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Bulls*%t, Next Slide…

We had an entertaining speaker at last night’s meeting of Anges Quebec. Andy Nulman of Airborne Mobile and Just for Laughs fame, spoke about his experiences as an entrepreneur and his thoughts on Angel investing. I don’t know Andy but he’s absolutely hilarious.

One funny anecdote he mentioned was pitching some VCs during the early days of Airborne and being told that their financial projections were not nearly sophisticated enough. They dutifully hired a bunch of experts to create what he described as the most beautiful set of financial projections ever created. At their next pitch to a big strategic investor, they went through their powerpoint and got to the financial projections. As soon as the investor saw the projections he said “Bullsh!t, next slide.”

Under “Lies Angels and Entrepreneurs Tell Themselves” #1 has to be that financial projections mean something. Projections are a good way to work out aspirations but they’re not good for predicting the future (in a startup). We’re investing in People right? Entrepreneurs are just as bad. When their pitch isn’t convincing they roll out excruciatingly complex financials to boost their case.

Angels and entrepreneurs should stop lying to each other. Entrepreneurs should be honest about what they don’t know (which would be refreshingly impressive) and Angels should realize that at the earliest stages they’re placing a big fat hairy bet on an individual. People who aren’t comfortable doing this probably shouldn’t be investing in startups.

Andy’s version was funnier…

Over $1 billion in stimulus for Canadian startups

This is a great time to be building startups in Canada. Ontario and Quebec have recently announced over a $1 billion in funding for new ventures through matching funds and fund-of-funds. There may be more good news when Ontario tables its budget on March 26.

Here’s a quick summary:

Ontario:

• $250 million Emerging Technologies Fund which will match private investments in IT, cleantech and life sciences startups

Quebec (link to budget):

• $825 million for a fund-of-funds to invest in 15-20 VC funds ($700 million from the government, $125 million from the private sector)
• $125 million for the creation of 3 seed funds ($100 from the government, $25 from the private sector)
• 10-year provincial tax holiday for new ventures that commercialize research from a Quebec university or research centre

So how does this trickle down to startups?

1. If you’re raising your first round it means there will be more seed funding sources and more money in existing funding sources. Private investors may be more willing to invest since the government is matching their dollars 1 to 1 or 2 to 1 in some cases.
2. If you already have investment it means your investors may be more likely to top-up if they are on the receiving end of these funds.
3. If you’re commercializing research, which Canada does a poor job of, you look a lot more attractive to investors. Not paying provincial corporate tax for 10 years has a huge effect on investor returns (assuming you’re planning on profitability).

The best part of these initiatives is that they support the existing investment ecosystem rather than trying to replace it with something government run. We already have the pleasure, privilege and intestinal fortitude to deal with the government for SRED and other subsidies. Best leave investment to experienced managers.

So is there any bad news? Timing will be an issue as nobody can deploy this much money quickly. It’ll be awhile before funds actually trickle down to companies. I personally don’t like any initiative with a geographical limitation. I understand the desire to create jobs in a particular place but technology companies can be spread out. In Canada, where we don’t have the density of markets and talent, an Ontario-only company doesn’t make sense.

But enough complaining. Does this mean that we at Flow are more likely to make investments in the near future? You bet!

(Link to more budget analysis from Chris Arsenault from Inovia)

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.

Bootstrapping Part 2: Government Funding

You wake up everyday and look in the mirror and say, “I am a capitalist.” You have The Wealth of Nations on your bedside table. But in tough times, smart people look for handouts from the government. $700 billion worth of bailouts has even made it socially acceptable!

In Canada, almost $2 billion (just .28% of the US bailout) is granted annually to companies doing R&D via the SR&ED program. Most provinces also piggy-back on this program and provide additional funding of their own. For (Canadian) startups, these subsidies mean cash in your pocket because they come in the form of refundable tax credits. This means you still get money back even if you aren’t profitable, which you probably aren’t. In Quebec, for example, the combination of federal and provincial tax credits means you could get 80% of your developer salaries refunded to you. That $80k developer really cost you $16k!

What’s the catch? First, you won’t get your refund until after you spend the money. You file for your SR&ED tax credits at the end of your fiscal year and after 4-6 months of “processing” you receive a check in the mail. So what’s the use of a refund on expenditures if you can’t afford the expenditures in the first place? Good point and one that the lending market still hasn’t quite solved yet. But you can turn a potential tax credit refund into cash in the following ways:

1. If you have a good balance sheet and a some personal assets, you might find a bank to loan you a portion of your expected SR&ED refund in advance. Honestly, if you’re a pure startup this will be very difficult because the bank cares more about your real assets than a future tax credit. Some government programs will provide loan guarantees which can help you get that bank loan. But banks are notoriously conservative about even taking on a tiny amount of risk (anyone out there with some stories they’d like to share?).
2. If you have finished your year-end there are now some secondary lenders who will loan you a % of your SR&ED refund for the 4-6 months it should take to get your check. These guys are expensive (1-2% per month) but they might be your best/only option. I know of two who advertise their services: Goldeye Capital and R&D Capital. I haven’t worked with either personally.
3. Many investors highly value the cash flow that SR&ED tax credits bring and might be convinced to invest more dollars, using your future tax credits as collateral. I’ve done this several times myself and it usually works out well for everyone because, unlike banks, investors know people who can claim the tax credits even if your startup, gulp, isn’t around to collect.

Canadian startups need to be very familiar with government programs given the economy and the relative lack of startup capital we have in this country. Next time we’ll talk about other programs that exist including Quebec’s new e-business tax credit and some of EDC’s funding programs.