Bootstrapper.com - Confessions of Serial Entrepreneurs

A significant number of entrepreneurs confuse the concept of market size and addressable market size (an addressable market is the total revenue that your company would generate if it captured every single viable revenue generating opportunity). Even those that understand this distinction often don’t calculate the right number.

Addressable market estimates are typically pretty soft in the sense that they are a compilation of estimates. However, this doesn’t mean that they aren’t extremely valuable for investment decision making. If each assumption is reasonable, meaning in the range of realistic outcomes given the best available information, then the output of the exercise will usually generate an answer that is in the right order of magnitude (meaning it has the right number of digits). It is helpful to know that if the company captured every revenue generating opportunity it could realize revenue in the millions, tens of millions, hundreds of millions, billions or more.

Where many entrepreneurs go wrong when they are calculating their addressable market is that they don’t get the assumptions right. There are two types of mistakes that are most common:

• Assumptions are not sufficiently refined: Entrepreneurs often exclude some of the logic that goes into this analysis, which more often than not shrinks the output of this calculation. For example, an e-tailer selling t-ball bats isn’t going to sell bats to every person in the US. Not everyone plays t-ball. So, when this estimate is being created the US population needs to be refined by another factor, the percentage of people that play t-ball.
• Assumptions are simply over-estimated: Entrepreneurs sometimes inflate inputs into the addressable market calculation. Demographic segments are often enlarged and CPM rates overstated. If you feel compelled to demonstrate the best case scenario it’s always best to create a low and a high case, which will demonstrate the range of possible outcomes. This approach will highlight upside while letting investors know that you are aware of business realities.

There are a couple of key reasons to be careful not to make these mistakes:

• First, good VCs will catch the errors.
• Second, when they catch the errors it will raise questions about management competency.

If your company doesn’t fit into a VC’s thesis because the addressable market is too small, don’t artificially manipulate the market numbers. You are better off trying to raise money from other parties that will be interested in your company (such as angels). Trying to force a square peg in a round hole can hurt your credibility

Some businesses rely heavily on securing key partnerships. While entrepreneurs will often make compelling cases for why the prospective partner will want to get involved, there are often unforeseen reasons why the partner never inks the deal. Key decision makers may be in a political struggle, they could be considering doing the same thing internally, the fight for budget allocations may not have gone in favor of the partnering department and the list goes on.

As a result, a VC will typically try to mitigate its exposure to the risk that the partnership will not be secured by having direct conversations with the potential partner. If they hear the partner say that the deal is going to get done, it is much easier to believe in the prospects of the startup.

If your company is currently in negotiations with the partner you will have to weigh the pros and cons of having the VC speak with them. While the VC call may add a new dynamic to your relationship with the partner, it may also signal to the partner that your startup is close to having deep pockets supporting it, mitigating financial risks. In this case, you have to make a judgment call, which typically boils down to letting the VC speak with your potential partner or waiting to get funding after the partnership deal gets done.

If you have not yet initiated conversations with your potential partner, you can leverage the VC due diligence process to initiate those relationships. Most good VCs have a deep rolodex and can usually find a way to get in touch with the person who would consider doing that deal with you. Not only can they make the introduction, but also they can give your company significant credibility when they are first introduced to the potential partner. When the potential partner receives a call from a respected VC who says, “We are looking at an interesting startup right now that could present a partnership opportunity for you. Would you mind having a conversation with them? We would love to hear your perspective on what they are doing.” If a serious investor is interested in your company the potential partner will likely give conversations with your firm more weight.

As a result, if your strategy depends on securing one or more key partnerships be prepared to facilitate the conversations that are required to give the investor comfort. And, if you have yet to connect with the partner you may want to leverage the due diligence process to help get the deal done.

While most VCs know a lot about running businesses and investing, it is rare that a VC will know more about a specific business than the entrepreneur who is launching a company. The entrepreneur typically needs to have a unique degree of expertise and knowledge about his target market in order to devise a viable disruptive strategy. As a result, VCs typically have less information than the entrepreneur about the prospects of company that they are investing in. To mitigate some of this information asymmetry, VCs lean on experts.

‘Expert’ is a loosely defined term here. It includes anyone who knows a significant amount about at least one aspect of the market in question. An expert might be an analyst who spends every waking hour thinking about this market or it might be a person who knows a lot about one aspect of this deal, such as the technology, customers, a government regulatory body or competitors.

VCs contact these experts because they often provide the quickest way to learn a lot about an industry, enabling the VC to get another perspective about considerations that present concerns. In a one hour call, an expert can give a VC the scoop, laying out the industry dynamics and highlighting the key issues that they should be thinking about.

Furthermore, these experts can validate key assumptions. If the viability of an entrepreneur’s whole business hinges on a key factor, such as incumbents not entering the market or customers being really frustrated by the current value proposition offered in the industry, an expert can provide some validation.

Entrepreneurs should be aware that VCs are going to contact experts when they conduct due diligence. It is worth noting that they can do this without disclosing your business idea; these conversations are often one-way. Experts understand that the VC can’t disclose key information and usually don’t mind sharing their wisdom.

Entrepreneurs should use the knowledge that VCs will likely rely on experts to their advantage. Founders can both expedite and shape the due diligence process by identifying experts for VCs. This enables entrepreneurs to increase the likelihood that the VCs are hearing perspectives that support their vision and it cuts out the time that VCs spend in trying to find and connect with thought leaders.

People always want to get the best deal they can. For entrepreneurs this typically means getting the highest valuation when raising money. The higher the valuation, the less of the company that the entrepreneur will sell to VCs when taking an investment.

Like all things in life, however, moderation is key. Entrepreneurs that succeed in obtaining extraordinarily high valuations can risk their own financial rewards; there are three problems that excessively high valuations can create.

First, inflated valuations can limit the company’s access to short-term resources. By maximizing the valuation, an entrepreneur may lose access to the credibility and resources offered by the most sophisticated VCs for the current round.

Second, as the valuation increases it is likely that fewer investors will be willing to invest in the future. If the valuation continues to increase after each round, entrepreneurs may find that there are no other investors willing to get involved, leaving them with the challenge of trying to milk their existing investors, reduce costs or consider reducing their valuation.

Reducing the valuation of the company in the future can be painful for the entrepreneur as they may lose a significant portion of their equity. This happens because many investors use anti-dilution provisions to protect themselves. These legal terms allow investors to partially protect their equity stakes in the event of future investment rounds being completed at reduced valuations (also known as ‘down rounds’). Ultimately, in a down-round the ownership of the current equity holders declines. These anti-dilution provisions leave the entrepreneurs to bear the brunt of this dilution. This protects the investor from the consequences of entrepreneurs that don’t perform well or over-value their company early on. Since these terms are commonplace, entrepreneurs have an incentive to value their company appropriately to ensure that future valuations continue to increase.

In sum, it rarely pays to be greedy. While some succeed in over-valuing their companies, cutting aggressive deals can come back to haunt them as sophisticated investors know how to protect themselves from overstated valuations. In the end, it seems that it’s always better to do deals that value your company reasonably.

There are a number of relatively common aspects of the due diligence process. In fact, these steps are so commonplace that many firms have ‘due diligence checklists’ that ensure that VCs taking all of the necessary steps in the process.

Ultimately, the due diligence considerations are typically segmented based upon each of the key strategic, operational and financial elements of a company. Each consideration is typically assessed through a combination of meeting with management, review of secondary research, and conversations with industry participants (e.g., customer, competitors, investors, experts). I intend to write a post on each due diligence consideration where I will discuss the due diligence process for that consideration as it relates to entrepreneurs.

Due diligence considerations:

• Business model and addressable market size
• Customer demand
• Competitive advantages
• Business development Marketing plan
• Technology and product development
• Operations Management & human resources
• Financial
• Legal

These considerations are addressed through a number of common activities:

• Customer calls
• Expert calls
• Partner calls
• Addressable market sizing
• Model review
• Competitive landscape

The due diligence process centers around the belief that it is more effective to assess granular aspects of a business than a business as a whole.

To illustrate this imagine that you are an automotive mechanic. One day a car owner drives up and asks you to appraise the general condition of his car so that he can sell it. While seeing the shiny new paint job and hearing about the make of the vehicle, mileage and performance to date will be helpful, it is simply not enough information for you to guarantee that the car will perform well in the future. In order to make that assessment, you will need to evaluate all of the aspects of the car individually. You will check the breaks, test the engine and look at the tires. And then, if each of the cars key parts and processes seem to be in good shape you can conclude that the car as a whole is likely to perform well going forward. If all the things that make up the car are in excellent condition, you can more reliably conclude that the car as a whole is in excellent condition.

This same logic applies to conducting due diligence on companies. Investors that simply look at the type of company, how long it has been around and how it has performed to date will typically not make as reliable judgments about the future viability of the company as an investor who takes a look at all of the individual aspects of a business that are required to create future value. The process of conducting due diligence forces investors to carefully check the competency of the management, test the strength of customer demand and look at future competitive dynamics. If all of the parts of the company are well oiled, then it is safer to conclude that the company is ready to go the distance.

People always want to get the best deal they can. For entrepreneurs this typically means getting the highest valuation when raising money. The higher the valuation is the less of the company that they will have to sell to VCs when taking an investment.

However like all things in life, moderation is key. Entrepreneurs that succeed in obtaining extraordinarily high valuations can put their financial rewards at risk. There are a few problems that excessively high valuations can create.

First, super high valuations can limit the company’s access to short term resources. By maximizing the valuation they some of the most sophisticated investors may opt not to invest, limiting their access to credibility and resources.

Second, as the valuation increases fewer investors will be willing to invest in the future. If the valuation continues to increase after each round, entrepreneurs may find that there are no other investors willing to get involved, leaving them with the challenge of trying to milk their existing investors, reduce costs or consider reducing their valuation.

Reducing the valuation of the company in the future can be painful for the entrepreneur as they may lose a significant portion of their equity. This happens because many investors use anti-dilution provisions to protect themselves. These legal terms allow investors to partially protect their equity stakes in the event of future investment rounds being completed at reduced valuations (also known as ‘down rounds’). Ultimately, in a down-round the ownership of the current equity holders declines. These anti-dilution provisions leave the entrepreneurs to bear the brunt of this dilution. This protects the investor from the consequences of entrepreneurs that don’t perform well or over-value their company early on. Since these terms are commonplace, entrepreneurs have an incentive to value their company appropriately to ensure that future valuations continue to increase.

In sum, it rarely pays to be greedy. While some succeed in over-valuing their companies, cutting aggressive deals can come back to haunt them as sophisticated investors know how to protect themselves from overstated valuations. In the end, it seems that it’s always better to do deals that are good for everyone.

In my post, How A VC Is Funded, I listed four ways that VCs obtain capital to invest in startups. Each of these four sources of capital has slightly different implications for entrepreneurs. In this post, I will discuss the implications of a public funded VC.

Capital Constraints
Similar to family office funded VCs public funded VCs raised a relatively fixed pool of capital from the public markets, which they continue to recycle from exits to new investments. Entrepreneurs should be sure to ask any fund that relies on recycled capital for future investments about their reserves to ensure that capital will be available in the future. While in theory the fund can always tap the public markets, that may not be the reality.

The Public Eye
Public companies have to make public disclosures. As a result, more about your company and its operations may be easily accessible to third-parties if you have a public investor. If your company requires substantial privacy because your strategy relies on being the first mover or otherwise then you should ask these VCs about the disclosures that they will make.

Bureaucracy
Too many entrepreneurs bureaucracy is the anti-Christ. If this is the case beware of the additional administrative burdens that might be required if you accept money from a public fund.

These funds are regulated by the SEC and have substantial reporting requirements. Be prepared to answer questions and provide lots of data as necessary.

In my post, How A VC Is Funded, I listed four way in which VCs obtain capital to invest in startups. Each of these four sources of capital has slightly different implications for entrepreneurs. In this post, I will discuss the implications of a government funded VC.

Both the federal and local governments have created venture funds that seek to harness the free markets to achieve a social objective. The federal government has one fund that seeks to identify and incorporate new technologies into the military. Many state and city governments use these entities to stimulate local economies.

Capital Constraints
Similar to both the family office and public funded funds these funds recycle capital from one investment to the next. As a result, capital constraints can be an issue if they don’t have robust capital reserves are timely exits from other portfolio companies.

Furthermore, these funds are subject to the whims of legislators. It’s possible that your capital reserves could be re-appropriated to another state agency with a change of administration or policy.

Double Bottom Line
As aforementioned, these funds typically invest both to increase the size of their capital pool and achieve a social objective (e.g., supporting new technologies, creating tax revenue or decreasing unemployment). As a result, you should be thoughtful about the motivations of these VCs. A pre-requisite for their investment may require moving the company to a new location or taking the time to license the product to the government.

In my post, How A VC Is Funded, I listed four way in which VCs obtain capital to invest in startups. Each of these four sources of capital has slightly different implications for entrepreneurs. In this post, I will discuss the implications of a family office funded VC.

By family office I am referring to one family’s private capital. In this scenario the VC firm is essentially working for a very wealthy family to enhance the family’s personal endowment.

Capital Constraints
Some of these VC funds can have a relatively limited amount of capital under management. Since they typically don’t raise capital from third parties, they can only invest what the family allocated to them. Furthermore, once that’s invested they have to wait for a company to be sold in order to have access to more capital.

One risk in this situation is that if the fund has invested a large proportion of their assets under management they may not have the resources to continue to support your company in future rounds. The takeaway is that you should take a look at their balance sheets before accepting an investment.

At The Mercy Of The Family
There is some risk that families may be able to pull their capital out of the fund if they have a sudden need for liquidity. The impact of this would again be an inability of the fund to support you in future rounds.

This is a question worth asking the VCs – they may or may not have protective provisions in their contract with the family that prevent sudden withdrawals.

Even-Keeled Investing Strategy
The psychology and objectives of a VC at a fund with fragmented LPs typically changes through the stages of their investment cycle; they are willing to take more risks at different points in the fund. While this is may be a pro and a con for the entrepreneur, it differs from the styles of family office VCs.

Family office VCs with pools of capital that far exceed their investment capacity are more likely to have a consistent risk tolerance, making for more predictable investment decision making. However, funds with more limited AUM may become more risk adverse as capital pools continue to become increasingly constrained.

Board Accessibility
VCs that have a fragmented LP base become very busy every 3 to 5 years as they go out to raise capital from their LPs. This can make them less accessible to their portfolio companies. However, the best ones make sure that they are still available.

Family office VCs don’t have to spend lots of time raising money, meaning that should be slightly more consistently available to their entrepreneurs.

Typically a company raises numerous rounds of capital through its lifetime. While there are not rigid rules about the fundraising stages, I have attempted to characterize these stages below. Note that these stages reflect the IT space and can differ greatly in other sectors.

Friends and Family: F&F capital is the starting point of the company that is often used for basic administrative details including corporate formation, market research and the creation of a business plan.

• Typical Round Size: F&F rounds can be as small as $5K and as large as $100K.
• Investment Structure: Convertible note or common stock.
• Hurdle For Next Stage: Business plan; management team.

Seed: Seed investments are typically provided to companies that have a business plan and a management team, but do not have a product. At this point, companies are raising money based upon an idea and a team.

• Typical Round Size: These are typically $100-500K but can be as large as $1M.
• Investment Structure: Convertible note or common stock.
• Hurdle For Next Stage: Product.

Series A: The word “Series” implies institutional money (money invested by a VC). The letter “A” means that it is the first institutional round. By the series A most companies have a product that is ready (or close to ready) to take to market.

• Typical Round Size: These are typically $2-5M but can be as little as $1M and as large as $10M.
• Investment Structure: Participating preferred stock.
• Hurdle For Next Stage: Market adoption.

Series B: Typically in order to raise a Series B the company needs to have demonstrated market traction, further developed the business and recruited a more robust management team.

• Typical Round Size: These are typically $5-10M but can be as little as $5M and as large as $20M.
• Investment Structure: Participating preferred stock.
• Hurdle For Next Stage: Growth.

Series B and beyond: After the Series B round the required achievements more frequently vary by company. Some companies are nowhere near profitability and need more capital to stay alive and others are profitable but need capital in order to accelerate growth.

In my posts about how much capital should be raised from an entrepreneur’s and VC’s perspective, I wrote about the incentives that drive the target size of a given round. However, there is another dynamic to consider: which round of capital is being raised. Later rounds are typically larger than earlier rounds. There are a few reasons for this:

• As the company matures its cash burn rate typically increases (until growth begins to plateau and profits offset burn), creating a need for more capital to take the company to the next milestone. The higher burn rate also means that the company needs more money in order to not have to conduct another raise as soon as they complete this round.
• Mature companies have higher valuations, enabling them to raise more money at a lower level of dilution.