averages to determine if you are being realistic with respect to receivables
  • Calculate return on equity.

You can read more about the balance sheet in Four Things a Balance Sheet Tells You.

In summary

Successful entrepreneurs need to be both detail-oriented as well as masters of abstraction. One of the many places where these skills come in handy is in the explanation and interpretation of financial statements.

Before the investor pitch, you should become comfortable with explaining your financials in 1-2 minutes. And yet in response to questions posed during due diligence, you should become comfortable with explaining any aspect of your financials with considerable detail.

ABOUT THE AUTHOR:

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money? If you’d like to verify that your great business idea makes financial sense, sign up for www.offtoa.com.

6 Reasons You Should Never Start a Company

Do Not EnterIf you are looking for reasons why you should not start a company, read on!

1. You Could Lose All Your Savings

As a founder, you are investing in your startup. You’re investing your time and your energy; you’re investing yourself. In addition to that, it’s also wise to invest financially in every round if you can. That way when you are raising money and potential investors ask “do you have skin in the game?” you can honestly answer “yes,” and when they ask or “if I say yes, will I be the first investor?” you can honestly answer “no.”

Putting you own money into the company demonstrates commitment. If this requires you to take out a second mortgage or a personal loan, so be it.

If you can’t commit to losing your savings, how can you expect others to put their assets at risk?

2. You Could Lose Other People’s Money

I thought that losing my own money was painful, but that was before I lost other people’s money. Now that’s painful! After all, when investors give you their cash in return for equity in a company you have founded and are leading, they are making a loud and clear statement that they believe in your idea and they believe in you.

Even when you involve your stakeholders and keep shareholders informed of all decisions being made, even when the vast majority of investors bear no hard feelings whatsoever, you spend considerable time looking back at past decisions wondering “what if I had done things differently?”

Bottom line: When you accept other people’s investment dollars, be prepared for the possibility that pain might follow if you fail. That pain might be self-induced, or might come from the investors.

3. You Could Hire the Wrong People

You can’t do it all yourself. You need to hire others to help make the dream come true. If you make the wrong hires, quality will be compromised, too much money will be spent, customer service will go down the tubes, the morale of the “good hires” will suffer, and so on.

4. You Could Lose Control

You like control. After all, the company you are envisioning is “your baby.” You want to control it. When you need to raise cash, you will be telling potential investors how much cash you need and what you plan to do with it. The percent of the company they get for that investment will be up for discussion.

Let’s say you need $500,000. You want to maintain control so you have no intent to sell more than 49% of the company. But the investors value your company at just $800,000. That means if you want their $500,000, you’ll need to sell them 5/8 of the company.

5. You Could Build the Wrong Product

You raise $500,000 from investors and build the “perfect product” for the market. You execute an expensive product launch with a major media presence. And nobody buys the product. The product is a total flop. You either misunderstood the needs of the market, you were too early or too late in the market window, or the competition outsmarted you with an even more impressive product.

6. Your Customer Acquisition Cost Could Be Much Higher than Expected

You did extensive financial planning, and that included modeling the sales process. Only one problem: you think it will cost you $250 to acquire each new customer. What happens if it actually costs you $750 to acquire each one? Now everything in your financial plan falls apart.

In summary

If the above situations scare you, you have an easy way to avoid them: Don’t start a company. Starting a company is not for the pessimist or for the risk-adverse. Nor is starting a company for those who want to get rich quickly and live on a beach.

Starting a company takes courage and optimism.  It requires stubbornness and the ability to rewind and clinically assess mistakes. It tolerates failure but demands success. As crazy as it may sound, if that excites you, you might be about to take your great idea and start your own company!

Let me close by sharing with you three of my favorite quotes:

 “Far better to dare mighty things, to win glorious triumphs, even though checkered by failure, than to rank with those poor spirits who neither enjoy much nor suffer much.  [They] know not victory, nor defeat.”

Theodore Roosevelt

“It is good to have an end to journey toward; but it is the journey that matters, in the end.”

Ursula K. Le Guin

“First, say to yourself what you would be; then do what you have to do.”

Epictetus

ABOUT THE AUTHOR:

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money?

Dilemmas of Founders

HartebeestsIf you are considering starting a company, or if you have recently started a company, an essential item for your reading list is Noam Wasserman’s The Founder’s Dilemmas. Based on years of solid research and experience, this book surveys many of the biggest problems facing founders of high growth start-ups. I want to share with you some of the thorniest of those problems here. But please don’t take my word for it. Buy the book for the complete story [No, I don’t get a commission].

1. Career Dilemma

You are currently employed and earn a comfortable salary. You have a great idea for a new start-up. How do you determine what to do?

If you stay with your current job, you maintain the security of a paycheck but likely give up the dream of starting a company, spreading your wings, and perhaps “getting rich.” Most investors will not invest in a startup without the founders/officers demonstrating a significant level of commitment, and that means “quitting your day job.”

If you quit your day job, you have the chance to make it big, but you give up the security of a paycheck. Can you afford to do that? Most start-ups cannot afford to pay the founders a salary for the first few years, so you need to have a significant enough nest egg put away to afford a few years of financial drought.

2. Co-Founders with Complementary Skills

Often entrepreneurs co-found companies with others who have very similar backgrounds as themselves. The advantage of this is you all speak the same language. The problem is that starting a company requires a diverse set of skills: technology, marketing, sales, financial, legal, and so on.

The best teams tend to ones that combine diverse skills and diverse personalities.

3. Title for the Founder

Many individual founders believe that they should lead their companies with a title such as CEO. Derived from Wasserman, the figure on the right shows the starting role that the “idea person” serves in start-ups. Although the initial idea person may be the perfect CEO for the start-up due to commitment and passion, the skills required for leading the company through long-term growth may not be present. Only 75% of founder-CEOs are still in the CEO position by the time of the first external investment round, and only 39% are still in that role by the time of the fourth round.

4. Who is in Charge?

Most start-ups have a single individual who serves as leader; s/he could have any
of a variety of titles; chief executive officer, president, and chief operating officer are typical. This individual reports to the board of directors. If you are considering having nobody in charge, or having two or more co-presidents in charge, think again. Tough times will come. And when those tough times arrive, somebody needs to make the tough decisions. The movie, Startup.com, exposes many start-up problems, not the least of which is what happens to relationships when one of two co-founders thinks they are “co-CEOs.”

5. Liquidation Multiples

When investors purchase preferred stock, they typical ask for (and receive) a liquidation preference, which specifies what multiple of their purchase price they will receive upon a liquidity event prior to general distribution of the remaining funds to all shareholders. I described some of the problems related to liquidation preferences in an earlier blog called Liquidation Preference and Avoiding Dilution.

According to Wasserman, Series A investors in 78% of all start-ups that raised external investments had a liquidation multiple of 1; 9% had a liquidation multiple of 1.1 to 2; 5% had a liquidation multiple of 2.1 to 3; and 8% had a liquidation multiple of greater than 3.

The dilemma is: Do you accept an investment whose terms include high liquidation preferences even though it in effect makes earlier investors’ return nil [and significantly dilutes the founders], or do you turn down the investment hoping for better terms from another investor?

If you accept the terms, you have thrown your earlier investors under the bus. If you refuse the terms, you may be throwing the entire company under the bus. Therein lays the dilemma.

6. External vs. Internal Boards

If you have a board of directors composed of the inner circle, e.g., co-founders and/or fellow officers, you can make decisions with your co-leaders and know they will be endorsed by the board. But now you have no “sounding board.” You have no independent thinkers. You have no checks and balances. The primary reason for a board should be to hear other opinions.

7. Control vs. Wealth

In an earlier blog called You Are Not Your Company, I described the problem founders have of trying to control their companies vs. distributing ownership and creating a much bigger pie to share among more mouths.

8. Compensation

Should officers of the company (and in fact all employees) receive cash compensation equal to what they would receive at a non-start-up company? Should they receive stock options as an incentive to join the company? Should they receive stock options in lieu of cash compensation? What is the right balance among these three?

There is no right answer. However, the decision is affected significantly by the amount of cash the company has (and this is affected by the desire to attract investors and/or the desire to time investments based on company valuation) and the amount of control that the founders demand or are comfortable with sharing.

9. How Long Should Vesting Be

When options are granted or stocks are sold to employees with reverse vesting, how long should the vesting period be?

On one hand, a long vesting period sounds like an incentive for the individual to stay with the company for that long period of time.

On the other hand, a long period of vesting could also cause a frustrated individual to say “I can’t wait that long; I might as well leave now.” The table on the right, from Wasserman, shows how long the vesting period is in start-up companies for founder CEOs vs. non-founder CEOs.

In summary

Starting a company is not for the faint of heart. Fortunately books like Wasserman’s Founder’s Dilemmas exist to guide you through the tough times.

ABOUT THE AUTHOR:

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money?

Photo of fighting male hartebeests by Filip Lachowski (Creative Commons)

Four Ways to Validate Your Great Startup Idea

You have a great idea for a start-up company.

Thumb

Validate your idea by answering four simple questions:

  • Is the market right?
  • Is the industry right?
  • Will it make money?
  • Will it need money?

Let’s explore these one at a time.

1. Is the market right?

Determining if the market is right means demonstrating that enough people exist who will purchase the product or solution you have developed, you can find them, and you can turn them into customers. For this you need to understand the size of your market and the characteristics of the buyers that personify your market.

Size of market

How large is your target market? You want your potential market (called the total available market, or TAM) to be quite large. But you want your initial target vertical market to be relatively small. By being focused, you can align your product features and marketing messaging with the unique pains/needs of this unique market.

And then you can claim you “penetrated 25% of your target market” instead of having to claim that you “penetrated .02% of your target market.” Sure sounds better to future investors!

You can measure the size of both your TAM and your initial target vertical market in terms of:

  • Number of customers
  • Dollars spent on products like yours
  • Units sold

Targeting Customers

NeedleHow easily can you find potential customers? Will they find you? Or will you find them? In either case, how? It is very easy to say “oh, we’ll just use Google AdWords and we’ll get tens of thousands of visitors every day.”

It is much harder to actually attract qualified leads. If you plan on finding the leads, how will you reach them and engage with them until they become customers?

Converting Customers

Catheter Solution 2Converting customers is not only influenced by the severity of pain your product is addressing. It is also influenced by how you position your solution and your messaging. Your target market must be able to identify with what pain your product resolves. The three bullets shown above demonstrate how one company, Adapta Medical, has honed their message to align perfectly with their target markets, C6-C7 quadriplegics and hospitals.

I like to use the words “clear and compelling” to describe the right message, i.e., when a lead hears or reads the message, they can relate immediately to the pain they are feeling and see clearly how your product will alleviate that pain.

2. Is the industry right?

If you want to do a thorough analysis of whether the industry is “right,” check out Porter’s Five Forces. But as a start, make sure you have a thorough understanding of your competitors, your potential partners, and your differentiators.

Competition

Few things turn off investors more than hearing entrepreneurs claim that they have no competitors. Every new company has competitors. If you really are the first to do something, then how are your target customers surviving currently? Here are some examples:

  • You’re “first” to provide on-line retail sales of gourmet food. Your indirect competitors include storefront retailers and catalog retailers of gourmet food. And your future competitors include on-line retailers of non-gourmet food (because they have all the logistics in place to add SKUs for gourmet food and thus become direct competitors).
  • You’re first to provide regular helicopter service from Denver to Colorado’s ski resorts. Your competitors include airlines, van shuttle services, rental car companies, and so on, all of which satisfy your target market with this capability using different means.

The way to determine if a company is a competitor is to imagine being a potential customer. If the customer could make a list of companies (including yours) and evaluate the pros and cons of each alternative (including price, convenience, safety, etc.), then those companies are competitors.

Partners

Look upstream and downstream on your supply chain. Who will you need to work with? Have you established those relationships yet? How easily will it be to establish? Can they control you (e.g., with price changes)? Or can you control them?

Differentiators

Think again about that list of competitors that a potential customer could create. What makes you special? Nobody cares about what you think makes you special! What will a potential customer think make you special when compared with the alternatives?

3. Will it make money?

In his February 20 article, Martin Zwilling explained how critical it is for you to use a financial model to determine if your company will be financially successful given the assumptions you currently believe to be true. I couldn’t agree with him more.

After creating such financial models for many dozens of startups, I would add that it takes many precious hours to create and debug such a model.

I would recommend that you use an online tool that has already considered and built in all the elements you must consider to be successful. Such tools allow you to enter your key assumptions one time, and they create your entire financial model. Then when any of your assumptions change, you just have to change one number, and your new financials are instantly created for you.


 

Offtoa Screen1


Martin provides 5 great examples of such “assumption changes” that are typical:

  • What if customers don’t want to pay the price for your product that you though they would?
  • What if the market size ends up being different than you expected?
  • What if your sales growth is different than expected?
  • What if your investors offer you an investment amount different than your expected?
  • What if your customer acquisition cost changes?

In reality, there are hundreds of such assumptions that could change.

4. Will it need money?

Another benefit of assumptions-based financial modeling is the automatic creation of monthly pro forma cash flow statements. You can easily scan the bottom row of these statements to determine exactly how much investment money you will need and when.

In summary

To prepare yourself for investors, you should thoroughly validate your business before you enter the shark tank. This article summarizes the key elements of such a validation. To summarize, here is the checklist:

☐ Is your total available market large enough?

☐ Is your initial target vertical market focused enough?

☐ Is it easy to find leads?

☐ Is it easy to convert leads into customers?

☐ Do you know your competition?

☐ Have you lined up your business partners (suppliers and distributors)?

☐ Are your differentiators unique and compelling?

☐ Will your startup make money?

☐ When your assumptions change, can you instantly see the financial effects?

☐ How much money do you need?

ABOUT THE AUTHOR:

Alan DavisDr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

ABOUT OFFTOA

Offtoa is a subscription-based SaaS that leads you, the entrepreneur, through a series of questions and transforms the assumptions you provide into a complete set of pro forma financial statements, including even a capitalization table and expected internal rates of return for the investors. Armed with this intelligence, you and your team are able to demonstrate to investors that you know your finances, understand your market, and have a winning proposition.

If you decide to subscribe to Offtoa because you read this blog, send me an email at adavis@offtoa.com and I’ll email you a coupon good for 50% off your first month’s subscription. This offer good only until May 31, 2015.

Needle in a Haystack photo by James Lumb (Creative Commons).

 

To Plan or not to Plan: That is the Question!

SignsI have been an executive in startups since the mid-1980’s, and still am. I have always proactively planned every business in detail, but the last “business plan” document per se I wrote was in 2001. How is this possible?

I want to address some basic questions:

  • What is the difference between planning a business and writing a business plan?
  • What should you include in your planning?
  • In what format should you document your plan?
  • How much detail? What is the right time horizon for business planning?
  • Why do you need to plan your business?

What is the difference between planning a business and writing a business plan?

A business plan is a polished, organized, physical document that describes every aspect of your proposed business and its environment. It usually cover 5-7 years from inception, ramp-up, through to exit. Although occasionally requested by investors, these days it is usually requested only by academics in “business plan competitions.”

Business planning, on the other hand, is the activity of lowering your risk by studying and understanding every aspect of your proposed business and its environment.

What should you include in your planning?

At a minimum, you need to thoroughly understand:

  • The macro market, that is, demographics of the general market you are aiming for. If you are creating a fast food restaurant for diabetics, how many diabetics are there? And are their numbers growing or shrinking?If you are creating a company to provide assistance to early-age retirees, how many individuals are retiring early? And are their numbers growing or shrinking?When tracking dimensions of a macro market, you could measure it in terms of number of customers, number of dollars spent for products like yours per year, or number of products like yours sold per year.

    Great demographics for your macro market are helpful to the success of your start-up. However they are neither necessary (after all, Starbucks succeeded quite well in its North America expansion efforts in the early 1990’s even without a dramatic increase in the number of coffee drinkers) nor sufficient (even terrific growth of a market cannot compensate for sheer management incompetence).

  • The micro market. As an entrepreneur, you need to focus on a specific target market that you can penetrate successfully. By aiming for a specific (usually narrow) target market, you can create a marketing campaign aimed directly at that market and its unique pains.Members of that market then quickly see how your solution addresses their pains and become easy converts and thus customers. On the other hand, if you aim for a more general market, your marketing campaign will have to address more general pains by necessity, and will then be successful at converting a lower percentage of leads. You want all odds in your favor when you start a company.Meanwhile, start with just one target market; if you start with two, you’ll double your marketing costs (or you’ll halve the effectiveness of your marketing by watering down the message).

    The research you need to do concerning possible micro (aka target) markets includes characteristics such as size, growth rate, accessibility (i.e., how easily can you find potential customers?), ease of conversion (i.e., do potential customers “feel the pain” vs. do you have to first convince them that they have a pain? how easily can you convince them that your solution to their pain is by far the best solution available?), and so on.

    As a general rule, having an unfavorable micro market is considered by most experts to be a showstopper. If your target market is not already focused on trying to solve the problem that your product solves, you are fighting an uphill battle.

  • Your competition. Almost every prospective entrepreneur I have come across understands the need to identify “the competition,” but many limit themselves to direct competition, i.e., those companies providing products similar to the start-up’s, which address the market’s needs in a similar fashion.Don’t ignore substitute competition, which customers can choose to address their need in an entirely different fashion. For example, in the electronic note taking industry, over 200 small companies compete with 2-3 very large companies for customers. They are all direct competitors.But this industry suffers from substitute competition from at least two sources: (a) pen and paper, and (b) standard word processors on tablets. Business planning for a start-up in the electronic note taking industry must acknowledge the reality that a very large percentage of the total available market will not be purchasing any company’s electronic note taking software product.
  • Threat of entry. Ideally, (a) you want it to be easy for your start-up to enter the industry, and then (b) once you enter, you want it to be incredibly difficult for others to enter and subsequently compete against you.Concerning point b, when planning your business strategy, what can you do now to make it more difficult for others to copy you? For example, do you have intellectual property that you can protect with patents, copyrights, trademarks, and trade secrets?Can you enter the market quickly enough so that your large market penetration deters others?

    Can you establish contractual relationships with either suppliers or distributors that make it impossible for them to work with competitors?

    Can you provide such good service that no customer would want to change to a competitor?

  • Your Differentiators. What makes you special? Why is your product better than the competition? Saying that you will have a “better user interface” will not cut it; everybody says that. What specific value does your product provide that the market will appreciate and that the competition does not already provide?Here are some examples:
    • We are the only e-tailer that provides restaurant chef-quality gourmet ingredients to the home chef.
    • We are the only manufacturer of a catheter that C4-C5 quadriplegics can use for self-catheterization.
    • We enable online purchasers to donate to their favorite non-profit at no cost to them.
    • We deliver products to your door using drones within 4-hours of ordering.
    • We provide Wal-Mart prices without the long check-out lines.
  • Your Marketing and Sales Strategy. If you haven’t already done so, read Eric Ries’ The Lean Startup. In it, you will discover only three ways to create revenue:
    • You can pay for new customers. So, how do you plan to make the market aware of your products? How will you convert leads into customers? What will you do explicitly to retain customers?
    • Current customers can refer new customers? So, what will you do to encourage referrals?
    • Current customers can buy more. So, what will you do to encourage customers to increase their purchasing?
  • Pro Forma Financials. Income statement, cash flow statement, and balance sheet. Maintain all your assumptions that drive these financials in a list.
  • Cap Table. Only needed if you are interested in investors.

In what format should you document your plan?

This is a matter of taste. I strongly recommend against printing all your plans, polishing them, adding an introduction, table of contents, etc., and binding the document. The problem with this approach is that every one of the planning components is constantly evolving. If you polish and print it, it will be out of date by the following week. This is why I say I am against business plans, although I am for business planning.

Personally, I maintain a series of electronic company folders; each has a corresponding physical notebook containing selected key excerpts. Each folder contains all information I have collected on one aspect of the business. They combine “plan” and “actual” and are:

  • Market and Industry. This folder contains all my macro and micro market analyses and competitive analyses (old as well as latest in chronological order). It also contains copies of any related articles or reports others have written.
  • Marketing and Sales. This contains copies of marketing and sales plans (strategic and tactical). [Once the company starts, I add ad copy, brochures, web page designs, and so on.]
  • Equity. Initially, this contains just the projected cap table. [Once the company launches, it will also have copies of private placement memoranda, investor subscription agreements, accredited investor questionnaire forms, the stock option plan, all stock options granted, updated versions of the cap table, and so on.]
  • Board. Initially, this contains articles of incorporation and the bylaws. [Once the company launches, it will also include updated bylaws, board meeting minutes, and actions by written consent.]
  • Organization. Initially, this contains the organization chart and hiring plan. [Once the company launches, it will also contain employment contracts and updated organization charts and hiring plans.]
  • Financials. This contains pro formas by month and year for 5 years. At the front, I maintain a list of all assumptions, including all expenses (by year and by category), customer acquisition cost, sales cycle, average order size, periodicity (how often each customer will purchase), retention rate, viral coefficient, viral cycle length, and many of the items from the above folders. [Once the company launches, I add actuals.]

I also maintain a 10-minute slide presentation that captures the essence of some of the above.

How much detail? What is the right time horizon for business planning?

You should be as lean as possible without being irresponsible. Here are my thoughts on the specific parts of planning:

  • Analysis of Market. I believe that you must understand your market as thoroughly as possible or you are being foolhardy. The lean community might argue that truly revolutionary products create their own markets and it is impossible to understand the market until you test its behavior with your minimally viable product (MVP) in hand. The right answer lies somewhere between these two extremes.For example, let’s say your idea is to create fast food restaurants for diabetics. I would argue that it is important to fully understand both the demographics and the dietetic needs of diabetics before endeavoring down this path.On the other hand, you will not be able to determine exact recipes or menu items until test marketing (i.e., creating MVPs), and you won’t understand the risks associated with attracting diabetics to your restaurants when their family members are not diabetics without experimenting.
  • Analysis of Competition. Absolutely essential.
  • Threat of Entry. It is never too early to start planning for how you will protect yourself. If you delay, it may be too late.
  • Differentiators. Here, time horizon is important. You have to perform a delicate balancing act between what you believe are long-term differentiators for the majority of the market and what you believe are short-term differentiators for early adopters.The only sensible approach is to build a series of successively larger MVPs, learning as you go, adapting to what the market is telling you. All the time, however, you must acknowledge that you may not know if you are accommodating the needs of just early adopters or if they are indeed representative of the market majority.For planning purposes, do two things:

    (1) define what you believe are long-term differentiators. After all, without these, it is unclear why you should even be in business.

    (2) define a series of experiments to validate which features, delivery mechanisms, prices, promotions, marketing mechanisms, sales techniques, suppliers, and so on (collectively called differentiators), are most effective with the market.

  • Marketing and Sales Strategy. As stated above, you will have three components of your marketing and sales strategy: paid, referrals, and organic. As part of your plan, you should calibrate all three of these components with your goals. See Five Steps to Get and Keep Your Startup on Track. Once the company starts, you will revise these goals with actuals.
  • Financials. You are lean and are taking one step at a time. However, you still have a responsibility to verify that you are stepping in a direction that could yield great financial results. Create your pro forma income statement, cash flow statement, and balance sheet annually for at least 5 years, and monthly for at least the first two years.

Why do you need to plan your business?

The reality is that investors place their bets on startups less than 3% of the time[1]. The other 97% of their money goes to businesses that have already been through rounds of funding and have demonstrated that a market is willing to buy their product.

But when they bet on a startup, they demand a detailed plan for the business.

They won’t necessarily ask for a business plan per se, but they will perform due diligence. And when they do due diligence, they will be asking every possible question about your market, industry, product, marketing and sales, financials, governance, equity structure, intellectual property, and so on, so you need to have all this information somewhere.

If you are not planning on having investor money, why would you do anything less? After all, you are an investor in your own company, with time and money.

ABOUT THE AUTHOR:

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will You New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money?

[1] http://www.forbes.com/sites/dileeprao/2013/07/22/why-99-95-of-entrepreneurs-should-stop-wasting-time-seeking-venture-capital/