Demystifying the Secrets of Venture Capital
I recently got another one of “those” phone calls. A friend has a “breakthrough” idea for a new business and wants me to connect him with some venture capital.
If it happened once, I wouldn’t think anything of it. But it seems like it happens all the time. People really don’t understand what venture capital is or what investors expect.
A Basic Definition
To put it simply, “venture capitalists” (or VC’s) are private investors who provide capital (e.g., cash) to companies that show high potential for growth. In exchange, they usually ask for an equity stake in the company. If you’re not familiar with that term, it basically means that they want to own a certain percentage of the company or to receive a percentage of the profits of the company. Often, that ownership stake is contracted for a set period of time, at which point they can sell their portion for a profit. If you’ve ever watched the TV show, “Shark Tank,” you get the basic idea.
Recognize the Risk
Even the best ideas can fail. Talented people can really mess things up. Small miscalculations can shipwreck a great business plan.
Investing in a business startup (or a small business that is ready to explode) comes with a great deal of risk. Venture capitalists typically have a very high tolerance for risk – higher than the average person – but they don’t have unlimited tolerance. Just because they have access to a much larger pool of money doesn’t mean they throw it around.
While there is a certain amount of gambling involved in any investment, especially at the level where most venture capitalists play (10 to 20 million dollars), they do a ton of homework before they commit.
Do You Know The Right Answer?
If you approach a seasoned investor with a request for money, you better be ready to answer a barrage of questions:
- How much experience do you have running a company?
- Who is the target market?
- How many competitors are there? What is each one’s market capitalization?
- What are your projected expenses for the first year? How accurate are your projections?
- How will revenue come into the company? What kind of margins do you expect?
- Who are your suppliers? How reliable are they? What is your Plan B if one fails?
- How many people do you plan to hire? What roles will they fill? What experience do they have?
- Who do you have advising you?
The list goes on and on. The typical venture capital investor not only expects you to have a well-researched answer for each one, but the answer that will give them peace. You don’t get to be a successful venture capitalist if you’re stupid. People who make emotional decisions based on a good pitch don’t last long. They might follow their gut when the numbers don’t look quite right, but they never violate their own sense of what will work. They have honed their instincts around good business sense. If your answer violates their good judgement, you’re toast. And if you don’t know the answer to a question, forget it.
Know your numbers inside and out.
Do You Really Need Venture Capital?
What does it really take to start a business?
If you are launching an Internet-based marketing business, the answer is probably no. Not always, but usually. It doesn’t take truckloads of cash to start a web business. If you need to borrow money for web design, videos, photography, and advertising, you can probably reach out to friends and family and get everything you need to get started.
Do you really need a million dollars? Maybe. It depends on several factors:
- Do you need to buy a bunch of expensive equipment or a specific type of building to operate your business? An example of this would be a restaurant or a body shop.
- Will you need an unusually large amount of inventory or materials to get started? An example of this would be a cosmetics manufacturing business.
- Will you need to hire a lot of people right out of the gate to do the work?
- Do you need to acquire the rights to patented or copyrighted materials?
- Are you planning to quit your day job to operate this business?
- Will you need to license the rights to a franchise?
My next question is really the one that seals the deal: why?
Ask Better Questions
So often, people who think they need a bunch of money from investors in order to get started haven’t really thought through the process with any creativity. Ask yourself:
- Are there ways you can get started with what you have available?
- Can you trade or barter some services in exchange for things you need?
- Can you start small and work your way up?
- What is your minimum viable product to generate some sales?
Granted, some business ideas require a lot of money up front. If you have an idea for a new pharmaceutical, you’re going to need some major investors to get started. But most startups don’t need all that.
Also be aware that if you ask someone to fund your first year of operations so you can quit your day job and focus on just this, you’re probably going to be laughed at. Investors would rather get behind people who are so committed to their vision that they are willing to work evenings and weekends to bootstrap a launch. By asking an investor to cover your payroll so you can focus on your “big idea,” you are basically rolling all of the risk onto them. No investor is going to take you seriously if you are not willing to share the risk.
Levels of Financing
Between your first web-based business and a mining operation are levels of investment, risk, and expectation:
- If you are asking your wealthy uncle to give you $20,000 to buy painting equipment, the expectations and risk are going to be less intense. They know you and what you are capable of, and they trust you to a certain extent.
- An investor is going to require a larger return for his larger risk, whether in the form of an equity position, decision-making rights, or a larger payout on the back end. They are going to audit you at an entirely different level, to ensure that they will receive a good return on their investment.
- In between, there are local investor groups, angel investors, or even ways of leveraging smaller investments into larger ones. If an angel investor sees that you have convinced 50 friends to invest $1,000 each, he may see that as a validation of your idea. Even better is to have a pipeline of paying customers or an email list of people who have expressed interest in buying the product.
When Does It Make Sense To Start Looking For Venture Capital?
Most people have ideas. Many have ideas about a possible business. But among those, few will ever follow through to act on those ideas. Fewer still will manifest a working product to show to potential investors.
I recommend that, before you begin reaching out to investors, you create a prototype – a minimum viable product that investors can see (and if possible, handle). A completed form of the product demonstrates the output and the process to investors. For example, if you want to make widgets, make one and show the investors the process that got you there. If you want to produce a TV show, shoot and edit the first episode (sometimes called a “pilot”). Let them see that you are capable of doing the thing you want them to fund.
Physical products should have a minimum viable product in a box, bottle, or somewhere that people can see and touch it. Don’t make investors imagine what you can do; make it tangible. Even if you just have the most basic materials to cobble together a demo, do that. Show the time and process required to make one before you ask for money to make thousands of them.
There’s A Track To Run On
Another thing I like to remind entrepreneurs is that there is a lot value to following the system. You don’t jump from your basement to a $30 million raise. Start at the “friends and family” level. Join a local angel venture capital group or “shark tank.” Most large communities have at least one group like that. They exchange finders fees. As your need for capital increases, so will your credibility and your exposure in the community. That’s as valuable as cash. Show longevity and commitment.
It’s Not Just A Product
An investor might look at your idea, see that the product makes sense and there is a market for it, but having a prototype will demonstrate that you are capable of carrying out the idea. Some people have great ideas but lack the capabilities to fulfill on the idea (or run a company). Smart investors are looking at the skills and pedigree of the person as much as the idea.
I’ve been in countless meeting where the idea was great, the financial modeling was great, and the market was ready, but the person presenting the idea was the wrong person to drive the business forward. It matters. Like I said earlier, you can have a great idea and still fail if you don’t know how to drive the business behind it. So much of investment is recognizing the capabilities of the team to fulfill on the idea. You might recognize this from our article on the Seven Pillars of Business Success. An investor is going to want to see that you have skilled people operating each of the seven pillars. As the risk goes up, the scrutiny of the audit goes to an entirely different level.
One Key To Working With Venture Capital
You have to know where you want to end up. It’s one thing if you want to grow a little and manage your business; it’s entirely something else to leverage up to a massive, 8-figure buyout. You might end up with only 15 or 20 percent of the company, but that 20 percent is worth a billion dollars. Be clear on what you want to end up with.
Investment always comes back to the question, “what will someone actually pay for this?” As entrepreneurs, we tend to be optimistic. It’s easy to overvalue our “amazing” product and think your product (and your business) are worth more than they really are. It’s important to get an objective voice to speak into your valuation before you talk to an investor, or you might be in for a rude awakening.
Let an experienced outside opinion come in and tear your business apart – evaluate the systems, processes, IP, market, and metrics. What is the company worth if you weren’t the one running it? I’ve talked to entrepreneurs who wanted an investor to come in and give them an amount of money that was unrealistic compared to what their business was really worth to an outsider. Could you make it with what you have on hand now? You need to know the truth objectively.
I know people whose only job is to tear apart businesses and determine what they are really worth. Fun.
This is just an introduction to the concept. I strongly encourage you to listen to this week’s podcast, where I deal with this topic in more detail. I also have a couple of great stories about Jeff Bezos and Elon Musk. You would be shocked at what’s really happening when you look past the headlines. Do you know how Bezos get started? Do you know the risk Elon Musk is taking right now? Download this week’s podcast from Apple Podcasts, Spotify, iHeart Radio, TuneIn, or anywhere you get podcasts.
Smart investors know the numbers behind the numbers, and they don’t read headlines at face value. The more you know about how they think, the better equipped you will be to present to one.
At Venture Studio, we offer courses, live masterminds, and other training resources. We also like to work with individuals to get their business (or their business idea) in shape to present to an investor. We provide pitch decks and run your numbers through a gauntlet to find the holes. Like the guy who came to me with a great idea for a business. But when we put him through our diagnostic, we found that what he really had was a great marketing campaign. He didn’t know a thing about operations or cash flow, so he really didn’t have a business at all.
Let’s Walk Together
I would be so honored if I could come alongside you and shepherd your idea from a good concept to a profitable enterprise. Contact me today to get started. In the meantime, join the conversation on Facebook or LinkedIn. We are building a community of entrepreneurs and investors who want to talk about building successful businesses. I look forward to seeing you there.