I understand.  I’ve been there myself.  I’ve worked with many clients on a similar path, and have seen hundreds of business plans in much the same vein – one which ultimately yields little gold.  I’ve also worked with many companies in the process of “doing it right.” In other words, they approach the business and its capitalization on the basis of staged development.  These companies are born with a focus on economical proof of concept.  They learn to crawl through the early stages of customer acquisition, revenue generation, product or service improvement, and support infrastructure build out. Then they demonstrate their ability to walk by successfully scaling both revenue and production capacity.  Lastly, using their proven approach and infrastructure, they run hard to keep up with the demands of significant growth.  These businesses have a much higher probability of success, and represent greater financial returns for investors of all kinds.

Here are some statistics from U.S. Census data that reveal the near myth of the hundred million dollar startup, and some of its smaller kin.

• There are typically more than 500,000 new companies founded each year in the United States.
• Approximately 80,000 new companies founded each year project annual sales of $10 million or more within five years.
• The number of new companies founded each year that achieve $100 million or more in annual sales within six years is 175.
• The number of new companies founded each year that achieve $50 million or more in annual sales within six years is 474.
• The number of new companies founded each year that achieve $10 million or more in annual sales within six years is 3,608.
• The odds of starting a company that achieves $100 million or more within six years are 3.5 in 10,000.
• The odds of starting a company that achieves $50 million or more within six years are 9.5 in 10,000.
• The odds of starting a company that achieves $10 million or more within six years are 72 in 10,000.

These odds are not well known, though many investors suspect something like this to be the case.  This is a major, justifiable reason why experienced investors are reluctant to believe massive projections from a startup company. If you want to learn more about reality versus myth in the arena of business capitalization, I recommend The Illusions of Entrepreneurship and Fools Gold? The Truth Behind Angel Investing in America, both by Scott A. Shane.

The truth is you don’t become a $10 million or a $50 million or a $100+ million company by getting fully funded in the startup phase.  Instead, you raise enough capital to support you from one development stage to the next, and earn your way up the revenue ladder.  This is reality. The exceptions to this rule are few in number.  As Mr. Spock of Star Trek would say, it is not logical to assume that your business is the exception.  Are you willing to gamble millions of dollars of your own money and several years of your life on these odds?  There is a better way, and that’s what we specialize in.

• Your opportunity must fill a significant need in a large niche in the marketplace.
• This opportunity should be suitably documented and presented (packaged).  If you don’t have a solid business idea and present your opportunity in a professional, focused, and credible way, your chances of getting funded are very low.
• Investors are unlikely to capitalize your business if they don’t like you or believe you can deliver solid results.  Your ability to relate well to others and your personal credibility are critical elements of the capital raising process.  In other words, investors invest in founders rather than in products and services.
• Most investors want to see strong management.  If you don’t have a strong management team yet, a credible approach for building one needs to be developed.
• The deal must be attractive and make sense to investors within certain well established guidelines.

Many early-stage company founders are not well prepared to address these issues with investors.  As a result, many never get past the first step.  They may get words of encouragement or a lukewarm response from investors, but receive little or no funding.  If you have tried to raise investment capital but have not been successful, the chances are good that the primary reasons are found in the five issues summarized above.

So what can you do about it?

1. You can read lots of books and articles about how to raise money from angel investors and do everything on your own.  Some of what you read will be very helpful.  Much will be repetitive.  Virtually none of it will tell you exactly what to do in your specific situation.  You will be on your own to figure out how to adapt the information to fit your business, which is the weak link of this approach.  How will you know if you are doing the right things in the right ways at the right times, especially if you don’t have experience in the entire process?
2. You can get someone with lots of experience to prepare the needed tools and do everything for you on spec (no money now, but the promise of money in the future after funding is raised), or in exchange for a piece of the business.  This is a great idea that rarely works.  People who successfully help businesses raise investment capital have paying clients.  They see dozens or even hundreds of opportunities on a regular basis, and have little time for pro bono work.  If someone has the time to invest weeks or months of effort to work on a business with a slim chance of getting paid, they are probably not very experienced in the process of raising investment capital.  This option is included here because many entrepreneurs think it’s the best way.  It usually does not work because the people you get often turn out to be the wrong people.
3. You can combine your best efforts with expert assistance as needed to give you the best possible chance of success.  In this case, you will spend the time and effort needed on your part, and invest in the necessary expertise to package the business and prepare you for the capital raising process.  Then, you will be integrally involved in every subsequent capital raising activity and meeting.  Even after all this, there is no guarantee you will raise a nickel for your business.  However, you will significantly increase your ability to succeed if you combine efforts in this manner.  A team approach can make a huge difference, if it’s the right team.

The third option represents the highest likelihood of success for most early-stage companies.  It requires a solid personal commitment to the business and the process of raising capital to support its growth, and often the prudent allocation of seed capital to engage the necessary expert assistance.

• They have a limited amount of time they can devote to looking at new opportunities because they are very busy people.
• They often receive dozens of funding requests per month.
• Every entrepreneur has a business plan and a private placement memorandum, but the format and quality of these documents vary wildly.  There is little consistency, and as a result, it takes longer to find and digest the key information they are looking for.
• Investment decisions are rarely made without first developing a personal level of trust with an entrepreneur.  When starting from scratch, this takes valuable time.
• Business valuations and deal terms offered by entrepreneurs are often based more on enthusiasm than reality.
• After investing all the time to sort through and finally find an attractive deal and develop a level of trust with the entrepreneur, it may take another 40 hours to conduct proper due diligence on a deal.
• Due diligence also costs money for background and credit checks, legal review and document preparation, and much more.
• After funding a deal, the statistics for success are not encouraging.  5 out of 10 businesses invested in will fail.  4 out of 10 are likely to survive but provide little return on investment.  Only 1 deal in 10 is likely to be a home run.  That home run has to make up for all the other losses incurred, and still provide a reasonable overall return.
• A down economy adds a whole new layer of risk, as successful exits through acquisition or public offering become fewer in number.

Even with all of these challenges, accredited investors still invest in deals.  Smart entrepreneurs recognize that the key to capitalization success is making it easy for investors to address all these challenges.

Respectfully, I disagree.  Here’s why.

• There are about 300 angel groups in the United States at present.
• The largest angel group in the United States is currently Tech Coast Angels.
• Tech Coast Angels normally invest in about 10-12 new deals per year.
• Assuming 300 angel groups each invested in 12 new deals per year, they would fund about 3,600 deals per year in total.
• 57,225 companies received funding from angel investors in 2009, including follow-on investments.
• Based on these numbers, angel groups funded less than 10% of all angel deals in 2009.
• Angel groups are easy to find.  I’ve encountered people offering to sell lists of angel groups.  What a crock!  You can find the biggest and best list of them here for free.
• Because angel groups are so easy to find, they are often inundated with business plans from entrepreneurs clamoring for attention.  What happens when the demand for capital far outpaces investor supply?  Investors get a lot pickier.  Is this the perfect environment for an entrepreneur?

Solo angels and informal investors represent a far better funding opportunity for most startup and early stage companies.   Here’s the story the numbers tell.

• There were nearly 260,000 active angel investors in the U.S. in 2009.  An estimated 20,000 angel investors are part of organized angel groups, leaving a total of 240,000 solo angels. These solo angels were responsible for more than 90% of all angel deals funded in 2009, with an estimated total investment of more than $15 billion.
• Informal investors (including friends, family, and associates) invested in more than 4,000,000 deals in 2009.  They provided more than $70 billion in small business funding in 2009.

You can draw your own conclusions from these numbers; the math is pretty straightforward.

All that being said, raising money from solo angels and informal investors takes time, lots of work, and persistence to succeed.  Some professional guidance won’t hurt either!

When raising money for your business, you have control over the truths you tell, and therefore the ability to earn trust from investors by demonstrating integrity.  But there is at least one truth that’s difficult for entrepreneurs and investors to candidly discuss, even though it’s a vital factor in the decision-making process of most investors.

Investors won’t write a check to your company if they don’t like you or find you credible.

Some may tell you to your face (particularly if you live in New England), but most will either simply stop communicating with you, or will offer a less offensive reason for not investing.  In either case, it can be difficult to know what really went wrong.

The best way to address this problem is through preparation, presentation materials that invite discussion, honesty, and humility.  Here are several tips for each of these issues that can help increase your likeability, credibility, and capital raising success.  They’re not meant to be comprehensive, but rather to point you in the right direction.

Preparation Highlights

• Be thoroughly familiar with the way you have developed the financial projections for your business.  Build your revenue model not on capturing some percentage of the market, but rather on specific activities that should result in the revenues you project.  Be conservative in your assumptions – it’s better to underpromise and overdeliver.  Find external data to show that your assumptions are reasonable.  Don’t lead with this data, but keep it handy to show if asked.
• Identify a significant and painful problem your business will solve, be prepared to give a few “real world” examples of how your solution is or will be better than other alternatives available to customers.  You’ll always have competition, and you need to be able to convincingly explain why customers will choose your solution over those offered by competitors.
• Be highly conversant in the “secret sauce” aspects of your business – those things that give you a significant competitive advantage.  While you won’t give the recipe to investors, they will have to get enough of a taste to validate your claims of competitive strength.

Presentation Materials

• Your presentation materials will perform several critical functions, which include demonstrating professionalism, communicating specific information, and providing a framework for dialog.
• Your materials should be professional in appearance and content.  Typographical and grammatical errors, sloppy formatting, and faulty data must be eliminated.
• Investors are not the federal government, so they usually don’t want to be buried under a mountain of research and projections from entrepreneurs.  You need to say the right things in the right way in the right amount at the right time to efficiently and effectively move investors through the decision-making process.
• Lastly, your documents should lead investors to ask you questions about those subjects they are most interested in.  If you are properly prepared, this is one of the most effective ways to demonstrate both your likeability and your credibility.

Honesty

• The tendency for entrepreneurs is to maximize business strengths and opportunities while minimizing weaknesses or problems.  This is both naïve and dangerous when raising capital.  Investors will usually see through the smoke and mirrors, hurting your chances to get funded.  If investors let you slide on these issues and make an investment, you will likely be unable to achieve your projections, opening a whole different can of worms that can put the future of your company in jeopardy.
• A balanced discussion of strengths and weaknesses is a far better approach.  Show that you understand the risks, know where the company is weak, and have appropriate strategies for addressing these issues.
• If you cannot answer a question asked by an investor, don’t bluff.  They’ll know.  It’s better to recognize the validity of the question, promise to get back with an answer, and follow through on your commitment.

Humility

• Investors like smart people, not smart alecks.  So don’t act like you know it all.  Be confident, but be receptive to input.  This does not mean that you have to implement all input, but you should at least express thanks for and appropriately consider it.
• While there are certainly some arrogant business owners, the majority of those I’ve encountered are approachable and open to the ideas and concerns of others.  In my capital raising experience, arrogance on the part of entrepreneurs is a deal breaker.

1. Customers buy from you and perceive value

The question professional investors often ask is, “Will the dogs eat the dog food?” If you have an existing business where customers pay reasonable prices for your products and services and perceive value in the exchange, you have the foundation for a successful business. The absolute best source of capital for your business is satisfied customers. But if your company has strong proven customer demand and you need expansion capital to meet that demand, you’re in a highly attractive position to investors. For start-ups, the question is more difficult to answer until customer traction is achieved, and we’ll address this issue in a future post.

2. Your business generates strong earnings

Many start-ups launch with strategies to attract customers with free or low-priced goods and services. Of course, the company eventually has to generate profits to be successful, so prices usually escalate and more revenue streams are established. Most start-ups lose money for a while, and even well established companies lose money occasionally. If your business is not currently profitable, you need to demonstrate a clear and credible path to profitability. Investors are looking for proof of your company’s ability to maximize earnings while keeping the customer value equation in balance.

3. Your business is scalable

How much realistic growth potential does your business have? Is there a way to double or triple your revenues within a year or two? What will it take to make it happen? If you can demonstrate the scalability of your company, you’ll find more investors willing to talk to you. However, if you have a $1 million business today and can grow it to $5 million within the next 3 years, your deal won’t appeal to venture capitalists or angel investors, but it may be attractive to informal investors or commercial lenders. The type of investor will depend on how much your company can reasonably scale. Proof of scalability enhances your strength in the eyes of investors, even if it is on a limited or trial basis.

Start-up companies generally don’t have much evidence of these issues, but are often able to achieve it after a period of bootstrapping with a focus on generating the necessary proofs. Both investors and lenders respond well to business owners who have taken this approach.

How would you respond?

• Smart money, of course!
• Dumb money, that’s why I’m talking to you.
• Which kind can I get from you?

The question is ridiculous, yet the issue comes up a lot. Money is inanimate, and is neither smart nor dumb in and of itself. The way entrepreneurs or investors manage and invest money can be smart or dumb, and this gets more to the heart of the matter. But before delving into this issue and its implications for entrepreneurs, let’s take a quick look at some definitions.

The term “smart money” is often used to describe investment capital from sources that also provide valuable expertise and contacts that will enable businesses to become more successful. This sounds like a smart idea, and I believe the principle is a good one. But the term is also used in other less useful ways, and not always explicitly. For example, a venture capitalist or angel investor may deem their investment as smart money, and infer that others who invested in your business at an earlier stage on an informal basis provided dumb money.

There are many elitists in the capital markets. But ultimately this doesn’t matter, and I’ll tell you why. I’ll also tell you what’s far more important as an entrepreneur looking for capital.

First, many of the “smartest” financial people in the world helped create the recent global economic meltdown. And even today, whenever they talk about the future, the only truth is “we don’t really know . . .”

Second, $18 billion (the same amount angel investors and venture capitalists each invested in 2009) was entrusted to Bernie Madoff by thousands of smart people.

Third, let’s compare the failure rates of companies that received angel investment, those that received venture capital, and the whole gamut of U.S. start-ups that survive at least 5 years. Perhaps surprisingly, the approximate failure rate in all cases is 50 percent!  While different studies report varying failure rates, these numbers reflect a reasonable average.

What does the data indicate about the value of so-called smart money?

Taken on the whole, it doesn’t seem to make much of a difference.

So what does matter for you, the entrepreneur?

YOU being smart.

Here are some tips to help guide you along.

• Bootstrap your company using appropriate capitalization solutions that don’t require you to go down the equity capital path.  Aside from banks, there are many other viable ways to grow a business by leveraging all available capitalization options.
• Smart entrepreneurs surround themselves with advisors, strategic partners, board members, employees, subcontractors, customers, vendors, etc. who bring expertise and contacts to the business. When you look at the big picture, you can get vastly more support from these resources than you are likely to get from your investors, though good participating investors can be very helpful members of your team.
• Investors who are also well-known and successful figures in your industry could be very helpful, if they take an active role in supporting you. There are many anecdotal tales of high profile experts that promised to help for a premium, but never did. Find out how active such investors will really be for you (check their references) before you take their money.
• Don’t take money from investors that are likely to become a problem for you later on. You can conduct due diligence on them by asking to talk to the owners of other companies they invested in.
• If investors are too “smart” you could end up in a dangerous situation where they can take over your business if you don’t meet certain performances on schedule. While this a a major concern for entrepreneurs, the reality is that it doesn’t happen very often. Most angel investors don’t want your business, don’t have time for it, and would rather support it with help from time to time rather than taking it over. Onerous terms and conditions proposed by an investor should flag you to perform due diligence on the investor, and talk to your trusted business advisors before committing to do a proposed deal. This is the path of the smart entrepreneur.
• Develop a strong financial model of your business built on leading indicators that will help you manage the business from the beginning of the marketing and sales cycle. Show it to experienced advisors you trust. Refine it until you completely believe in your ability to achieve these numbers. Don’t start trying to raise money until after this has been accomplished.
• Expect that you’ll have to do a major overhaul of your business model within a few years in order to ultimately succeed.
• Know that a smart entrepreneur can make just as much with so-called “smart money” as can be made with “dumb money.” So focus on being a smart entrepreneur. That’s something you have a lot more control of.
• Don’t be a smart aleck, that’s not the same thing as being smart. You’re unlikely to succeed with Tip #1 if you’re a jerk. I’d like to be able to say that jerks are also more likely to fail, but I haven’t seen any reliable numbers on that issue yet . . .

Here’s what I mean.

High profile angel investors and venture capitalists are focused on high growth businesses, those that can grow to $30-100 million within a few years.  This is not necessarily based on greed, but more often on the realities of the financial world where they operate.  They have compelling reasons for this focus.  And so for the most part, they ignore smaller companies.

There were about 600,000 new businesses with employees that started in 2009 in the U.S.  Angel investors funded some 13,000 start-up deals, and venture capitalists funded 312.  Statistically, angels funded 2 percent of the new companies, and venture capitalists a tiny fraction of 1 percent.  The SBA reports that nearly 70 percent of start-ups survive at least 2 years, and more than half survive for 5 years. One other statistic of interest is that the average person born in the later years of the baby boom era held 10.8 jobs from age 18 to age 42, according to the U.S. Department of Labor.  This equates to changing jobs every 2.2 years on average.

From these numbers, we can conclude that your odds of starting a business that succeeds on some level for at least 5 years are better than staying with the same employer for 5 years.  While many millions of people do stay at their jobs more than 5 years, most don’t.

So how successful are those businesses that survive?  According to the IRS, 81 percent have net income of less than $1 million per year, 16 percent have income from $1 million to $10 million, and just 3 percent have income of more than $10 million.  By the way, only 0.5% have income greater than $50 million annually.

One other statistic is useful to consider.  Of all the small business funding provided during 2009 – a year of economic turmoil – just 7 percent came from angel investors and venture capitalists.  All the other small business funding came from somewhere else.

Most small businesses, whether start-up or well established, will never receive a nickel from sophisticated angel investors or venture capitalists.  Yet there are more than 5 million households in the U.S. that have a net worth of more than $1 million.  Most did not inherit their wealth – they earned it from their own business or by being a successful executive for a major company. Small business owners have a much higher probability of success in this world than in the realm where angel investors and venture capitalists live, all due respect to those at the top of the food chain.

And so while we aspiring entrepreneurs can learn much from angel investors and venture capitalists about getting funded, we should remember that 93 percent of small business funding comes from somewhere else.  Somewhere that shares key viewpoints of high profile investors, but also takes many other issues into account.  Things that are often more favorable to you.

Learning to successfully navigate in the world of the 93 percent offers your best chance for success in funding your company.

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