We at Seedcamp know that entrepreneurship doesn’t stop for the holiday season. Because of that we decided to put out to the startup community this inspirational series of videos covering the master classes we had during Seedcamp Week 2012. One per day until the New Year! Hope you enjoy them:
Our Christmas treat of today is a keynote speech by Ciaran Rooney from Skimlinks where he shares his journey on building Skimlinks to scale. Today, more than 14 billion API calls are served per month. This master class was part of Product Day during Seedcamp Week.
We at Seedcamp know that entrepreneurship doesn’t stop for the holiday season. Because of that we decided to put out to the startup community this inspirational series of videos covering the master classes we had during Seedcamp Week 2012. One per day until the New Year! Hope you enjoy them:
On our first post for the holiday season we recap a master class from Product Day during Seedcamp by the IDEO team. In this talk they give a brief introduction to user-led design.
The Best Ways to Reach out to an Investor by Carlos Eduardo Espinal @cee
Getting in touch with an investor is probably one of the hardest and most frustrating things to do. It is usually, step 1 in a fundraising process. As such, it isn’t to be taken lightly… The worst thing you can do, frankly, is the non-descript email to the info@investorsdomain dot com email that goes to no one.
Just don’t do it.
1) Research the Investor and his or her firm. The worst thing you can do is reach out to someone that invests in the wrong sector or stage of your business. Review their website. Read about what they are interested in, professionally and personally. This will make your interaction with the investor far more relevant.
2) Rely on a 3rd party for an introduction. If you can find someone that knows them, that introduction will serve you far better than reaching them directly. One tool I use is LinkedIn to find out who of my network knows them. This makes the introduction process far more relevant.
3) Keep your initial email short and to the point. Don’t over do it content wise and length wise, otherwise you are likely to have the investor gloss over the sheer mass of your email and relegate the email to the ‘to read’ bucket.
4) Think of your initial email as merely a ‘preview’ or elevator pitch and with a call to action, such as for more information if they are interested in the idea.
5) Don’t forget to thank the person who introduced you. If you want to, feel free to keep them updated on the conversation as well, but remove them from the cc of the initial intro email. You don’t want to overburden their inbox either!
6) Twitter is increasingly becoming an efficient tool for contacting people for quick things… if used sparingly and in a very specific and non-generic way, you can @ reply someone you are interested in to engage in a conversation or comment on what they said as a starter, but use this tool sparingly, don’t tweet-stalk someone.
7) Get out of the Office! Go to networking events. When there, find people to introduce you to them or network your way into the conversation, avoid interrupting ongoing conversations, but don’t be afraid to be friendly and try and work your way into the conversation if they are open to it, if they seem engaged, back away and come back later. Remember, you might be a ‘relief’ to the conversation they are having, but you don’t want to be the ‘distraction’ either.. feel it out, but don’t be afraid to take the risk…. and get to the point quickly. You have about 30 seconds to make your conversation with someone, anyone, relevant to them. BTW, If an investor gives you feedback during this conversation, the worst thing you can do, also, is to come across as defensive.. that will make you stand out for all the wrong reasons.
I hope that helps…
Remember, Investors are just as eager to meet you as you are them.. they are just very time-starved and don’t want to waste time on opportunities that are likely not for them.
Setting Appropriate Milestones in an Early-Stage Startup by Carlos Eduardo Espinal @cee
Updated Nov 11, 2013 – See bottom of post for update.
When looking to plan for your company’s growth strategy or to go fundraising, it’ll serve you and your company well to break down what you need to do in terms of projected milestones. Technically speaking, I believe a milestone is a future ‘marker’ within your company’s stated growth trajectory.
Therefore, milestones, in the context of startups, are effectively points in time along the company’s timeline prior to a future event or goal. These points in time are usually defining points in a company’s history… such as a key hire, a product launch, a certain number of users, a retention rate, first revenues, first profit, etc.
Rather than the goal itself (an example goal could be to create a successful, cash-self-sufficient company, that provides tangible value to its customers and is floated on the public market), milestones are a subset of ‘the goal’. As such, milestones of any size can be created throughout the lifetime of your company as it progresses to your company’s ultimate goal.
Milestones are important from a fundraising point of view because they can define whether a company is caught with little to show to potential investors at the point of fundraising or with a strong showing of what the company’s been able to accomplish to date.
Lets, for example, look at the following points in a company’s history (I’m making the timing up for example only, don’t assume these are ideal timings):
If a company knows how much money they need at all points in the timeline (see the article on how much money should I raise), then the question is which is the best milestone to fundraise on?
From an investor’s psychology point of view, risk is what is being managed. Minimization of risk while not losing an opportunity to invest in a hot company is the balance game that all investors play. Investors are constantly trying to find the least risky point to invest in a company relative to what they afford to invest (valuation) and the ability for them to invest (there is space in the investment round for new investors).
As such, the best time for a company to fund raise is either right before the completion of a key milestone or right after the completion of key milestone but before too much time lapses right after its completion such that there isn’t a sustainability of the reached milestone.
Let me explain. First, let’s look at the psychology of investing right before a key milestone is completed:
If an investor feels confident that the company is on track to hit its milestone, the investor knows that once the company succeeds, the company will inherently be more valuable to the outside market because it has been meaningfully de-risked by some amount. As such, the investor wants to ‘get in’ on the deal right before ‘launch’ for example, so that they can get a specific valuation while the company is still a little bit riskier, but not overly so.
This makes sense and is therefore quite simple to understand, but only companies that can instil confidence in potential investors of managing growth post milestone completion, generally get investors rushing to get this done. However, it’s a great for a start-up to be in, because generally, for things like a product-launch milestone, it is easier to control than say, a specific user growth rate.
Now let’s look at the psychology of investing post a key milestone being completed:
If an investor feels like he wants to ‘stall’ to see if the company is completed, or the number of users hit, etc.… then he is trying to effectively fully de-risk the investment before committing cash. However, he knows that being playing the cards this way, other players will also be on the table quite quickly because the company is not only attractive to him, but also to many others that were standing by the sidelines waiting to see what the company would do (relative to their risk profiles as in, this doesn’t mean that late stage investors, for example, will change their mind to invest in your company). Therefore, the investor in question wants to get in before the company is too valuable for them to invest in.
Therefore, the art of picking milestones is trying to determine which ones are the key ones to focus on.
As a rule of thumb, these are the biggest ones:
Human Resources – Hiring key people that will make a huge impact on your organization (not just employees for workload purposes, but like a shit-hot marketing person, for example).
“In terms of team growth, I believe there are other significant milestones, where organization changes happen roughly every doubling in size: founding team (usually 3 -5) expands to 7 -12, expands to 25-30, expands to 50-70, then above 100 and beyond. More often I see companies do quick jumps rather than continuous growth, and the jumps are always followed by significant growth management challenges.”*
Product – Product launches vs. version releases
Market – Market validation. As in, first customers, or first paying customers, etc.
Funding – Maybe some money being committed to a round that the investor in question can lead or participate in.
You can break these down into smaller and smaller ones if you’d like, but that’s where you start having to make judgement calls as to what is meaningful and what is not.
Other examples of milestones include*:
Just keep in mind, milestones are all about moving from one stage of risk to the next. As you start planning your fundraising strategy, you want to make sure you time it so that you have ample time to fundraise so that you are in control of which milestone your company hits when. You just want to make sure your fundraising strategy uses these milestones to your benefit and not get caught between them and stranded for cash.
* Additional Comments from Bostjan Spetic of Zemanta.com
Update Note from Nov. 11, 2013
You should raise as much money as you can, but at least enough money for you to accomplish your next most meaningful ‘validated’ milestone + some buffer funds to help you spend time fundraising afterwards. This means you should look at a variety of points across your company’s timeline to see which can be made into meaningful milestones.
Whichever country you are in, you will have different fundraising challenges depending on the mix of individual and institutional investors. In a country where the funding comes mostly from individuals, you will likely not be able to raise substantially large rounds, in countries where you have access to organised groups of individuals, you’ll have access to larger rounds, and in countries where you have access to many institutional investors, you will likely be able to raise the largest rounds.
If you want to go for really really big, you should go to the geography where you can get that meaningful amount. Otherwise you will be underfunded, regardless. Keep in mind that in those markets, costs of running startups are going to be higher, so you need to include that in your plan.. hiring star coders, for example, in the USA is very very hard these days.
In markets where you are not going to be able to raise the appropriate amount you need up front, try and articulate your requested amount this way: “This is what I need [big number], but this is what I can accomplish [milestones] with this [smaller number]”
Managing the Legal Process in an Early Stage Startup
by Carlos Eduardo Espinal @cee
One of the most time consuming things founders have to do other than raise money is deal with all the legal paperwork pre and post termsheet that fundraising typically generates. Not only can the legal process be time consuming, but also it can be emotionally difficult depending on how many items are being discussed before finalizing.
While there is no standard process (largely due to the variability in deal types and jurisdictional issues) that can be outlined for how to deal with your unique legal situation, I’d like to propose a few tips that might help you navigate your process along the way. As such, read this post not so much as a how-to, but more-so as a list of things to consider while going through your investment documents.
0) Always be mindful that the most important thing you have at your disposal is your word. If you make promises, keep them. Create trust between everyone you deal with. Say what you mean and mean what you say, and ask questions if you’re not sure. This will help build you a good reputation that will greatly help you along your way.
1) If you aren’t incorporated yet, or if you’ve just started working on an idea with friends, have a pre-founder and advisor arrangements (relating to splits and vesting) agreed before lawyers start drafting stuff later. Lawyers often need to change docs several times to accommodate founders changing their minds or negotiations taking a different turn before the legal docs. We’ve put up a document on our Seedhack site called the Founder’s Collaboration Agreement, which you can use if you don’t have something like this. I assume that for most of you this is not a relevant point, but perhaps for some of the newer teams that haven’t incorporated yet.
2) Always check what your legal responsibilities with existing shareholders are before taking any decisions with or without them. When you have existing shareholders, involve them (including the distribution of information about the new round) as per whatever rights they may have agreed with you as part of their investment documentation. If this means you need to inform them, then inform them, if this means you need to ask them something, then ask them, but don’t leave it to the last minute. Generally speaking, they’ll try and be helpful, but depending on how busy they are, they can take a while, so don’t leave it for the last minute.
3) Don’t be annoying:
a) Lawyers cost money for both sides of the table. Do as much research as possible on your own and try and aggregate your questions as much as possible so that you use your lawyers and their lawyer’s time efficiently. b) Make sure you have a position on items that are being discussed so that you don’t go back and forth on stuff on the phone or after decisions have been made. Nothing is more annoying than backtracking in legal processes. c) Don’t let your lawyer get annoying or overly aggressive with your investor. The investor can always walk away if you and your lawyer are coming across as overly difficult and asking for stuff that might actually be destructive for the company in their view. Be assertive for sure, but don’t be divisive. Seek to understand the issues and always think creatively on how to solve them rather than letting the lawyers get into a stalemate or in an argument with your potential investor. Always feel free to say “let’s park this point for now and return to it after we’ve had to consider it”. d) Don’t let paranoia of what others could do to screw you get the better of you. It is OK to be slightly paranoid (I know I am), but don’t let it be so bad that you make the legal process feel painful as you come up with bogus reasons by which to reject perfectly common clauses in an investors proposed documentation.
4) Legal documents have two parts, the commercial stuff (like valuations, percentages, etc) and legal stuff (like which jurisdiction, which filing/reporting procedures, etc). Get all or as much of the commercial points agreed between you and the investor before involving the lawyers (this is effectively what the termsheet is, but sometimes some stuff slips into the subsequent docs to keep the termsheet ‘light’) so that the lawyers are just left with representing these on your documents. If you need to have a discussion on a commercial point, do it with the investor alone and offline (even if you had to ask your lawyer or another shareholder for advice) you shouldn’t spend time on the phone with lawyers negotiating commercial points. Lawyers will help you through the technical points.
5) Always ‘red line’ any changes you make to documents. Keep track of all changes. Use track changing on Word. Google Docs may have this, but lawyers don’t use Google Docs generally.
6) Generally speaking.. and this is just a general rule… conversations are Founder <> Investors and Lawyer <> Lawyer.. meaning, you rarely speak to the counsel of the Investor directly or the Investor with your counsel directly without you guys being on the phone with them.
7) Keep CALM AT ALL TIMES. If you lose it, you will lose it.
8) Always seek solutions. There are multiple ways to skin a cat. Any issue can usually be solved via some creativity. The lawyers aren’t there to come up with stuff for you, you have to sometimes be the one (along with the investor) that can come up with solutions and then the lawyer’s articulate it legally. Although.. Don’t get too creative too, cause that can burn you.
9) Most of you are using lawyers that have been recommended and are experienced, but maybe you are struggling with your current counsel and are looking to switch. It is important that you get good counsel (read my post on this here). Don’t be cheap on this one. You’ll regret it later.
10) Do propose using standard documentation that other lawyers have frequently seen, in the USA consider using the Series Seed docs, or here in Europe, the Seedsummit docs which are based on the US Series Seed docs, or the BVCA ones, etc. there are probably a few more out there, just familiarize yourself with a few to ask them if the ones they send you are based on ‘standards’ as that will reduce everyone’s workload.
11) Managing the closing process. This is a difficult one and in the UK, with deed execution requirements can be difficult, but when there are multiple angels involved lawyers often spend a lot of time getting signatures and it increases the costs that founders don’t want to pay (I just heard of a deal that had 9 angels and the lawyer spent 20 hours managing that process for the entrepreneur, thus ended up overall 3x over budget). Sometimes, you as founder, can handle this but best case is if one of the leading angels takes charge of this process, we have seen this and it has been really good but you can’t count on having that organized person being on board, so be prepared to be ‘that guy’.
12) Do your due diligence homework. Get your IP agreements, employment agreements, etc organized to help the process go by faster and smoother for your new investor as they will likely have to review these documents.
Hope that helps, and feel free to add your suggestions in the comment section below!
How much money should I raise from an Early-Stage Investor?
by Carlos Eduardo Espinal @ceduardo
Raising money for your startup is never fun. It takes time, distracts you from developing your product, is fraught with emotional ups & downs, and doesn’t have a guaranteed outcome. Frankly, many founders would rather go jump into an icy lake than take another fund raising meeting where they aren’t sure what they should say to ‘convince’ an already hesitant investor to open their purse strings and invest in their company.
So, back to the main question… how much money should I raise?
The flippantly short version of the answer is, “as much as you can”… but in some cases, more isn’t necessarily better. Although you should raise as much money as your company needs to achieve major proof-points/milestones, overfunding a company can also have its drawbacks.
Let me explain this last point before going further on the ‘how much money should I raise’ question:
Many founders are obsessed about raising as much money as possible all at once because well, if you do raise a big war chest, then that’s one less problem you need to worry about. However, with a large amount of money come several potential problems:
1) With more money usually come more investment terms and more due diligence. It is probably a fair statement to say that the more money involved, the more control provisions an investor will want as well as more diligence to make sure that their money isn’t going to be misused.
2) A high implied post-money valuation. In order to accommodate a large round, investors need to adjust your valuation accordingly. For example, if your business is objectively worth 1 million, but you are raising 2m, unless the investor plans on owning 66% of the company after investment, they need to adjust the valuation upward (I’ll abstain from giving ranges for now). Having an artificially higher valuation prematurely can put a lot of strain on a startup if things don’t go well and then later need to raise money again, as it increases the likelihood of a subsequent round being a down-round (when you take a negative hit to your valuation) or rather, other new investors passing on the deal in the future because it is ‘too expensive’.
3) A propensity to misuse ‘easy money’. You could argue this point from a psychological point of view if you wanted, but suffice it to say, I know many VCs that believe that over-funding a company leads to financial laxity, lack of focus, and overspending by the management team. Perhaps it is lingering fear over the hey-days of the late 90′s were parties were rife, and everyone got an Aeron chair, but the general fear with overfunding a company is that it will be tempted to expand faster than it can absorb employees into the culture, integrate new systems, or expand real-estate needs without substantially disrupting the efficient operations of the company.
4) A last one, which is hard to really quantify and happens only to very few startups, is the media’s reaction (positive or negative) to how much money you’ve raised relative to what you have. Think about this story, although very rare, it’s what the effect of what too much can cause.
Ok, got it, overfunding can be bad… too much money can be a bad thing, but if you said I should raise as much as I can, where do I start and what is the ‘magic’ number to ask for then?
Alright, let’s look at this question from a different point of view, as I mentioned in my previous post on how an investor evaluates your financial plan, an investor (depending on their areas of focus) may not necessarily know what the exact figures your business will need to grow to its next major milestone, but rather, the investor will rely on your ability to communicate this on your financial plan for the investor to then make a decision on whether your accurately understand your cash needs or not. Tied to this cash need is an implied understanding of your company’s milestones.
Let’s define what a milestone is before proceeding:
A milestone is a quantifiable achievement, be it in terms of product development, team expansion, or market adoption of your company’s value proposition.
Your financial plan will likely be a series of chronologically organized milestones. For example:
Month 6 – Hire UX guy to optimize app Month 8 – Launch mobile app Month 10 – Start charging on the mobile app Month 11 – Hit 10,000 users Month 12 – Launch partnership with key distributor Month 18- Hire CMO
These are all milestones. Some more important than others, and frankly an investor will likely want to talk to you about the importance of each one of them to get a feeling for which ones are the key ones to focus on to determine if your business is going to ‘take off’.
The reason for this is simple, the best time to go fund raising, is RIGHT BEFORE or SHORTLY AFTER the successful completion of a key or series of key milestones. For example, right before a key milestone, you can woo new investors with the promise of how successful you will be at the completion of the milestone and basically you convince them that if they don’t get into your company by investing now, that they won’t have a chance after you’ve achieved the milestone because many others will also be interested and the competition will be stiff (remember, investors don’t want to lose out on potentially hot deals). Shortly after achieving a key milestone is also a good time to try and convince investors because you’ve effectively accomplished a major thing (like launching a product), which de-risks the investment for them, but they can still get in the company before it ‘takes off’. Frankly, the worst time to go fundraising is when your last major milestone has grown stale and the next one is too far away to be de-risked. So, this is why it is key to know your milestones, and when they are happening.
Parallel to this milestone timeline is the ‘cash timeline’. As in, how much money, in aggregate, you will have spent to get there. So using my examples from above:
Month 6 – 60K Month 8 – 80K Month 10 – 100K Month 11 – 110K Month 12 – 120K Month 18 – 240K
Ignore whether this is a realistic example for your business for the time being, but I’ve assumed a 10K cash burn on this example up to the end of year 1, and then starting in Year 2, I’ve assumed 20K monthly cash burn. If you don’t know what your monthly cash burn is, you’re in trouble. Monthly Cash Burn is a KEY figure to know before meeting any investor.
As you can see, an investor could choose any of the milestones above to focus on for your cash needs. The idea is simple, fund your company through the achievement of major milestone(s) (to reduce investment risk and to see if your company has any traction before putting more money in) and then go fund-raising for more money, hopefully on a strong note, where you will have met your timelines and expected outcome (be it market traction, or successful completion of your product, or hiring of the appropriate person).
For example, an Angel investor (someone that usually invests from their own money) typically can’t invest millions, so their investments tend to be less than 300K. However, they’ll want to make sure your business is going somewhere before putting all their money in, so it’s likely they’ll want to come in early to give you enough cash to achieve something plus a little extra to help you fund-raise after, but also to see how you achieve the milestone before putting in more. So, perhaps this Angel may opt for funding you through month 10 with your requirement of 100K plus a few more for fund-raising. This would get you through your product’s launch and give you a couple of months to see how it goes in terms of market traction (all the time you will be speaking to new potential investors) so that you can have something strong to talk about for fundraising purposes.
Alternatively, an institutional investor (one that invests other people’s money as well as their own), say a VC fund, may see that your company has some real potential in what it is trying to do, sees that you have a plan that requires 100K to launch before you start trying to monetize, but with their experience of seeing your kind of business having to do a few pivots before getting the launch product 100% right, think that perhaps the best quantity to give you based on your calculations is about 500K for about a year to a year and a half. This should also give you some breathing room to work on achieving your various milestones rather than having to focus on having to be constantly in fund-raising mode.
So now you are probably asking yourself, how is it that some investors have different perceptions of how much money I need and wish to give me? Effectively, how much money does an investor ACTUALLY think I need vis-a-vis what I ask for?
Your exact calculations may have said that you needed 100K to launch your product, but an experienced investor may have seen various companies like yours and seen that there are usually mistakes done along the way that consume cash without quantifiable progress towards the agreed milestone (you may have learned something, but you may be delayed in your launch because of some screw up). Because of this, investors some times include ‘buffers’ into the number they offer you in a deal. This buffer could come from the various sensitivity analysis the investor did, such as, what if the company is delayed in launching their product by two months, or what if the company can’t find that key employee, or what if the company can’t start charging for their product for an extra few months, or what if the product needs a pivot, or what if people aren’t willing to pay what the company expected? All these things will affect the cash flow of the company and because of them, the investor may assume some or all will occur, leading to the company needing more money than was planned by the founder. Effectively, your 100K in a perfect execution timeline, may actually be 250K after some minor delays and mistakes, and with the extra cash the investor in my example above gave you, you now may have enough cash to go fund-raise without having to panic about having to get cash in ‘yesterday’ or be constantly in fund-raising mode.
Keep in mind that this larger amount an investor may be willing to give you will also affect your valuation range, too much and it ‘inflates’ the valuation range your company sits in (as per my point number 2 in the intro), so an investor won’t give you ‘excessive’ buffer so that it forces the company to be ‘overpriced’ for them and for the company’s future. Inversely, hopefully you can also see where an investor may deem a company to be ‘underfunded’ if it doesn’t have enough money to get to where it can achieve a meaningful milestone(s) upon which to go fundraising with a strong foot forward for future investors to be attracted.
In conclusion, raise as much as you can but understanding your monthly cash burn and map out your company’s important timelines and the cash you will realistically require to achieve them. Then have an engaging conversation with your potential investors as to how much they think you need based on their experience. As a rule of thumb, try and raise enough money so that you have time to go fund raising after you’ve accomplished your next key milestone(s). In a future post I’ll discuss how much time you should set aside for fundraising, but to make the rule-of-thumb complete, add AT LEAST 6 months to the amount of money you need for your next milestone to include time to go fundraising.
Hope this helps.
Update 1:
A friend of mine emailed in and mentioned that perhaps there was a difference in how investors from different geographies look at this issue of how much they want to invest in a company up front, and yes… I would agree with that statement, but the point of my post is merely to provide the reader with a ‘framework’ by which to approach the question of how much to raise, not so much to answer the multiple varied ways that investors might look at the amount required and subsequent fundraise amount. For example, some investors may choose to just want to back the team and thus will just give them an amount that they think startups typically get for the stage the company is in, and others will give an amount of money merely to exclude the investor competition from winning the deal from them!
However, I believe the framework I’ve mentioned in this post can help a founder assess how much money they may need for a period of upcoming time no matter the risk averseness (or not) of the investors they meet with. Whereas a bolder investor may not really focus on minor milestones, but rather just focus on a larger one such as ‘grow the network’ and for that the amounts invested is done with far less due diligence and far more quickly, a more risk averse investor will probably be more specific about what you plan on accomplishing with his money.
In the end, the most important thing, is to be keenly aware of your cash needs on a month by month basis, so that if the question comes up, you know how much you plan on spending and by when. You should also focus on raising enough money in your timeline so that you also have time to accomplish your key milestone(s) before going fundraising again, and lastly you should include enough buffer in your last fund raise to help you through your next fundraising period post-milestone. If you meet an investor that wants to invest a lot quickly, great, if you meet with various investors that are more risk-averse, at least you won’t get caught not understanding your execution plan. If you want another rule of thumb, many Early-Stage VCs will look at the next 12month to 18month worth of cash needs + a buffer to estimate the cash needs of a company. Add to that 6 months of additional cash burn and you have a rough starting point for a ‘headline figure’ from which to start discussions.
Hope this helps clarify the question further..
How does an Early-Stage Investor Review your Financial Plan?
by Carlos Eduardo Espinal @ceduardo
You are about to go meet an investor… you’ve read on the web and heard differing views from people on whether you need a financial plan… some say you don’t, it’s a waste of time as its all made up numbers anyway… others say, you absolutely need a financial plan… so you walk into an investor meeting full of anxiety as to whether not having something is going to reflect poorly on you or if what you’ve created (if you did create something) will be crap in the investors eyes… so what to do?
The financial plan, for most tech-focused early-stage founders, is probably one of the most dreaded bits of the investment pack to send your prospective early-stage investors. The variety of opinions online don’t help either as they just confuse the matter…
Let’s face it, as much as we’d like to think we can predict the future with all sorts of fancy extrapolations on growth rates… but we can’t… Considering that most people create financial projections based on assumptions of what needs to happen for an upcoming month’s worth of operating events to happen and then project from there for x number of months or years, you effectively create a series of increasingly improbable chronological events with the last event (month) in the series being effectively a function of the compounded set of decreasing probabilities, all of which are asymptotically approaching zero percent in their likelihood of happening “according to the plan”.
What’s my point? Well, that your financial plan isn’t worth much from an accuracy perspective. So what then? If my numbers are crap, why bother with whole financials nonsense?
It is in its forensic analysis of your thinking behind the model, however, where an early-stage investor really gets a feel for how you think and how you want to direct your company in the near future. Next, it is in how your cash will be used efficiently to accomplish the mutually agreed goals.
Before we continue further, I want to clarify that I’m not going to discuss how it is that you should format your financials, or explain basic accounting principles, or how financial statements work. There are plenty of resources online that can help you with that. Rather I want to explore how an early-stage investor (well, at least myself) forensically reviews the financial plan of an early stage startup (vs. a later-stage startups where there is a historical performance record already there and with multiple years of budgets and actual figures).
So what do I mean by conducting a forensic analysis of company’s financials?
Well, I certainly don’t mean it in the sense of reviewing the financials of the startup from a post-mortem basis, but rather reviewing them with the same level of scrutiny on ‘reasons’ why things may have occurred or may occur as one sees on TV shows like CSI. Effectively, I’m looking for what are the cause & effects of each of the numbers and what are the key assumptions behind them, with emphasis on the word “assumptions”. The verbal discussion with the entrepreneur’s financials will focus entirely on their assumptions and the reasoning behind them.
When an investor is discussing numbers (which may be entirely wrong from a future-perspective) with an entrepreneur, if the entrepreneur shows a solid understanding on why the numbers are there, having a clear view of the market dynamics in which their company operates, with realistic customer acquisition assumptions, realistic hiring plans, effective use of marketing budgets, appropriate expenses for a growing company, it can have a HUGE impact on establishing the necessary credibility of competence an entrepreneur needs to inspire confidence in the investor. The opposite, seeing a financial plan with current month revenues/expenses projected five years into the future assuming linear or exponential growth in all aspects of the organization and then stated with a confidence of ‘this is what we realistically expect to happen’ can be both demoralizing for an investor if not outright humorous.
Let me share with you a little secret: With a few exceptions, you will always know your industry and its numbers better than any investor will. However, an experienced investor will ask you the right questions to ascertain whether or not you know your industry well enough to increase the probability of your own company’s success. As such, really do your homework… by homework I mean, don’t just go out and build a product and hope there will be customers. If you take the Lean Methodology approach, for example, as soon as you have customer validation, make an effort to understand the market dynamics of that customer… how many of them are there? What is their concentration? How do you reach them? Are they locked in with a competitor with some sort of monthly or annual contract? Do they buy in a cyclical pattern? Do they prefer to buy online or only from salespeople? Do they need help with setting up your product or can they use it as is? What are they generally willing to pay for other similar services? How is the market growing? Mind you that in some circumstances the ability to ‘charge’ money of your customers may not be deemed the real potential for revenues at first (think Twitter 3 years ago), but again it is how you articulate the future value that matters.
If you take all those questions and research them, what you will find are key components of what will make up the assumptions on your future revenues (or value creation objective). Perhaps your customers are only willing to buy your product during the holiday season, so you will have a hard time with cash coming into your company during the off-season. Financials that didn’t take that into consideration would look to an investor as somewhat unrealistic, not in the numbers, but in the market dynamics of your product. Take other assumptions for example, if you can only reach your customers via another party (perhaps a distributor?)… As in you aren’t directly selling to your end customer, how does that affect the time until you get cash, and the amount of customers you get all at once (or lose all at once)? How long are your customers likely to stay within your service (churn)?
Again, all of these examples are about doing your homework on how your company will operate within its industry and how it will acquire customers. The better you can explain the reasons why a number in your financial model is based on a realistic set of assumptions, the better off you will be. But look at it another way… while you are doing this exercise, you will realize whether there is actually a business that can make money (or other method of value creation) or not. For example, if you do the analysis and find that in the sector you are exploring people aren’t willing to pay and that many other competitors are giving the product away for free, and that there aren’t many opportunities to inject ‘advertising’ as a supplementary source of revenue, you may have just saved yourself a serious amount of wasted energy!
Which brings us to the next part of the homework: the understanding of your company’s expenses. If you have found a market where your product is actually capable of generating some sort of value (note again that I’m not necessarily focusing on “revenues” because there are many ways investors define what “value creation” is, whether it be a growing user base or actual sales) the next part is how do you spend your money to match that customer growth. When do you hire new sales people (and how many sales people do you need relative to a customer sale?), when do you bring new servers online, spend on marketing, spend on new offices, laptops, etc.. Obviously the types and amounts of expenses vary from company to company, but what matters here is how they map to what you are trying to do and whether that mapping is realistic (what is your customer acquisition cost?). For example, if you have a marketing charge of $500 one month, is it realistic to expect that next month your customer sign ups will increase by 500%? Well, as I said before about the “little dirty secret”… I have no flippin’ idea, but I will expect you to tell me how the $500 will equal 500% in customer growth and I will basically evaluate the credibility of your answer. If you answer, I will buy $500 worth of flyers and pass them out, you can rest assured that I will not believe your 500% figure, but if your team’s background has a track record of low-cost viral marketing campaigns, and your answer is basically a version of that… well guess what, I might just find it plausible. I may be exaggerating the bit about having ‘no flippin idea’ as most investors will have seen enough of what works and doesn’t work to call BS, but again, if you can walk an investor credibly through your assumptions, it will do wonders for the confidence you create.
Lastly and most importantly, is the review of how the expenses map to the revenues as far as cash flow is concerned. The lifeline of a company is how much cash it has before it either dies or needs to go fund-raising again. As such, investors not only want to know how much a company needs in terms of cash to execute its vision (perhaps the subject for an upcoming post), but also on how that cash is being used. If there is a huge mismatch here or there isn’t enough time for you to reach your company’s next point of tangible progress (a validation point), this may be a point worth discussing. Much is joked about how an investor will take your revenues and cut them in half, actually an investor may outright eliminate your revenues from the overall sensitivity analysis he is doing to get a feel for how much cash your company would burn on a monthly basis at time x in your plan (you should know your current monthly burn number by heart, by the way). This is because if your company has to do a pivot or something else goes wrong, this will not only accelerate the cash drain relative to your plan, but also have an effect on when the company needs to go fund-raising again and an investor needs to take all of that into consideration as part of the investment analysis.
In summary, do your homework before you build your financial model, but definitively go through the exercise of building one. It will be hugely helpful in helping you identify how your business may need to grow in order to adapt to the sector in which it operates and how you may need to spend money in order to achieve your goals. Most importantly however, by being prepared with a thorough understanding of why everything is there within your model, the less anxious you will be when meeting potential investors… and remember, you may not know all the answers, such as how much money will it cost you to acquire a new customer, but even if you at least start with a reasonable assumption, confess that you aren’t sure about it, and then play around with a range to see if things work, that is also helpful to the investor for them to get a feel for how you can evaluate uncertain circumstances and adapt accordingly.
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