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    0 Replies Latest reply on Jun 18, 2008 12:44 PM by SEOpro

    Getting funding for a startup, and alternatives to funding

    SEOpro Adventurer
      I've run the whole gamut of startup - from original idea all the way to $7m/year revenue.
      Taking investment doesn't reduce risk; it delays risk.

      These are some of my thoughts.

      Summary:
      First-timers
      in starting up worry about things like (1) competitive products, (2)
      competition stealing their ideas and (3) VCs divulging their precious
      secrets, (4) how much of the company they can retain, etc..

      Those
      experienced at starting up focus on (1) how to deliver ever-increasing
      value to customers and (2) internal execution to achieve that while
      staying liquid.

      A second point:
      When it comes to a
      bacon-and-egg breakfast, the chicken is involved but the pig is
      committed. With VC investments, the VC investor is involved but you,
      the entrepreneur, are committed. This means the typical VC investor has
      a portfolio of maybe 10, 20 or 30 companies. You have, most likely,
      only one. If it fails, it takes your single five to ten year investment
      in time and effort down the drain with it. You lose your whole
      portfolio.

      The Details
      I'm
      well into my third real startup. I started a software company in 1994
      which ran for three years, and another software company in 1999 which
      is still in good business, and in 2005 I started a hardware product
      company.

      The first company, I started with two partners, the second with one partner and the third one I started alone.

      We never managed to get financing for the first company, mostly because we didn't have a clue how to go about it.
      I
      was the product guy and one of my partners was a well-rounded business
      development and marketing guy. Happily, he is a close friend of mine to
      this day.
      The third partner fell apart early on in the startup, so we were quickly down to two.
      With
      two versions of two software products, we secured some several hundred
      customers over the 3-year life of the company. We didn't make a lot of
      money out of it, but got some badly needed startup experience.

      It is no surprise to me that the vast majority of new companies fail pretty quickly.

      After
      Startup #1 eventually sputtered to a halt, I went back to the workforce
      with a little hard-earned but valuable humility regarding making a
      business successful.
      Within 18 months, I was smitten with the possibility of starting another software
      company. That eighteen months gave me the time and space to think hard
      about the lessons I learned and I religiously applied my newly learned
      principles to Startup #2.

      For almost two years, my co-founder
      and I buried ourselves in his basement, cutting as much code as we
      could before cash or motivation ran out. We were fortunate to stumble
      upon a very sharp fund-raiser to whom we offered the position of CEO
      and significant partner. Over the course of 4 or 5 years, our new CEO
      deftly secured three rounds of financing at a good price every time.
      I learned a few things during those 4 or 5 years.

      I'll talk about startup #3 a bit later.

      What
      are the ramifications of getting funding for your startup? Getting
      funding for your startup has a number of implications that founders
      typically don't understand.

      #1: Liquidation Preference
      In addition to how much stock you retain in your own startup, Liquidation Preference affects how cash is divvied up in the event of your startup being acquired.
      Typically,
      the people who put cash into your startup have a "2x Liquidation
      Preference". This means that they are entitled to get twice their
      investment back before you get paid anything, in the event of an
      acquisition. That's just the theory, of course, and a lot of it is
      still open for negotiation, depending on how the company is doing, and
      other factors.

      Let's look at a theoretical example.
      You have
      an equal partnership with your co-founder. Investors want to invest
      $10m into your startup, and for that, you agree to give them 40% of the
      company. This means the company is "valued at $25m" in terms of what is
      called "pre-money". (If 40% = $10m, then the company should be worth
      40% + 60%, you'd think. "Pre-money" means 'before the investment is
      made').
      So now you and your co-founder have 30% each of a company that is worth $25m (on paper) and has $10m in the bank.

      Yippee!

      Not quite Yippee.

      Your investors have what is called Preferred Stock. You and your co-founder have Common Stock. Preferred Stock has typically a Liquidation Preference associated with it and Common Stock typically does not.

      Aside
      from money speaking louder than words, Liquidation Preference is there
      for a number of reasons. (1) it discourages founders from forcing a
      sale at a price at which Investors would lose money (imagine a week
      after the investment, you got an offer to sell the company for $10m)
      (2) it forces the Common Stock holders to increase the value of the
      company to a number where it makes investment sense for the Investors.
      There are other reasons too, but I'll get back to that.

      It's
      great to get all that cash injected into your startup. Overnight, you
      go from scrimping and scraping to make ends meet, to getting paid a
      salary and still being able to pursue your brilliant idea. You are, as
      my friend Randy put it, betting with house money.

      Pigs get Fat; Hogs get Slaughtered
      A
      risk with this model is, with every round of financing, you
      significantly raise the acquisition price required for the Common Stock
      holders to make any money. After the first round, you have to sell the
      company for $50m in order to satisfy the Investors with their 2x
      Liquidation Preference. Mind you, if you do sell the company for $50m,
      and you still have 30% of it, you're in good shape.
      The problem is,
      it will take a long time and a lot of effort to double the value of
      your startup to reach that $50m. And the journey to get there is
      fraught with danger.

      Rule of thumb: a 2x Liquidation Preference = 2x the company price must be.

      You'll
      have to bring out newer, better versions of your product or products,
      reel in more customers, get process in place and generally prove to the
      world that your company is growing. A lot of things can go wrong in
      that time. And when they do, you can't just make a few phone calls and
      secure another $10m to take another swing at it. Or rather, if you do,
      you'll have to give away another big piece of the company, perhaps even
      more than 40% if your company is having troubles. Having company
      troubles means that you might need a "down round". A down round is
      where you give stock away at a price that is less that the previous
      investment price. If you have to give away another 60%, everyone loses
      60% of their share of course, investors included, but your Common
      Stock, now at maybe 10% of the company, needs a significant acquisition
      purchase price before you make a dime.
      The biggest problem with
      Common Stock is, your share of the company is "diluted" with every
      round, so you have to continue to be successful every year of the
      startup. One bad round and you're what they call washed out.

      Question: What makes a company work?
      Answer: Creating customer value.

      In
      the long run, you must create customer value in order to stay in
      business. You must deliver something to your customer that they feel
      good about paying for...something they get a multiple of the value for.
      Profit will eventually come if you continue to increase customer value,
      but customer value will not necessarily come as a result of
      profitability.

      #2: A Conflict of Interests - Investors versus Founders

      The
      typical VC investor invests in many different companies at roughly the
      same time. They might have investments in twenty different startups
      chugging along and as long as two or three of them turn out to deliver
      bumper returns, most of the others may evaporate, yet still the VC is
      in excellent shape overall.

      Not so for the lowly entrepreneur who is strapped to a single company.

      The
      typical entrepreneur has his or her retirement buried in the startup.
      Or at the very least, has bet a lot on a successful return from the
      startup. Yes, the VC might have poured $10m into it, but as soon as it
      looks like it is, as they say in the vernacular, going south, the VC
      tends to shift focus towards the prosperous companies in his portfolio
      and away from the troubled one. The mathematics of the VC's investment
      portfolio makes him or her unmotivated to deal with hard issues in the
      startup.

      This inherent unwillingness to make hard choices,
      coupled with the fact that their Liquidation Preference protects them
      from an entrepreneur selling the company at a fire sale price, puts the
      entrepreneur into a vulnerable position, one that is not obvious before
      problems arise.

      How can an entrepreneur protect himself/herself?

      To
      be fair, when an investor sticks millions of dollars into your idea,
      he/she is making a huge commitment. You will probably draw a salary and
      pay into your retirement fund while you work your idea at their
      expense. That is a significant commitment they are making to your dream.

      Still, you should understand the mathematics that make you vulnerable in ways the investor is not vulnerable.

      Taking investment into your startup does not decrease risk. It delays risk.

      The pros of taking investment:
      • You get to draw a salary.
      • You get to apply extra resources into your startup.
      The cons of taking investment:
      • You need to sell the company for a much higher $ figure for you to make anything.
      • You introduce a lot of complexity into your startup.
      • You lose significant control over the direction of the company and everything in it.
      The Illusion of Almost Acquired
      A
      lot more companies get sold for $3m than get sold for $10m, or $30m, or
      more. The higher the number, the fewer companies get sold for that
      amount, the less likely you can strike a sale, statistically speaking.
      What's
      more, many companies get the opportunity to get sold as a technology
      play early on, before the startup really becomes a company. After that,
      there can be a long, parched road before another opportunity to get
      sold appears.
      This means, whilst you may have had an opportunity to
      sell the company for $5 - 10m, you may not get another chance to sell
      it before it passes well beyond the $100m company value range. There is
      a big difference between having a product and having a company. There
      is very little in between that a potential acquirer will be interested
      in taking on.

      If you are a Product Builder, which many entrepreneurs are, and you are not a Company Builder, which many entrepreneurs are not,
      then you might be successful at building your initial product, at which
      time your startup will be worth something, and selling it to the first
      suitor.
      After that, during the steep learning curve of you learning how to build a business,
      you may fritter away lots of the hard-earned company value you accrued
      early on, and end up diluting your value by effectively investing your
      hard-earned value (you built a product) into something which is not
      your specialty (building a company).

      Moral #1: Always be selling your stock.

      Moral #2: Start a business that does not require significant investment, but does exploit your specific skill set.

      For
      all the assumed goodness that millions of dollars brings to your
      startup, the fact is, things quickly get more complicated with all that
      money involved. Suddenly, there is serious time pressure to deliver.
      Sure, everyone wants to be successful quickly, but now that your
      company has taken the VC money, your investors are anxious for you to
      burn the midnight oil and give them a return quickly.

      In many
      cases, another 40 engineer bodies on the problem will only make a
      marginal improvement to your chances. Often, VC investment in a
      software company is a exercise in posturing. With software in
      particular, you might actually be better off limited to the original
      two or three engineers working the problem. Sometimes just a few hours
      work every night, while you keep your day job, is enough to keep the
      startup progressing enough,
      but takes a lot of other pressures off. For instance: (1) you can keep
      the price of the software at whatever you think is right, even free, if
      that gives some advantage (2) you can mull over some decisions for a
      long time before making them, (3) only perform the key improvements
      that you know will add value. But most of all, when you get an offer
      from someone to buy out the technology, a few million will probably be
      very attractive to you. There are MANY big technology players out there
      who will fork out a few million just for the chance to try out your
      fledgling product in terms of an acquisition.

      You see, people
      think, just because they suddenly have this $5 or 10m in the company
      coffers, their chances of success are suddenly improved.
      They're not really.
      The risk of failure is simply postponed, or exchanged for a different kind of risk down the road.

      So,
      when you take a big investment from a VC company, understand that it
      brings with it significant risks that are not obvious when your company
      deposits that check into its bank account. Think long and hard before
      you strap yourself to that Big VC Rocket.
      Once you do, there is no turning back.

      I wish you good luck, no matter what.
      Liam
      Further Ramblings can be read here...
      http://www.siteleads.net
      or email me at liam.scanlan@gmail.com