February 8, 2010

Venture Capital: Funding Business Ideas

Starting a Business

If you're a starting a business, whether its an incubator business or a startup, your number one goal is to see your business succeed.

We have had some ups and downs in the process of starting Leximo, and we decided to reach out to venture capitalists (VCs) for some advice. We figured we aren't the only ones with unanswered questions.

The problem is people are quick to tell you whats wrong but don't know how you should fix it. With that being said, we teamed up with other fellow entrepreneurs and created a list of 7 Startup Questions That Venture Capitalists Should Answer.

These questions where not "Softballs" by any means. We pitched these questions to several VCs from all over North America. Some of them hit them out of the park. Their responses are below, and so are their bios.

Hopefully their answers are of help to other entrepreneurs all over the world.





7 Startup Questions That Venture Capitalists Should Answer:

1 - Without a prototype or some tangible evidence that an idea has been accomplished somewhere, it will be treated like space flight between stars in one hour or less, i.e. impossible!
"pie in the sky".


How does an entrepreneur establish credibility by convincing an investor that his product might be feasible?

Dave:

What you're referring to is a Napkin idea, which is very common. A business Owner should seek out capital language mentoring, such as those taught at CEO Space.

Ric:

Come from the industry served. Be accomplished in the technology to be deployed. Use the “Field of Dreams” model. Have a prospect state that if its built they will buy/be a customer.

John:

Typically entrepreneurs produce a prototype, mockup or a bare bones system as starting point. There is a large amount of open source freeware available along with modeling or prototyping tools that the feasibility of a product is not an issue. I usually assume that the product or service is feasible and proceed to the due diligence on the business issues. If the company passes this stage then I do an in depth analysis as to whether the product or service can be created at the price points required by the business plan. In my case, 999 out of 1,000 fail the business due diligence process.

Harley:

While it's usually an easier pitch when an entrepreneur doesn't attempt to 'invent the wheel', and instead takes existing products / service and improves it, this doesn't preclude one's ability to pitch something completely novel or unique to a potential funder. Often, if the entrepreneur is meeting a well-matched investor, one who properly understands the technology being developed and has strong experience in that specific sphere, the investor will be able to see the value (or lack thereof), despite not having a basis for comparison with a competitor / similar product that is already at market phase. I would think that the best way to convince an investor that there is value in your product, without the luxury of having sales figures or market data, is to provide other tangible metrics; such as focus group feedback, letters of intent from potential partners, and some sort of endorsement from a reputable source (note: the definition of ‘reputable’ is changing from the ‘man’ in the ivory tower, to a few thousand twitter followers).

Farhan:

Well we focus on early wins and quick prototypes, so your statement is correct. Many of our portfolio companies are able to get working code that can be demo'd within 2 weeks (yes, that short a time frame). Once they have a working prototype, then can iterate and adjust features/functionality all the while showing off their technologies to key stakeholders and potential customers.

Ted:

We tested our flagship product extensively (a party game). The investors we approached were our testers – they were already familiar with the product, believed in it and were excited to invest.


David:

In cases where a prototype is possible, even if it isn't elegant - this is preferred. We (21Ventures) invest in clean technology companies. In some cases, asking the entrepreneur to show us a prototype of a carbon recovery plant isn't feasible. The next best thing is for the entrepreneur to have a clear picture of their technology and to answer these three questions for me on the spot:

1) Is it real?
2) Is it worth it?
3) How do we win?


E
ntrepreneurs that can still remember the days of 1996-99 need to forget them as the super outliers that they were in the history of venture capital. Today, entrepreneurs are doing more legwork on their own, spending more of their own money to start, and bringing in VC money once they are closer to a proven concept.

2 - How should you develop your revenue and gross margin forecasts with more detailed back-up?


Dave:

IMHO, a strategic plan will uncover revenue & gross projections. Most try and plug these into a business plan, though a savvy investor does not look at a business plan. The biggest myth in business is that a business plan is crucial, where in actuality, it is the biggest waste of time in a business, other than a receptionist on Facebook.

Ric:

Have a good understanding of your cost of goods sold (COGS)

John:

An early stage seed angel investor requires an exit which is at least 10 times his investment. This requires gross margins in excess of 70% or dramatic leverage in terms of units sold. These high margins also allow for the company to make a mistake or two without taking the company down. Companies with lower margins can be very successful but cannot generate the type of returns that professional angels require.

Harley:

Let’s first understand the difference between a ‘forecast’ and a ‘projection’. A forecast is typically based on past performances, and reasonable assumptions, and enables a user to reflect on previous results to provide an estimate of future outcomes. A projection however is more of a hypothetical assumption and may turn out to be less than probable. As such, there is no perfect way to build a forward looking estimate without previous experience of data, and often the best way to provide an investor with ‘forecasts’ and ‘back-up’ is to construct a model using certainties. This can be done by using US Census Bureau data, or prominent survey info, and building an analysis around facts (example: product X will be sold in California to first time mothers of Catholic decent with an income of $60,000 and up – and therefore we know, based on real data, that there are approximately 250,000 individuals in our customer demographic). On the issue of ‘margin’, there are basic industry rules that relate to what percentage of a product/service’s retail price will be considered ‘profit’ – software/tech tends to be rather high (above 60%), retailers tend to like using ‘key stone’ pricing (50%), and pharma is whole other ballgame due to enormously high R&D costs. While one can speak to others in the industry in an effort to gain some perspective and insight, chances are your pricing and costing structure (or profit-loss) may change as you move from beta to market phase.


Farhan:


We know that most financial forecasts are educated guesses at best. We encourage as much testing as possible throughout the cycle. That means trying to sell your product and vision before you've even built anything, to see how much customers are willing to pay. Spending time on making things as detailed oriented as possible is likely not the best use of an entrepreneurs time. Instead, rough estimates, and evidence of testing your theories should be enough.


Ted:

We create sales forecasts for each product and work backwards from there.


David:

The best way to back up revenue and gross margin forecasts is by providing an impartial third party that can validate the data for me. I am not referring to an advisory board that has equity in the company, but truly impartial parties. Because 21Ventures is aware that this can sometimes be costly for the entrepreneur, we occasionally hire our own third party consultants to evaluate the validity the forecasts. In the case of clean technology, an economist isn't good enough. We need the third party to have an economic and science background to be effective in this role.

3 - How should you describe the size of the potential market?



Dave:

There are only two ways. Modeling of a competitor, or estimations.

Ric:

If it is an existing market state the published numbers. Understand your value and the number of prospective customers.

John:

For a completely new market this would be a pure guess. What the investor wants to see is the logic and thought that went into this determination. For a market that exists one needs to relate the product or service to existing metrics.

Harley:

See answer above. I always prefer candor over exaggeration when meeting entrepreneurs for pitch-presentations. Try and stay modest, generally, but especially when it comes to giving numbers. There is no way the founders of a Facebook-type site could have ever predicted that the size of their market could reach 350 million to a billion users, and had they boasted such figures at their inception, it would have been likely that someone in the room would have laughed. While it may be true that the market for, say, a new online t-shirt retailer is the same as the market for anyone who buys t-shirts in brick and mortar retailers, and is within the ‘online-age bracket’, this is surely not the case, and the online market is probably a 10 to 25 percent of that size (compare Amazon’s annual sales to Walmart’s).


Farhan:

Using research data as well as the maths of consumption. i.e. if you were trying to determine the size of the market for McDonalds you would figure out:
  • number of people who eat fast food
  • number of times per day they eat fast food
  • amount they spend when purchasing fast food
  • etc..
Ted:

Research. We produce and sell consumer products and don’t have a problem describing the size of our various markets.


David:

Bottom-up analysis is key. Research from Forrestor or any other analyst firm is useless to me. I need to hear the assumptions laid out for me and then to investigate if they are credible or not. How can we know what the potential market is for leafy greens grown with aeroponic technology? Build the business case for me. How many potential grocers could potentially benefit from this technology? What percentage are likely to be early adopters? How long before early adopters branch out into the mainstream? I need to hear the assumptions directly from the CEO. If he can't answer those questions without referring to Excel spreadsheets and PowerPoint presentations then he or she hasn't done their homework.

4 - In the "Business Model", how do you best estimate how much someone would be willing to pay for service/product


Dave:

Cost & Demand Curve are the two biggest factors. Others include Legal/Environmental, profit/revenue maximization, Differentiation, survival, value, consumer psychology, positioning, and brand identity versus simple branding.


Ric:

What is the value it brings? (cost savings of X, efficiency of Y, scale of Z) What are similar products in the space priced at?

John:

If a comparable product exists in the market, the new product must be significantly cheaper than the existing product. If the product has some must have features or does not have comparable then some pricing flexibility exists. If this is so then one tries to establish the elasticity of the product thru trial and error.

Harley:

I once had a mentor who taught me that if you buy a widget for 1$, you don’t sell it for 2$ or even 10$, rather you sell it for how ever much someone (or the market) is willing to pay for it. There are many terms for this concept; Adam Smith suggested that the ‘invisible hand’ will regulate markets, and many of my MBA professors would suggest that you price accordingly to your nearest competitor. Ultimately, I think it depends on where you are in the life cycle of your business. When we launched Finkinc, we initially out-priced every one of our competitors in an effort to acquire new customers and get our ball rolling, even though we were a very close to our break even point. Our margins, and price points, rose considerably in the subsequent years, however it remains a company policy of ours to adjust our pricing as necessary when engaging new potential customers. I believe that one’s margin, or selling price, should be determined on a case by case basis, and should reflect the most important factor facing the company, be it growth or profitability, or simply building strong brand awareness regardless of the cost.


Farhan:

The only way to do this is to test it. I'm a big fan of trying to sell something either in-person or online, before you've built it in order to understand the need for the product and also willingness to pay. I don't think guessing works.

Ted:

We look at comparable products. What prices are our competitors able to charge?


David:

Value pricing analysis instead of cost plus analysis. I always ask the CEO to answer two questions for me; a)what is the return on investment for their customers? and b) what is the normal ROI in their specific industry. Is it a three year payback or a one year payback? Those are very different propositions. Walk me through your analysis and I will go meet with some potential customers and see if the assumptions are correct.


5 - How do you convert the market size into gross revenue?

Dave:

This depends on profit/revenue maximization, Differentiation, overhead, value, and demand.

Ric:

Figure out how many customers you can reach and serve well prior to adding headcount. Then add water as needed.

John:

For the first year, we do a bottom up analysis. List all your customers and the amounts they will buy (angels will of course confirm this). For the second and third years add in some potential customers and the remaining years all potential customers. This should be a very small percentage of the overall market. Given the assumed growth rate check to see if the R&D and support costs are appropriate.

Harley:

[repeat of Harley's last answer]

Farhan
:

There are many models for this, one easy way is to simply determine what % market share you can acquire. Again, I'm not an advocate of spending loads of time on analysis, but rather build it, test it in the wild and refine.

Ted:

We don’t do those machinations, which I never find convincing.


David:

Tell me the about the appetite for your technology/service. How willing will customers be to adopt the solution? How long do you project early adopters to translate into mainstream adoption? Throw away your spreadsheet. Take out a piece of paper and show me your forecast and explain it outside. I am a huge skeptic of powerpoint end excel which I believe create a "theater of authority."

6 - How to best outline your R&D costs, marketing costs, and support costs to determine what your margin would be after incurring these costs

Dave:

I always use a simple formula of 5xCost. If I can't hit that mark as a minimum, it's probably not a worthy endeavor. Others banty about 3x or 4x, but their clients are broke.

Ric:

In a standard proforma layout. A good exercise regardless. Although I once had a VC tell me otherwise. He said Ric I like you. You are a smart guy. But if you hit the targets in your proformas you would be the first Entrepreneur that I have ever seen do it – save it.

It made me chuckle. One guess what coast he was on?

Harley:

In my experience, I believe that one’s ability to spend money on R&D and marketing should be determined based on the company’s financial situation and revenue model. While I may allocate 20% of our annual budget to marketing for our collegiate promotions company, I tend to spend a significantly larger percentage on Smoofer.com, our online t-shirt shop. The reason for this is simple; they are very different business models and no two businesses are exactly the same. My advice here is to simply try out a few different ratios of sales-to-marketing dollars (or R&D if that is the case) and with continuous evaluation and constant monitoring you will eventually find your winning formula.


Farhan:


A high-level income statement will get you what you need here. Again, a rough estimate (not spending too much time on the nitty gritty details) is what's warranted.


Ted:


I’m not sure I understand the question. We show these expenses on our financial projection spreadsheets.


David:

Again, show your math. Validate your assumptions for me off the page with regard to R&D, marketing and support costs.


7 - When talking about advertising revenue as part of a business model, how should one go about it?


Dave:

With tea or over a beer - Seriously! Advertising is NOT revenue. Anyone thinking of it as attached to revenue should consider getting coaching on their business. Revenue is a result of sales and nothing else. Revenues come from sales. Sales can be generated from marketing, PR, advertising, relationships, distribution, etc. When anyone ever mentions Advertising as an adjective for revenue, I know that they have been poorly schooled and will require quite a bit of work. They will get just as much out of CEO Space, but should plan to go about 10x in two years, in order to fast track their business. This will keep them from being one of the 95% of businesses that fail in the first year, and the 80% of what's left that fail after two years.


Ric:

Don’t lead with it. Have other revenue opportunities where you can better control your destiny.

Harley:

Again, I believe it depends on your business model. If you are an online retailer (like Smoofer or a Zappos) my suggestion is to stick to your value proposition, which is selling goods to customers. But if your business model is blog or freebie dating site (like a PlentyofFish.com) than you will need to rely heavily on ad revenue. The point is not to be ‘everything to everyone’ which means making certain sacrifices. The likes of eBay and Amazon are now at a point where they can post ads on their shopping platforms, but if one of my sites did that I would anticipate considerable push back from our customers who came to buy a t-shirt and not be inundated with Ad Sense or banners from ad clients. To reiterate, if your business plan is about selling ad space than pitch it, but if your model is completely different, and ad revenue is simply a way to make some extra money, I would suggest sticking to the core product/service and leaving the rest aside.


Farhan:

We can look at this, in a similar way to market sizing. Let's take a mobile application as an example. If you estimate:
  • # of downloads
  • # of page views
  • % of pages with ads
  • % click through rate
  • $ cost per click
  • you can end up with a ball park estimate
Ted:

Very carefully and realistically.


David:

As a cleantech fund, 21Ventures doesn't invest in ad-based revenue models.

Interviewees:

Dave Phillipson
CEO Space
www.GlobalCEOspace.com

Ric Fleisher - Serial entrepreneur and an LP in a fund.

John Ason - As an angel investor who typically invests in one or two people in a garage most if these questions are really not answered. What I rely on is a gut feeling that the entrepreneur is smart enough and aggressive enough to build a successful company. Even with this 60% of my companies fail totally, which is typical for early stage angel investors.

Harley Finkelstein is a serial entrepreneur, having launched a number of successful startups, and the founder of one of Canada’s leading apparel companies, Finkinc. Additionally, Harley serves as a mentor to the Ottawa Centre for Research and Innovation (OCRI), sits on the financing committee for the Canadian Youth Business Foundation (CYBF), and is an advisor to both the Canadian Internet Policy and Public Interest Clinic (CIPPIC), and to the Ottawa Community Loan Fund (OCLF).

In 2007, Harley co-founded Innoventure Capital, a unique seed financing firm that provides funding and strong mentorship to early-stage startups. Innoventure’s latest startup is Smoofer.com, which purports to be Canada’s leading online t-shirt shop. Harley recently received his law degree from the University of Ottawa, and completed his MBA at the school’s management faculty in the summer of 2009. He is also the co-founder of the school’s Law/MBA Student Society, and the ‘Canadian MBA Oath‘. As of September 2009, Harley will be working with one of Toronto’s leading business law firms where he’ll be focusing on corporate finance and commercial law.

Harley may be reached at: Harley[at]superangel.ca


www.superangel.ca

Years - 3
Companies under mgmt - 4 to 6

Farhan Thawar
Dean of Studies
Extreme Venture Partners
farhan [at] extremevp.com
www.twitter.com/fnthawar
txt me: www.awayfind.com/fnthawar

Ted Scofield - I have been in the business for about 12 years, as both a consultant/attorney for start-ups and investors, and as the owner of a company that received angel funding during its pre-revenue phase.

As a securities attorney & consultant, I advise entrepreneurs as they launch their companies. (Occasionally I bring money to the table as well, when I see a quick exit.) Recently I worked with a company from its pre-launch phase all the way to its IPO.

As an entrepreneur myself, my wife & I launched a consumer products company a few years ago with pre-revenue angel funding. We now have products for sale nation-wide at Barnes & Noble, Kohl's, etc.

David Anthony
- Managing director of 21Ventures (http://www.21ventures.net) - an early stage cleantech VC that has invested more than $400 million in just over 40 cleantech companies.

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