I moderated a recent Angel Launch panel at Founders Space where some early stage investors shared their expectations with attentive entrepreneurs. This San Francisco event was very well-attended. The investors' wisdom was a fresh reminder that I always have something to learn. I'll share some of what they revealed below, commingled with my own thinking.
Startup founders need to implement good financial and legal controls at the very inception of their business. Getting good advisers helps avoid common problems. Setting up legal structures, bank accounts, and accounting software is the necessary first order of corporate housekeeping. The founders must delineate their ownership stakes with term sheets that feed the initial cap tables. I've blogged before about how attorneys sometimes deal with "phantom founders" in later stages whose rewards were not clear at the beginning.
Experienced early-stage investors will set expectations for bottom-line results. The team's goals for closing sales get a boost if they land a big-name customer. Leveraging a corporate VC's brand name and ecosystem are important; some other gurus at one of the many conferences I've attended call this "hacking your pedigree." Raising capital is not success, but too many startup CEOs think raising capital is their primary job. Sales revenue from customers is real success, and CEOs need to think of revenue as a non-dilutive capital injection.
I keep hearing about the importance of scaling from investors and entrepreneurs who succeeded. Scaling matters only after a startup proves it has something customers want to buy. Once the early adopters are in the pipeline, the total addressable market (TAM) they represent must be big enough to allow scaling. Making the early customers happy is more important than worrying about scaling too early. Startups can tweak their approaches to marketing channels later if they stay flexible. Startups rarely fail for lack of scaling, because revenue from sales drives the enterprise's ability to scale. I totally see how startups with unsound business models fail by scaling too early; they burn their capital on unneeded physical plant and IT infrastructure before they can pivot to a market segment that allows for revenue-based scaling.
Founders should expect decent terms from early investors but understand that investors must apply a high discount rate. The founders who can protect their interests with liquidation preferences should expect investors to be just as sophisticated. Founders should expect friend / family / fool (FFF) investors to subscribe to warrants, just like later investors.
Serious investors must perform due diligence before committing to invest in a startup. A small team of young people running a brand new company is the easiest to check. They probably have very few legal or financial troubles that will pop up in a background search. Top VC firms often hire private investigators to evaluate a startup team's background before committing millions of dollars in capital. My own preference is to use the basic online search tools available to anyone, plus some pattern recognition techniques common in military intelligence training. Running several Google searches on permutations of someone's name usually yields enough data points to vector their professional experience. San Francisco Superior Court and other regional courts have case histories that anyone can look up free of charge.
Every early investor has their own set of deal-breakers that will stop an investment decision. The most important red flag for me is a lack of personal integrity. I try to give people the benefit of the doubt at first contact. Once I discover inconsistencies in the story someone gives me, they are gone from my professional life with no explanation necessary. I tell people not to ever lie to me. The people who don't listen don't deserve to have me around. I can forgive an entrepreneur who has been through bankruptcy, especially if it resulted from a previous startup. Entrepreneurs are expected to be fully committed to their dream and they do suffer financial penalties when dreams end in business failure. I can understand a divorce settlement and child custody payments, because humans aren't perfect. Sometimes people who possess bold, risk-seeking business personalities leave messy personal lives in their wakes. The deal-breaker for me (besides lack of honesty) in personal affairs is a chain of unrelated bankruptcies, liens, divorces, and other financial train wrecks that recur for years. A business person so immature and reckless needs to sort out their personality problems first before soliciting risk capital.
Subsequent rounds of investment do change the relationship between founders and early investors. The preferred order for expanding a capital structure is sales (first and foremost!), FFF, non-dilutive grants, crowdfunders, angels, and finally VCs. The FFF and grant rounds are somewhat blended in a startup's chaotic early days. Subsequent rounds are more complex and dilute early investors as the enterprise issues new shares. Early investors are often pushed aside in those startups lucky enough to attract huge VC commitments, and they may even be forgotten after forced management changes. The earliest backers need to store their original term sheets securely (yeah, no-brainer, but no one wants to be the FFF who lost their term sheet prior to a billion-dollar IPO). The startup's attorneys are supposed to maintain the cap table proving early ownership but startups do change law firms sometimes. The records transfer may not always be perfect. Perhaps you can tell that I don't completely trust third parties to keep my best interests in mind.
My regular readers know that I see the social / mobile / Big Data investing trend cooling off. The smartphone market in developed countries is at or near its saturation point. The next hot trends in wearables, IoT, and hardware are already visible but I believe early investors will be shell-shocked when they see the price tags for investment. Hardware success stories need a lot more capital than software stories. The elegant solution is early sales of simple beta products, but of course nothing is ever so simple. I would like to see enterprise solutions address the performance gaps in supply chains. Large VCs look down at such solutions because they don't scale to multiple billions of software sales, but I say they can provide startups with enough capital to help pioneer cheaper hardware as IT/OT integration takes off. Startups aiming for base hits will take momentum from those seeking home runs in the next few years. You heard it here first.
Startups deserve to inhabit healthy ecosystems. I blogged about The Rainforest: The Secret to Building the Next Silicon Valley when I discussed my experience at this year's Cleantech Open National Academy. Entrepreneurs operating a virtual enterprise in software can stay lean and code from anywhere. They have fewer concerns than a hardware startup that must weigh physical distance to markets, length of supply chains, and sources for technology collaboration. Colocation with a major research lab may matter in the early days. Locating in a HUBZone may be relevant to startups targeting the government market or the supplier diversity programs of major government contractors. Tax incentives matter once a startup has enough revenue to scale up its capacity; this may dictate a change in location. San Francisco loves giving tax breaks to big tech companies that promise to bring in lots of new jobs. Civic leaders who are serious about following suit in other towns need to follow the Rainforest blueprint. The City By The Bay never gave me any tax breaks for creating my own job with Alfidi Capital, but I can't complain.
None of these meditations mean jack squat without action. Entrepreneurs can will themselves to success if they move forward daily.
None of these meditations mean jack squat without action. Entrepreneurs can will themselves to success if they move forward daily.
