August 12, 2003 - The Clueless
Entrepreneur
by
Bill Snow
I periodically post messages
in an on-line venture capital related network. The array of people who
participate range from very experienced investors and entrepreneurs, to what I
would call the completely clueless neophyte.
The past week has seen an
explosion of posts. Some were written by sage advisors, but tellingly, many
more were written by disturbed, distressed, and agitated entrepreneurs. Guess
what? I saw the same frustrations, the same misconceptions, and the same errors
that regular readers of my column will recognize. Let’s review some more of
these very common mistakes that early stage and wannabe entrepreneurs make.
Ideas are not enough – you
have to have a company
A large part of the posts
dealt with ideas, namely what makes a great idea. One neophyte suggested a
"great idea" was “one that leads to a very profitable business if properly
executed and adequately funded.”
No kidding! Talk about
qualifying your answer. That’s like saying “a great at-bat in baseball” is when
you make contact and hit a home run.
As I tried to point out, the
whole “great idea” conversation is moot for a simple reason: VCs (with the
notable exception of Tom Churchwell at
Arch Development Partners) do not invest in ideas. And even in the case of
Churchwell, he’s usually only interested in the idea if it has some intellectual
property attached to it. Don’t contact him if you’re looking for someone to
back your lemonade stand or record store.
The bottom line is the vast
majority of VCs invest in existing companies that already have sales. Ideas are
great, but much like opinions and a certain part of your body, everyone has
one. A company with a market validated business model is what venture
capitalists look for. Your friends and family are the investors who will
(maybe) back your ideas.
You have to be willing to
work
VCs do not make investments
in order to do the work. That’s the entrepreneurs’ job. Believe it or not,
many the neophyte entrepreneurs on the Internet board actually think that VCs
should not only pony up the dough, but they should also help them flesh out the
idea, make sales calls, and do all the work the entrepreneur is supposed to do.
I was fully expecting someone to say that VCs should also do the entrepreneurs
laundry…and clean the house, too!
VCs provide the financial
backing and they will naturally be involved in the operations of the company.
But the roll that most VCs will take is similar to that of a board member (and
many VCs are board members): they help the entrepreneur with long term planning
and provide some advice. But the nitty gritty, day-to-day work will be covered
by the entrepreneur.
Venture Capital is not a
stamp of approval
Much like my dog, which has
an uncontrollable urge to eat whether he is hungry or not, entrepreneurs seem to
have an uncontrollable urge to seek venture capital, whether they can raise it
or not. If we could read my dog’s mind, his prime directive would say, “Must.
Eat. Food.” Likewise, if we could read the prime directive buried deep inside
the unconscious minds of many wannabe entrepreneurs, it would say, “Must. Seek.
Venture Capital.”
Venture capital is not a
stamp of approval delineating between “good” company and “bad” company. Venture
capital is a type of financing that only a very select type of company can
raise. Many entrepreneurs seem to place their initial energies on obtaining
venture capital. Instead, they should focus on building a company and
generating sales. Venture capital should be the last thing they think of.
Reluctance to give up enough
of the company
Worse than the Pavlovian
drive to seek venture capital, many early stage entrepreneurs seem to lack
awareness that if they raise venture capital, they will have to give something
up. There is often a stunning disconnect between the thought of getting money
from a venture capitalist, and the realization that you will have to give up a
sizable chunk of your company. I have meet with, and talked with, countless
entrepreneurs who think that they can raise $10 million and still own nearly all
the company’s stock. One Chicago area wannabe entrepreneur told me he wanted to
raise millions of dollars of venture capital in order to buy an existing
company. He wanted to hire me, give me stock, and since he was in a jovial
mood, he wanted to give stock to all the employees, too. Sounds great, right?
I should add he wasn’t
prepared to put a dime of his own money into the venture.
When I asked him how much of
the company he expected to own, he told me, “Ninety percent.” And he sounded
pained when he said that. I told him he’d be lucky to own 20% of the company
when it was all said and done. Frankly, his ownership position would most
likely be under 10%.
Then there’s the case of
another angel funded Chicago area company. Believe it or not, the angels behind
the venture felt they could raise $10 million and only give up 1% of the stock.
At the time, the company was still pre revenue.
Scale is needed
Having scales means
you have a skin condition and should probably see a doctor. So what does
scale mean? Scale can mean the cost to deliver the product or service is
the same (or virtually the same) whether you have one client, 100 clients, or 1
million clients. Scale can also mean recurring revenue (contact sales). And
scale can also mean the product has a large price tag (six figures). The best
of all worlds would be having a product that has all three of these attributes.
Someone who is selling an
interesting retail product recently contacted me. The problem? The thing costs
less than ten dollars, and once a consumer buys one, it is unlikely he’ll buy a
second. I like the product, but selling a low priced retail product is a very
difficult way to become a millionaire. Impossible? Of course not. Just very
difficult. Low cost consumer goods are about as far away from scale as you can
get.
Detailed financials
File this one under yet
another area where the early stage entrepreneur thinks the VC should do all the
work. Many early stage entrepreneurs flat out expect the VC to create and
refine a detailed financial model. This misconception is found mostly in the
people who do not understand accounting.
Why should entrepreneurs
create detailed financial models? After all, it is highly unlikely that any
single number generated on the spreadsheet will actually occur in real life.
What the model does is demonstrate that the entrepreneur fully understands the
full scope of the business. What are the key numbers? What happens to output A
if input X is reduced 20%? While it can seem like a lot of busy work to create
projected financials, the company will have to create detailed financial records
if it gets funding. Demonstrating in-depth understanding before the
investment will only strengthen the odds of receiving that investment. Being
clueless is not a good option.
Either learn accounting, or
hire someone who understands it. If you are an accounting neophyte, find a
partner who is a ringer.
What’s the exit?
This is another venture
capital basis that seems to trip up many wannabe entrepreneurs. If there is no
clear plan for the investors to get their money back, an investment is highly
unlikely. One of the sage voices on the Internet board likened the exit
scenario to owning a piece of David Lynch’s production company. The company
might be worth something and might generate strong cash flows, but what happens
if/when Lynch leaves the company? There’s no public market for the stock, and
once the namesake leaves, it is unlikely the company will have any value.
The two main exit scenarios
are IPOs and acquisition by a publicly traded company. Since IPOs are rare
(especially today), entrepreneurs need to build businesses in industries that
are ripe for consolidation. If you create enough value (or become a big enough
pain point to a competitor), someone will come a-knocking with a large check.
Then you can become an angel or VC…or you can sit on a beach and sip pina
coladas.
Conclusion
It boils down to this:
Entrepreneurs must mitigate as much risk as possible. Avoid what I call the
“lump of clay” syndrome. VCs will only fund your company (maybe); they are not
about to do all the work, too! Entrepreneurs must create and refine a business
model, validate it via sales, run all the day-to-day operations, get a dose of
good luck tossed in, and maybe, just maybe, they can raise money from VCs.
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