Archive for December, 2006

Making the VC cut

December 31, 2006

“ You are not VC ready “ – Startup founders often get this baffling censure from VCs ( or worse, none at all ) after they submit their Business Plan. At times, it gets on founders’ nerves and infuriates them no end. Founders like to say “ hey, now what…? We’ve developed a bug-free prototype, been thro an extensive beta,  got a brilliant team of people to work, a tried and tested mentor,  set of high quality advisers and what the hell, we’re  into year two with a good set of paying customers too…what more do you expect from us …a Microsoft rolled back in time ? ” 

Where the hell does it suck…?

I am letting you in on some inside metrics.  Too bad if you’ve tried this already.  

Uptight with strap :  Burn less capital to finance overhead before generating revenues. In other words, suck cash only if it makes revenues grow.  Stick with Top Ramen noodles for lunch, Sushi can wait. 

Burn rate is usually quoted in terms of cash spent per month.  It’s bad if the burn rate begins to exceed forecasts or revenue fails to meet expectations. The usual recourse is to reduce the burn rate by reducing overhead or by looking at ways to improve profit margins.  

Lead earnings : Companies with high operating leverage ( lower cost of incremental sales ) can make more money from each additional sale if they don’t have to increase costs to produce more sales. The minute business picks up, your assets as well as existing workers can do a whole lot more without adding to costs. Profit margins expand and earnings soar faster than revenues. ( imagine Consumer internet like travel portals, online DVD rentals etc.) So get your business to recover its fixed costs early and keep adding to the bottomline with every additional sale. This can be achieved by keeping the initial development costs low by scheduling a faster go-to-market. Secret here is to quick-brand staged product development and serializing it.  Features can be added later  which can be released as V 2.0 followed by V 3.0 etc. Take a leaf from Google and Microsoft who are masters at it. 

Strong tailwinds :  VCs have a commitment to the investors ( limited partners ) in their funds for realizing a rate of return well in excess of the market average. VCs rankings go up if they could achieve their ROI targets fast and return the money to the investors early enough.  As such, VCs prefer to lock-in $$ for as short a duration as possible. Closer your venture is to a liquidity event ( like IPO, buyout, M&A ),  more attractive it is to the VCs.  You stand a better chance of getting noticed by acquirers ( or lapped up by investors ) if your venture is highly scalable with the momentum provided by the VC money. Sooner you position yourself in the eye of the acquisition storm to get swept by it, the better.  Approach the VCs with a clear roadmap for them to exit quickly thro such events and get invited to dance. 

Be the current flavor : VCs are paranoid by nature and fear to tread alone. They prefer to move in herds.  If your venture belongs to a sector which is currently funded by some VC, you stand a fair chance unless you screw it up hopelessly. So belong to the sector which is the current flavor. Conversely, time your approach to VCs as soon as your competitor got funded. Technology / Internet / Semiconductor wave of the 90’s, followed by Biotech and Clean Energy wave are all examples you can relate here.   

Suck up to a dud : This is sure to work. Just be a bit charitable. If you know of any dud among the VC portfolio that could be useful to your early development efforts, it’s a great favor that you’re doing to him.  There are quite a few in almost every VC portfolio. Seeing an opportunity to recoup his dead investment in the dud, VC will make the dud offer everything it has including its IP for a song. So while you zoom in on a VC to pitch, remember to scan its portfolio for complementary duds. Better still, find a dud to build your idea upon. VCs are quick on the uptake,  just tell him the story nicely.  He wouldn’t miss it.  If he’s desperate enough,  you might even escape from draconian  multi-x liquidity preferences or anti dilution clauses in the term sheet.

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Deserve goddammit, don’t demand

December 14, 2006

How high a valuation can you get us from investors…?”

On the face of it, there is absolutely nothing wrong with this question from an entrepreneur.  In fact every entrepreneur must.  But not everything is right with it if it happens to be the only question that you field while you consider working with an entrepreneur in his VC pitching initiative.  It means the entrepreneur has a horrendous screening process whereby he chooses to work with someone who bids the highest even before he diligences them.  Worse still, if their attitude doesn’t let you review their business plan or executive summary ( can’t be wrong….we are Ivy league…!!! ).  All they need you for is just to “negotiate” on their behalf to get the most bang for the buck.  Wuff…self righteousness stretched too far – or is it just plain arrogance…?

I recently faced it from some first time entrepreneurs, seemingly brilliant team with proven business model with some early revnues.  Normally this breed is viewed as people who are deeply clued in about the psyche of investors and their risk-reward framework. It was a bit awkward to explain the basics of valuation to people who are supposed to be knowing it. 

At first they wanted me to sign a 3 year NDA.  Trying to create an aura around their technology which by now has almost become a cottage industry.  You don’t sign NDA with companies which are in a highly competitive sector, have a few products which have enormous competition ( my first random Googling yielded 42,500 results ),  technology is neither bleeding edge nor disruptive – simply put, nothing confidential about it.  I refused to sign it unless they compensate me for loss of  my opportunity that it might entail.

Sanity must have prevailed when they got back. This time with a high sounding Executive Summary.  ( – ah, yes, ` we are from Ivy league’  found mention 23 times in it in one form or other…! ) After several meme passages and look-at-how-great-we-are bragfest,  my `distilled’ version ( I do it all the time with boring summaries )  looked something like this.

– Company in telecom sector ( CRM / Enterprise space ),  founded in 2003 ;

– Product suites notch up a revenue of close to $1.2 MM in 2006 

– Active in the SME segment customers ; 

– 5 year projections indicate touching a revenue of  $ 190 MM by 2012 ; 

– Estimated market size $ 10 billion ;

I tagged it like this.  Brilliant team / average product / no marketing alliances / Arrogant zealots.

I quizzed myself  – why is the company targeting only 1.5% of the market even after 5 years from now…?  Is it not confident enough to get ahead of competiton…?  Or is it just lacking in ideas…?

Then I scanned the competition.  I got all my answers.

There are at least 3 real big players in the segment ( Avaya, Cisco, Nortel ) threatening to wipe out the entire lower stream in terms of cost / quality / features. They spend heavily in R&D and are miles ahead of these hedgehogs. The only advantage our guys have is that of  being small and hence nimble by default.  But that advantage is stymied to a great extent since these guys do not have the market outreach.  The big players have terrific logistics network and a good tech support backup.  They can always acquire customers by throwing in some freebies for good measure and by saying “stick with us – we are big.  Don’t take that road,  it leads to nowhere.”   Many customers will bite that argument. 

If that was the story with the big ones, even other mid segment players were eye openers.  There was this company founded in 1997, notched up revenues of $1.6 MM in first year of operations and by 2005,  were doing $ 62 MM.  ( 39 times growth over 6 years ). All this supported by over 240 resellers, presence across 64 countries and their software application having been released in 20 languages.  And… And…And  they were spending almost 30% of their annual revenues in R&D just to retain their market share thro sustained innovation.  Such futuristic initiatives had shrunk its net profit margin to under 5%,  no dividends to shareholders so far and yet the market gave it a thumbs up by giving a PE multiple of an amazing 51 times its EPS of 13 cents.   Stacked against this,  our Ivy leaguers are doing $1.2 MM in their third year and are projecting a growth of 158 times ( $ 190 MM ) by 2012,  with little or no distribution network. Their projections show a sustained net profit margin of 30% all along. Does that mean no R&D spend envisaged…?  What are the takeaways here for our guys…? 

The sand is shifting beneath your feet,  provide for sustained innovation,  your NPM is not 30%,  it’s going to be under 5% soon and if you don’t innovate,  get trampled by elephants and even some goats. 

Just yet,  the only question they had was “ who can fetch us the highest valuation”…?

To them I would only say this.  Please learn a thing or two about VC’s probing ways.  They invariably probe.  Do you think they can’t see you thro…?  Too bad. They are significantly well networked than you and may be, have even looked at your business even before you realized it. Had they found it compelling, they would not have waited for you to approach them.  Now that you walk down that road, do your homework and take a hard look at what you’ve got to offer.  And, for God’s sake, stop bragging about your League.  Allow them to make that out when they see your presentation.  May be that is the 14th biz plan from that League that they are staring at for the day. ( Gimme’ a break,  let me puke ).  

You’ll get what you’re really worth.  A good negotiator will still have to go by what you got.  Nobody pays anybody for having just a name.  In fact, a good negotiator would beef your plan up by inserting de-risking strategies to steer it towards a favorable risk-reward.  And that, is going to get you better valuations.  No magic mantras here. 

Shorn of your arrogance, when you come down to earth with your feet firm and rooted,  tap me.  I’d still be around.  Then may be, we can talk deal. 

Deserve your valuation,  goddamit,  don’t demand…!