You can never have too large a network

You should be constantly building your network

As an entrepreneur, you must meet as many people as you can.  This means that, whether you like it or not, you have to network, network, network.  It’s a simple matter of statistics.  Investors typically invest in 1 out of every 100 deals they see (in the best case).  That means you have a 1% chance of getting money.  Well, simple statistics will tell you that if you add 1% that one investor represents with the 1% that another investor represents, you have a 2% chance of getting funded.  Now, unfortunately for us entrepreneurs, it’s not as simple as meeting 100 investors to be sure we’re going to get funded… but you’re going to have a MUCH better chance if you do than if you only meet 5 or 10.

What does this mean for you?  That you have to go to ever single event that you can and make sure you’re ready to give your elevator pitch.  One other important thing you should be aware of is that because investors get pitched ideas all the time, it might behoove you to not be too aggressive about your pitch.  Be assertive and introduce yourself, show a genuine interest in the investor, and make it plain that you are an entrepreneur seeking funding, but do not be pushy.  You’ll have a much more interested audience if you build rapport with the investor first.  Be likable, and your pitch stands a much better chance.  Remember what investors do… they invest in PEOPLE, not ideas.

Now, how are you going to find your networking opportunities?  Well, find investor functions, join your local chamber of commerce, network with other entrepreneurs, and get involved with your local incubator.  If there are no incubators in your area, find out what small business development programs your local government offers and get involved with those.

Another great place to meet potential investors is through professional service providers.  This technique works best with independent providers.  That is to say, Merrill Lynch may not be too interested in providing you with an investor from their client list, but Joe Smalltown CPA might.

Finally, use your personal network.  Alumni associations are a fantastic source because they often have events to get alumni back together.  Better yet, get involved with the alumni office… they know which alumni have the extra cash available for a high-risk investment like a startup.

Okay, so now you’ve got your network to get some capital… but what about all those other people you met along the way?  Should you throw those business cards in the garbage?  Well, I think the answer is obvious.  Once you’ve gone through this process… even part of the way through, you will have found that those contacts are just as valuable, if not more so, than the investors.  This is because those contacts are your potential future clients, suppliers, and service providers, all of whom can help you build your business.  So save those cards!

Networking is important in business, but for an entrepreneur, it’s absolutely crucial.  Get out there, be confident, be assertive, and be friendly, and you will soon have a fantastic network that will get your business growing and, with a little luck, funded!

Bootstrapping

The one method of financing a startup that has the highest risk, and therefore highest potential return for the entrepreneur is the bootstrap.  The concept of bootstrapping is simple enough, just take your own resources, put them into the business, then re-invest any profit that is generated, rinse, and repeat.  The devil is, of course, in the details.

What if you don’t have cash to invest up front?  What if the company doesn’t throw off profit for a long time?  How do you determine into which part of the business to re-invest profits?  These, and many other challenges, are why going it alone and bootstrapping is the riskiest and most profitable way to proceed.  We will help you here as best we can, but recognize that if you choose this path you’re in for an uphill battle.  On the bright side, if you can sustain the bootstrap for some time, you can always try other paths to capital down the road and you will be in a better bargaining position for having done so.

Let’s start with the first hurdle: cash.  Nothing beats having cash on hand for starting up… but how many of us really have that luxury?  Not many… so we must look to our other option, the entrepreneur’s best friend, the credit card.  When choosing to go the credit card route, it’s best if you can get one in the company’s name.  For companies that have no financial history, this may not be possible, although it can occasionally be done if the entrepreneur co-signs for it.  Also, by the point, you should have gotten yourself an EIN for the company, which will help separate your finances from those of the company.  An important thing to consider here is that if you’re going to run all your spending through a credit card, you will likely be well advised to get a card that rewards spending.  $100,000 spent in one year on a card that offers 2% back is a free $2000 bump in profit.  Similarly, travel rewards can be quite a nice bonus for you at the end of a long, bootstrapped year.

Venture Capital Conferences

Trying to get in front of a VC to pitch your next big hit?  Try going where they go!  Here are a couple of the upcoming events that you’ll want to try to get to:

15th Annual Venture Capital and Private Equity Conference
Harvard Business School
Saturday, January 31st, 2009
Keynote speakers include: David M. Rubenstein of The Carlyle Group, David Skok of Matrix Partners and Steven B. Klinsky of New Mountain Capital

The 15th Annual Columbia Business School Private Equity and Venture Capital Conference

January 30th, 2009 - Alfred Lerner Hall
Columbia University - New York, NY

Financial Projections

Financial projections: predicting the future

Financial projections (”pro-forma financials” or “pro-formas”) are a representation of what you think your company’s financial statements will look like in the future.  Creating these documents is often an arduous task for the entrepreneur because it requires him/her to make many assumptions and to build a model based on those assumptions and industry research.  Further, these projections often change, because the assumptions upon which they are based change.  Thus, pro-formas are living documents that will require the entrepreneur to keep them up to date on a regular basis.

Why would anyone go through such trouble if these are just estimates anyway?  Because investors demand it.  You will not get funding unless you produce and maintain financial projections.  More importantly, you must produce financial projections that you can explain and that are based on observable facts.  It’s easy to say you’re going to make $13M in revenue in year 5… but HOW are you going to get there?  What is the basis for this?  You have to be able to explain it all, which leads us to an important point.  None of the documents in your investor information package are stand-alone.  You will find that changes to one often require changes to all.

Ok, so you know what pro-formas are now, and you know why you need them… now how do you create them?  Well, it depends.  We will walk through some of the basics here, but there can be much more to it.  Keep in mind also that individual investors may want to see your financials in different formats or ask for different types of projections.  We will go over the most common here: income statement, balance sheet, and cash flow statement.

Income statement

Your projected income statement: a map to profitability

This is the bedrock of your pro-formas.  To begin, you will estimate your revenue (also called sales).  This is simply the amount of cash you are bringing into the company in exchange for the goods and services the company provides.  Do you sell t-shirts for $10 each?  Then the revenue or sales for each is $10.   You will estimate this for the first year you are in business, but then you must estimate out for the next 5 years.  What kind of growth do you expect?  This should be reflected in the ensuing years.  Note that it is important to be realistic here.  Do not overstate to look good and do not understate to be modest, you’re going for as much accuracy as you can muster.  Once you’ve gone through this, you should have something that looks like this:

Of course, I have put in phony numbers here.  You need to make sure that the numbers you enter make sense.  A good quick check on that is to calculate the growth rate: (Year B - Year A)/Year A.  So for us to calculate our first year growth rate, we would get (1500-1000)/1000 = 0.5 or in other words, a 50% first year growth rate.  Now, let’s look long term: (2250-1000)/1000.  This gives us a long term, 5 year growth rate of 125%.  Is that outrageous?  Not at all… as a matter of fact, many startups grow that fast in their first year… it’s important for you to determine if that is going to be the case for your company by looking at comparable companies in your industry.

• Note: entrepreneurs often wonder if they should be showing sales figures based on their current state, or based on when/if they get funded.  The answer is both.  You need, for your own management and budgeting, a version that reflects your unfunded state.  However, you need to be able to show an investor what his/her money would enable your company to do long term, so you have to create a funded version as well.

Now that you’ve figured out your sales numbers, you need to work on the other side of the equation, expenses.  To do this, you need to list all your likely costs associated with running your business.  Often, you’ll see these costs grouped into various headings like Cost Of Goods Sold (”COGS”) and Sales, General, and Administrative (”SG&A”).  You don’t have to group them, but it sometimes makes it easier for readability.

There are some things to keep in mind here.  First, you need to make sure you understand what an expense is.  For our purposes, we’ll define an expense as anything that you purchase and use in the business to provide the goods and services which has a useful life of less than one year.  Why less than one year?  Because items that have a longer lifespan become capital assets and are treated differently from an accounting perspective.  To get a true understanding of this, please speak with your accountant.  For the purposes of this article, we will assume that all your cash outflows are expenses and that you are not investing in long-term capital goods.

Now you should have estimated out your first year expenses, detailing all the money you think you’ll have to spend in order to run the business.  Yes, your SALARY is included, but not other means of pulling money out of the business - again, see your accountant for this more advanced topic.  Now that you’ve got Year 1 down, you need to go through the exercise of projecting again.  Things to keep in mind here are inflation, pay raises, and increases in supplier costs.  A good trick is to use a percentage of sales as your basis, so as sales grow, so do your expenses.  For example, Sam’s t-shirt business may find that ink costs 10% of revenue.  So, as Sam projects out the revenue for years 2 through 5, the ink costs simply remain 10% of those years’ revenue projections.  Thus, we’d now have something like this:

And putting it all together, we get:

Note the “Net Income” line at the bottom.  This is the difference between your revenue and your expenses and is often refered to as “earnings” or “profit”.

• Note: This example is HIGHLY simplified.  Your business may have many expenses that are not reflected here that would further complicate the calculation of Net Income such as depreciation, amortization, and interest payments.  Speak with your accountant for details.

This is the basics of how to produce a pro-forma income statement.  Please feel free to post questions below.

Valuation

If only it were this easy

Early stage companies are nearly impossible to value.  There are so many factors that are simply unknown, that traditional valuation methods just don’t apply.  However, it is important for any entrepreneur to understand the ideas behind valuation and why companies are given the value they are.  Realize that once you know what gives a company its value, you can keep an eye on those factors as your business grows.

Comparable transaction value

This one is pretty straight forward.  Find as many private companies in your industry with a similar financial profiles that sold recently as you can.  Determine the mean selling price.  This is an estimate for your company’s value.

Public Comparable value

This is similar to the comparable transaction value method.  Simply look for publicly traded companies that have similar industry and financial profiles.  Average their “market cap”, and you’ll have an estimate for your company’s value.

Multiple valuation

This is almost the same as doing Public Comparable Value, except it should have less volatility due to irrational trading behavior.  The market price of stocks in a given industry tend to trade at a price that reflects a multiple of a specific metric.  For example, the technology sector tends to trade on a multiple of earnings.

Discounted Cash Flow Valuation

This is a complex topic that is beyond the scope of this site.  I will provide a summary here, but to truly understand this topic, please refer to authoritative sources on corporate finance.

Discounted Cash Flow (”DCF”) is a valuation method which takes into account all future cash flows that the company is expecting to earn, and it discounts them back to today (the fact that they’re future cash flows means they’ll be worth less  than today’s dollars due to inflation).  In particular, this method looks at the value of the Free Cash Flow (”FCF”) dollars available to the stockholder.

Caveat Venditor

Let the seller beware.  Your company is not comprised of just equity and cash flows.  There are MANY things beyond equity to consider when valuing a company - debt, intellectual capital, synergies, etc. The valuation techniques outlined above are just to give you an idea of how valuation will be initially looked at down the road - there are many moving parts.  If you need to get a more in-depth valuation done, please consult a professional.

Friends and Family Round Basics

No one is made of money. Make their investment count.

Most startups are founded with money from the entrepreneur’s family, friends, or significant others.  This round of funding is commonly referred to as the “Friends and Family” round (although some professional investors change it to “Friends, Family, and Fools” to reflect the lack of sophistication most seed-stage investors have).  The Friends and Family (”F&F”) round is typically designed to just get the idea rolling: a proof of concept, a formal design, or something else of substance that would advance the idea towards a more viable form that would interest a more sophisticated investor.

Formalize it!

Because this source of funds is usually someone close to the entrepreneur, there is frequently little formality around the investment.  This should not be the case as it creates potential issues down the road.  The required documents can vary, depending on the investment type, the state, and a number of other variables, so consult an attorney.  The cost will be greatly justified down the road.

Deciding on what structure to use when raising funds can be tricky for new entrepreneurs.  Most people either take the money as a personal loan or decide to give up equity in the new venture.  Either of these can be a good option, but there is another option that should be considered: the convertible debt note.

Convertible Debt Notes

It may sound scary if you’re unfamiliar with the concept, but you will find it has enormous advantages over the other two options.  First of all, it’s a loan… to the company.  Your personal assets aren’t on the line, so if (perish the thought) the company should default, the investor cannot come after your house, car, and you fancy flat-screen.

The next advantage is that you don’t have to place a value on the company to execute the investment.  This is probably the biggest reason the professionals use this instrument.  Valuing an early-stage company is a black art at best, and is more realistically, just a guessing game.  An equity investment would require you to look deep in your crystal ball and value the company now so you can determine how much equity to give the investor based on his investment, whereas a convertible debt note is just a loan to the company, which can convert to equity AFTER a REAL value is assigned.

This leads us to the third benefit to convertible debt notes: alignment of interests.  The investor gets the security of knowing that he’ll have first claim on the assets of the company, should anything go wrong, which will motivate you; you get to receive your capital without having to value the company or give up equity too early; and everybody gets to participate in the up-side if things go very well for the start-up.

Consult an attorney who has specific knowledge in securities law to help you design the convertible debt note.  He/She can guide you through the process of setting up the triggering event, determining a discount schedule, and the vast array of other moving parts that can be present in such an instrument.

Follow the rules

Once you have determined what securities you’re going to issue, and you have your documentation in place, you’re ready to accept checks.  Be aware that you can really only take money from people with whom you already have a relationship, unless they are an “Accredited Investor”, the definition of which is spelled out very clearly by the SEC.  Also be aware that you cannot just spam the internet looking for Accredited Investors, because the SEC has an issue with that too (It’s called “General Soliciation” and it’s a no-no according to Rule 502(c) of Regulation D).  Again, check with an attorney to make sure you’re doing everything legally.

Don’t forget them

Ok… you got your first big chunk of change to get your dream start-up off the ground.  Nice work!  Now remember that this money you took comes with strings.  You need to keep your investors up-to-date on major goings-on with the company.  Did you hit a major milestone?  Sign a new distribution agreement?  Have a technological breakthrough?  Send an email telling them about it!  You will always have to be updating investors, so you should start early with the ones that got you going.  It’ll make them feel good about their investment, and it will keep you in their good graces in case you need to come back to them to raise more money.

Angel Investors

Angel investors: like dollars from heaven

Most people have heard the term Angel Investor, but many don’t know what the term really means, and fewer still know how to find one.

Angel investors are wealthy individuals who actively invest in (typically) very early stage companies.  They often have had success building their own business and are looking for a way to parlay their windfall and experience into further success by building up a portfolio of fledgling companies.  These investors often know each other and generally will band together to create an investment group.  This allows them to spread the work of evaluating opportunities while ensuring that they can get in on good deals they might have otherwise missed.  It is through these groups that an entrepreneur will find the most angel investors.

There are a number of things that the savvy entrepreneur should know about approaching an angel investor:

• First, while an angel investor will always be motivated by making money, it is rarely his primary motivation.  Often, angel investors are compelled by helping companies similar to those they, themselves, built.
• While you want to pitch your startup to as many angels as possible, you should be aware that the vast majority only invest in their own back yard.  Spend the lion’s share of your time on local angels because they’re the ones that are most likely to invest.
• Don’t expect the process to go fast.  Angels are not in a hurry to put their capital at risk.  They want to build a close relationship with you and make sure their money will be in good hands before they pull the trigger.
• Unless you are an experienced, successful entrepreneur, don’t overlook the opportunity to glean insights from your angel.  He is a resource beyond a dollar figure.  He has experience, connections, and market insights that can really help you.  Use it.