.

When does $5 million = $50 million? Comparing entrepreneur payouts.

There has been a lot of healthy discussion about the true implications of VC investments. Markus Frind (plentyoffish.com) wrote about it a year ago and Basil Peters (AngelBlog) has been analyzing how VC math influences a startup’s DNA. Dharmesh Shah’s (OnStartups) excellent video briefly mentions the expected value of entrepreneur payouts in VC-backed ventures and I wanted to expand on that.

In a nutshell, a $50 million exit = a $5 million exit when you factor in two things: risk and payout (the cash you actually take home). In the example below, the upper tree shows a $50 million exit and the bottom shows a $5 million exit:

The $750k represents the expected value in both cases. How come they are the same?

The VC-backed example represents a “home run or bust” investing philosophy. The exit is bigger ($50 million) but so is the risk (only 1 in 10 will make it). Also, your portion is smaller, only 10% at exit in my example. So if there is only a 10% chance you’ll earn your $5 million payout, the expected value is only $500k (10% X $5 million). Add to this a 50% chance of a “sideways” exit, i.e. not much, and you get $750k.

The other example is a startup done lean or with some friends, family and Angel money. The exit may be much smaller because the funding isn’t there to go big. But nor is there the desire to “go big or go home”. So out of a much smaller $5 million exit, you retain $2 million (a bigger chunk) plus your chance of success is now 25% instead of 10%. So 25% X $2 million = $500k. Add to this a 50% chance of a “sideways” exit, i.e. not much, and you get $750k.

Some people may object to the numbers:

• 10% ownership at exit is too low - Actually, you may own less these days given lower valuations. See this presentation from Union Square Ventures.
• 90% chance of failure is too high - I agree this may be pessimistic but there are a lot of VCs out there who don’t have one home run every 10 investments.
• The success rate is too high for modest exits - Few people would claim they could get higher rewards with lower risk…

I’m definitely not suggesting that the numbers I’ve used are the right ones for you. But they are a revealing way to explore alternatives when funding your company. Every option has pros and cons and it’s up to you to understand them. This method gives you a way to quantify those options.

You may be surprised to find out that bigger is not necessarily better, at least not in terms of how much money you take home when you exit your company.

10 tough questions to ask yourself before raising money

CC by greefus groinks

I seem to spend a lot of time convincing people not to raise money. The #1 culprit is not The Downturn or a lack of good ideas. The real problem is that people are trying to raise money too early when things are still half-baked.

Here is my top 10 list of tough questions all entrepreneurs should ask themselves before trying to raise money:

1. Is your idea ready? - Most ideas need time, not money. E.g. time to really vet ideas, get outside feedback, and do a deep dive into everything. Money won’t help you do this faster and will be a distraction.
2. Are YOU ready? - Anyone can, and should, start a business, but you should be honest about your personal timing. Can you afford to take a pay cut and work long hours at this stage in your life? Have you built up some relevant career experience to help you? Do you have good general management skills? What can you do to develop your own skills?
3. Do you have a good network? - It is so much easier to build a company when you have a good network to support it. Networking is free and fun and you’ll hone those skills you’ll need when you are building your own company. Don’t like networking? Don’t start a company!
4. Do you have big gaps in your team? - Don’t try to raise money when you have a technical product with no engineer on board. Build your core team first. Hint: don’t do it alone, ever!
5. Do you understand the fundraising game? - There is no excuse to be under-educated about the fundraising game. Everything is available on the Web and many funders blog about their deals. Don’t wait until you start pitching to learn what a term sheet is or what valuation to expect.
6. Do you know your target customer intimately? - Don’t just talk about customers as if they are an abstract concept. Be able to personally name 10 customers (who you have talked to) and be able to describe them in intimate detail.
7. Do you have a detailed and paranoid view of the competition? - Why start a business before thoroughly understanding the competitive landscape? And yet most competitive analyses fall far short. Many ignore obvious direct competitors and few deal with substitutes effectively. Be more paranoid!
8. Are you ready to work for someone else? - When you have shareholders you’ll no longer be working for yourself but for them. It’s a major mindset change from being a sole owner to being a manager who can be fired…
9. Do you have a better alternative? - Successful bootstrappers know that you can do without most of the things you believe you can’t do without. Make sure you weigh the time and probability of raising money with your next best alternative, which might actually be pretty good.
10. Are you ready to give up a modest payout to yourself to go for a bigger, riskier payout for your investors? A lot of people don’t understand that a “lifestyle business” that generates $1 million in profit per year is not interesting to many investors. But it’s very interesting to most entrepreneurs. Understand why investors and entrepreneurs have different motivations before you take on any investors.

Answering these questions will help you diagnose whether you’re ready to raise funding or if you should be looking for investors in the first place.

Angel Co-Investment Summit Roundup

Last week’s Angel Co-Investment Summit, put together by the NACO, was one of the best investment forums in recent memory. Over 150 active Angel investors (yes, you read that number correctly) heard pitches from 25 companies who had already raised Angel funding.

Here is the list:

• PCA Services
  
• Open Ocean Systems
• Amika Mobile
• Picomole Instruments
• VanRx
• PlantForm
• SpeechBobble
• Well.ca
• Comagulation
• Signalink Tech
• Streamlogics
• PSI Engineering
• Home Stars
• HousAll
• Scisense
• Spartan Bioscience
• Sempa Power
• Viroforce
• Siamons
• Esotera Storage
• Heliocentric
• iotum
• LoyaltyMatch.com
• Nulogy
• Surface to Surface

Here is a more detailed breakdown of companies and fundraising:

• 48% were science or medical technology companies, 32% were Web and 12% were telecom based
• 72% were from Ontario, 16% from BC and the other 3 from Saskatchewan, New Brunswick and Newfoundland. Nothing from Quebec perhaps reflecting what little presence NACO has in Quebec.
• The median amount companies had already raised was $1.15 million
• The median burn rate was just below $40k/month
• The median amount sought was $1 million
• The median pre-money valuation was $5 million

Overall I was impressed by the quality of the companies, particularly the science and med tech companies who seemed to have great CEOs, unique IP, customer traction and relatively little capital burned. The Web companies in general did not hold up.

If this is what “early stage” investing looks like these days, those entrepreneurs raising seed capital are going to have to work twice as hard to get investors’ attention. In any case, I hope events like this  encourage more deal syndication which would mean more capital available for companies.

StartupDrinks Montreal

Startups and drinking are both positive influences in my life so I never miss an opportunity to combine both. Heri at TechEntreprise has announced the next StartupDrinks Montreal which is happening next Wednesday (Nov 26) at Reservoir. It’s on Duluth just east of St. Laurent (head up to the second floor). Festivities start at 5:30pm though no one will judge you if you decide to start drinking earlier. You can always blame “the market”.

If you’re an entrepreneur or you’re thinking of becoming one, please register at TechEntrepreprise and come on out. Funders, students and service providers are also welcome. It’s exactly the kind of event I like: lite on presentations and heavy on networking.

Bulletproof Your Ideas: Part 2 - Be a Skeptic

I previously talked about how to vet ideas by putting them through a quick screening process. Another good technique is to take your idea and argue the opposite. Philosophers have done this for centuries so I didn’t just make this up. In a nutshell: assume your idea sucks and try to convince yourself it doesn’t.

The technique is simple: take each of your claims (e.g. “people will buy our product”) and argue the opposite (e.g. “people will absolutely NOT buy our product”). You’ll be forced to spend time thinking about your idea’s flaws, which no entrepreneur enjoys doing. If you aren’t skeptical by nature, find someone who is. They’re usually easy to spot because they annoy you.

Here are some examples:

“We are first to market”

The Believer: Even if I see a competitor I’ll convince myself that they aren’t in my space. I somehow found a huge untapped market that everyone else in the world overlooked.

The Skeptic: I know there are competitors (including people who aren’t competitors now but will be later) and I want to be aware of them. My customer’s desire not to switch to my product is a form of competition. I doubt that being first to market is the right strategy anyways.

“Our market is huge and growing”

The Believer: I can quote a Forrester report about the market being $X billion. I still talk about how worldwide Internet use is growing, fast.

The Skeptic: It doesn’t matter how huge the market is, I can’t afford to reach everyone in it. Big markets attract big scary competitors and crowded markets drive down prices and margins. This early in the game I probably have no clue how to size my market anyways.

“We have a real competitive advantage”

The Believer: Everything about my startup, from the cool name to the indentation of my CSS is a competitive advantage. My competitors have great stuff but it’s not integrated

The Skeptic: Our customers don’t care about our differentiators. Most things we consider competitive advantages are easy for others to duplicate (unless they don’t work).

Playing the skeptic is unnatural for all entrepreneurs, that’s why it’s such a useful exercise. Sometimes that idea you’re only pretending to think sucks will actually suck at the end of the exercise.

StartupEmpire Roundup

Hats off to Jevon, David, Jonas, Michele and the StartupNorth team for putting on StartupEmpire last week. Startups do not exist in a vacuum and a better community means better startups.

There’s not enough space to mention everyone who was there but it was nice to see early stage funders out in force (JLA, Growthworks, iNovia, MontrealStartup, Sigma). It was especially nice meeting the 10 entrepreneurs who won the StartupEmpire contest, sponsored by Austin Hill and Flow Ventures. The packed audience was full of entrepreneurs and there was a real buzz about the event that comes with having 300 people simultaneously give each other elevator pitches all day long. Truly inspiring.

There were 3 important takeaways from my perspective:

1. Just Do It - I was really pleased to see the focus of the event NOT be on fundraising. I don’t think we need another event teaching people how to pitch VCs. But we do need more events that help entrepreneurs take those crucial first steps in their ventures. Bootstrapping seemed to be the word du jour.

2. Idea vetting - The pitch panel, where entrepreneurs gave elevator pitches, was a great way for entrepreneurs to learn that there’s no substitute for harsh criticism when honing your pitch. Entrepreneurs are always pitching, to co-founders, customers, funders, and many don’t take the time to practice until it’s perfect.

3. Finding Co-Founders - Many entrepreneurs I spoke with are looking for co-founders. Some are developers looking for businesspeople with specific industry expertise. Others are experienced in a particular field but aren’t programmers. We have to come up with a better way to match co-founders together.

Next week we’ll be at the NACO Co-Investment Summit where there will be 20+ funded startups pitching an audience of Angels.

Bulletproofing Your Ideas: Part 1 - The Quick Screen

As entrepreneurs, we all have great ideas and we love turning them into reality. Unfortunately, most people spend more time justifying why their idea is great rather than questioning whether it is great. Here’s an example:

1. Have brilliant idea, e.g. Curling Rink Management Software


by Reverend Aviator (cc)

2. Daydream about becoming the Microsoft of curling
3. Write business plan about how you will dominate the curling software market
4. Convince poor souls to jump on board your curling startup
5. Do an investor road show to raise funds for MyCurlingERP.com

What’s wrong with this picture (besides thinking that curling is just plain wrong)? The problem is that there was never a rigorous process for vetting the idea. This is a missed opportunity because vetting can reveal hidden strengths and weaknesses in ideas.

I use the following quick screen process for evaluating ideas:

1. Are you an expert in the field? If you aren’t you’re probably overestimating your idea or underestimating the difficulty of executing it.
2. Does your idea make something 10 times better than the alternative? If your answer is “how am I supposed to measure that?” you’re in trouble already.
3. Do you understand how the industry makes money? Understanding how people give away things free is not the same thing.
4. Can you win? Being #17 in an industry sucks.

If you answered NO to all 4 questions it’s a good indication your idea needs major surgery. If you answered NO to some of the questions, it’s time to focus on improving its weaknesses.

photo by Divine Harvester (cc)

E.g. if you aren’t an expert in the field take the time to recruit one. Better yet, try to recruit the industry’s best expert. If your value proposition is a combination of ease of use + slightly cheaper + runs on a Mac + is multi-lingual, you’re probably proving your idea is only incrementally better. No one ever switched painkillers because of better taste and they won’t adopt your solution unless the thing they care about really works. Prove that and the UI can be ugly.

Don’t understand how your industry makes money? You probably won’t make any. Before inventing a new revenue model study the revenue models of your competitors and complementors. One tip: if no one is making money in an industry (e.g. curling software) it’s a good sign you won’t either. Finally, seeing a path from your idea to dominating some industry niche is very important. If there are insurmountable barriers to entry or high capital requirements to win, your idea may never get a chance to win. Think about this in advance.

The point of idea screening is not to generate ideas. That’s your job. Screening protects you from your natural tendency to believe that your ideas are great. If they are great, screening will help you prove it.

If you have other ways to screen your ideas feel free to post them.

Winners of StartupEmpire Contest Announced

Thank you to everyone who submitted entries to the StartupEmpire giveaway. The quality of the writing and thinking was excellent and it was inspirational hearing so many people wanting to further their entrepreneurial careers. Our hats off to all of you.

We only had 10 tickets to giveaway unfortunately so Austin and I had to make some tough choices. The good news for anyone who wasn’t selected is that there have never been more entrepreneurial events happening across Canada. I hope to meet all of the companies at one of these events at some point in the future.

So here is the list of winners (in alphabetical order):

• Chris Advansun (DramaVida)
• Bryan Bogensberger (Reasonably Smart)
• Leonardo Borda
• Felipe Coimbra (YOWTrip)
• Dan MacGrady (IntegrateSales)
• Paolo Mazza (Alexandria High)
• Chris Pyper (MyWebVine)
• Christine Renaud (E180)
• Raul Rupsingh (Softshell Computers)
• Reynold Xin

Congratulations everyone. We’ll see you all at the conference in a few days.

Contest - 10 Free Tickets to StartupEmpire Available

Flow Ventures, Austin Hill and AngelSoft are co-sponsoring a contest to help 10 entrepreneurs attend next week’s StartupEmpire for free. This is going to be a great event to focus on building new companies in lean times but we realized that, for some, the cost of admission and travel might be a problem. Winners of the contest will receive:

• Free admission to the conference
• A $100 subsidy for travel (which we’re asking GTA-area people to donate to those traveling from farther away)
• Two great business books: Reality Check by Guy Kawasaki, and Randy Komisar’s The Monk and the Riddle
• Some discounted and some free passes to post your funding pitch on AngelSoft’s OpenDeals program which will be seen by Angels and VCs across North America

Here are the questions we’d like you to answer as part of the contest:

1. If you are a startup tell us about your company, size, market, product and what stage you are at in your growth. (If you are not part of a formed startup but) If you are an entrepreneur, programmer or aspiring entrepreneur tell us about your background, your plans as an entrepreneur. Tell us what you’ve done to advance your entrepreneurial aspirations.
2. Why do you want to attend Startup Empire - what do you want to accomplish there?
3. What are the 3 questions that you would want answered by any of the speakers @ StartupEmpire?

Send your answers to startupempire [@] brudderventures.com by Saturday November 8th and we’ll announce the winners ASAP.

Free MS Software for Startups

Microsoft has just launched a new startup initiative called BizSpark which provides free Microsoft software to startups. What software?

• MS Visual Studio Pro
• SQL Server
• Windows Vista, XP, Server etc.
• Office & Project
• Sharepoint
• And premium MSDN subscriptions for all

These are not only development licenses but production/hosting licenses as well so this is a good deal. To qualify you have to be a private company in software with less than $1 million in revenue. The program is free but there is a $100 charge when you leave the program. Also, after 3 years you’ll have to revert to a normal paying customer (but then again, you’ll be making more than $1 million already, right?).

You also have to be sponsored by a partner but you can do so through Flow (just shoot us an email).

You don’t have to be building your application on .NET so I’m pretty sure there’s something for almost everyone, even people building Web 2.0 apps on LAMP. I know one of the people behind Microsoft’s emerging business group, Yi-Jian Ngo. He has a great blog about core infrastructure issues and he’s a real believer in startups.

This is a new program so we’ll have to check back when people sign up and can provide feedback. But I’d say getting free software is a great way to build lean startups.