Editor’s Note: This post was originally published on Seattle 2.0, and imported to GeekWire as part of our acquisition of Seattle 2.0 and its archival content. For more background, see this post.
By Gerry Langeler
When is a lemming not a “lemming?” When it’s bath time!
I’m not even sure where I was going with that, but there is a point to be made. Many folks criticize VCs for acting like lemmings, all blindly jumping off the same cliff into the sea, investing in the same sectors, while ignoring interesting projects outside those currently hot spaces. There is a lot of truth to that complaint. But there is a rationale for it, too.
As I’ve said in other posts, often the hardest check to get is not the first one but the second (or third!). When reality interjects itself into the financing process, the sparkle and promise of a Series A investment gives way to hard questions when initial targets have been missed. It is in times like this that financing risk can become the most important risk facing a start-up. And this is when being in a “hot space” can help overcome an otherwise cold start.
Most entrepreneurs believe in at least one of two fallacies:
- Their business plan is correct, or better yet, conservative.
- If they need more cash, investors will automatically pony up, regardless of how they’ve performed on the initial tranche.
The reality is that those business plans are not correct, much less conservative. As I’ve stated many times, we’re now at over 120 companies backed, and NOT ONE has made their initial business plan metrics. And we’ve seen many, many examples of companies that, having missed their initial plan, struggled or failed to raise follow-on capital. Not only do the entrepreneurs pay in that circumstance, we do too.
So, when we look at a new start-up opportunity, we are asking ourselves about the financing risk in that deal. That risk comes in at least three forms:
- What is the capital intensity of the business? The more money needed to take the company to the promised land, the more chances there are for a stumble to turn into a problem financing, which turns into a down round, or a fire sale. In addition, the more money needed, the more VCs will be needed to share the load. And the more VCs you have, the greater the chance of one or more turning negative on the deal and upsetting the syndicate dynamics. (bad syndicate dynamics kill more deals than ever gets reported)
- What is the investment popularity of the business? Here, lemmings rule. I’d much rather be looking for the Series B round for a company in a hot space than a cold one. The same holds true for the Series A. We’ve gone “off popularity” enough to know how hard it can be to get another VC firm to co-invest with us when we are “out-of-step” with current market psychology. (That said, we often like to be temporarily out-of-step, as that is where the big rewards can be found.) In addition, there is nothing quite as frustrating than to have an investment in a company that is succeeding where others have failed, but be told by our friends in VC-land that they won’t look at our firm for the Series B because they lost money in a similar deal years ago.
- What is the time predictability of the business? This is actually a part of capital intensity, but in an unsuspecting way. You may have a business that is not capital intense on its face. But, if it is one where no one can tell exactly when the market will engage (or if appropriate when regulatory hurdles can be jumped), then it may be more capital intense than it appears. We saw this years ago in wireless location-based services. We got in early (too early in retrospect) and so those start-ups that really were not very capital intensive by nature became more so as we had to wait around for the market to develop.
So, what can you do about these issues? First, recognize they exist and they are just as important as the previous three risks in this series (People, Product, Market). Be ready to discuss the financing risks with us. Next, find ways to mitigate them. For example, while most software companies don’t have to worry about capital intensity, even they can find creative ways to use fewer dollars (cloud computing, etc.). If your start-up is in a currently unpopular sector, find a strategic partner who would benefit greatly from your success and get them into the first round. Or find a customer who is desperate for your product and get paid 50% up front as a deposit. If you are in a “cold space” either find a way to morph the plan to get closer to warmer climes, or belly up to the fact that you are looking at a long, tough slog to raise capital.
Next, value your investment syndicate the same way you value your most critical employees. When it comes time for the next check, you absolutely need all your VCs to be telling their partners, “Yes, the company is behind plan, but our investment thesis still holds. This group deserves another check.” rather than, “There is still an opportunity here, but I’m less confident in this team than I was initially.” You’d be amazed how many start-ups take their VCs for granted once that first check is in the bank.
Never say, “I can’t wait to be done fund raising so I can get back to running the business.” Fund raising IS part of running a business! In fact, you are always (or should always be) fund raising. So, be looking for opportunities to expose your firm to investors beyond your initial set. Those are the ones who might lead your Series B or C round. Jump on any chance to present in the private company portions of the investment banker beauty shows in your sector.
If you treat Financing risk with the same attention that you treat the other three, you’ll positively stand out from 90% of the entrepreneurs who go looking for venture capital.
While this concludes the initial intent of a 4-part series, I’m going to add one more in the coming weeks. It will be titled, “Part 5 – Potpourri” and deal with a number of irritants and mistakes entrepreneurs make, that while not conclusively leading to a “no,” get us leaning in the wrong direction.
