Early Stage Entrepreneurs — Beware the Message You Convey
Working at a family office I have seen opportunities that fall into many different asset classes. I focus mostly on venture capital investing in all of its facets — GP investing, co-investing, and direct investing. In this post I will focus exclusively on direct early stage investing given that late stage companies have overcome most of the uncertainties discussed below.
Direct investing is an exciting field, with startups often tackling problems their future customers don’t even know they have. Surrounded by “overnight” successes and massive funding rounds, entrepreneurial hubris can take over the rational thought process. This mindset manifests in many areas of the early stage company, starting with…
The Good Ol’ Financial Projections
I love meeting with entrepreneurs, dissecting their ideas, understanding their traction, and poking holes in their business models. However, what I look forward to most are their financial projections. My experience in Equity Research taught me that for publicly traded companies, guidance is everything. So much so, that when a company musters the guts to miss its own guidance…forget about it.
What I first thought were just a few overzealous projections from management teams turned out to be the status quo. I realized that guidance for an early stage entrepreneur is really just an “educated” guess. The reason I put “educated” in quotes is because most of the time I look at financial projections, I more often see figures of imagination than the figures of sound analysis. $500K in revenue this year, $10M next year. Just because a handful of startups have achieved this, the vast majority won’t even take off.
Do entrepreneurs really just intend to show that they can grow their business? Do they think big numbers on paper will impress the person they are pitching? If so, there are a few kinks in their plan. The first is with accountability. I enjoy catching up with entrepreneurs 6–12 months after our first meeting and asking them how their sales ramped up. Inevitably, most miss their estimates, and usually by wide margin. The most common reasons include (but are not limited to): longer than anticipated sales cycles, inefficient sales teams, and the inevitable frictions of life.
These bumps in the road are totally OK. In fact, the people you are pitching are acutely aware of the uphill battle you are facing. I would encourage you to be cognizant that you are pitching to experienced professionals who have a knack for determining what is real and what is fake. As such, giving fine-tuned guidance on sales cadence with realistic assumptions to back it up could bear fruit down the road. Building out a clear revenue model should be an exercise every founder goes through. Specifically, they should use a top-down and bottom-up approach. Top-down analysis should include focus on the total addressable market (with a meticulous focus on the obtainable portion). Bottom-up should include assumptions around client ramp, ACV, churn, and margins. This isn’t an exercise in wishful thinking but rather a valuable opportunity to give investors a glimpse of how your mind operates. No one knows the exact size of a potential market, there only is consensus. How successful you’ll end up being will depend on your ability to separate fact from fiction.
As an entrepreneur, it’s in your DNA to think big. Having projections that you are accountable for doesn’t detract from your vision, it only makes the conversation with the next investor a lot more intelligent. Keep the big thinking to your pitch and away from your guidance.
The Ball Isn’t In Your Court As Far As Timing
With the exception of the rare entrepreneur who gets hounded to sign term sheets from multiple VCs, most face a long and windy road to getting funded. Endless introductions, meetings, data rooms, and customer references all take time — time for the investor to digest and for the entrepreneur to provide. Keep in mind that yours is not the only investment that the VC is looking at. In all likelihood, you probably have no idea where in the long line you really stand. Investors may just be curious about your idea, while spending the majority of their time doing due diligence on an investment they are truly passionate about.
Knowing that, when you get the question about “timing” of a round, faster isn’t always better. Many times I get the answer of 1–4 weeks. I take that as a challenge — if this was black jack, I would make a killing betting over/under on when funding rounds actually close. When I reach out to the entrepreneur at the tail end of their range and ask “where are you?” I’m not surprised to learn I have another 3–6 weeks to make my decision. I’d imagine the reason that they gave their original projection is to convey a sense of urgency. What they don’t take into account is that most entrepreneurs convey the same sense. It’s up to the investor to discern the signal from the noise.
Instead, entrepreneurs should keep the time frame open and start narrowing it down as they begin to receive interest. Entrepreneurs, if you are in early days of pitching your idea, your timing is negligent. However, if you are meaningfully subscribed you can set a very realistic range for your closing date. Some will disagree with me on this point. The common argument is that you want to initiate a competitive process and that process usually starts with the urgency of timing.
I would prefer to have transparency in the timing presumption with intermediate updates, rather than a date that becomes largely meaningless. Lastly, if you don’t close in the range you set, did you just seed doubt in your prospective VC? I hope not.
Not Every Idea Should Be Backed With Venture Dollars
I can’t stress this enough. Time and time again my reaction to entrepreneurs that pitch us is — “this is not a venture business”. The entrepreneurs responses span from polite disagreement to exaggerated ambivalence. What many entrepreneurs need to understand is that investing in a venture structure (SAFE, CLA,or Priced Round) necessitates a narrow end-goal for everyone involved— broadly speaking, a sale of the business. Simply put, entrepreneurs request funding but in reality don’t have a path to returning it.
It doesn’t mean you should give up. It means you may want to look for a different source of funding. If you start a business that’s bootstrapped and provides for your desired luxuries in life (and does so almost as a dividend) why even bother hassling with the VC vultures? Remember, venture capital was started in the first part of the 20th century — before that, people built this country on finding alternative sources of capital.
Conclusion
It is the job of the VC to understand which projections are real, what the timing is, and whether they are being pitched a venture business. It is up to the entrepreneur to stand out from the crowd and show accurate projections, realistic time frames, and thoughtful approach to why they need venture capital dollars.
On the projections point, I’ve joked with colleagues about entrepreneurs giving up extra equity when they miss their targets. I have yet to convince someone to take that offer.
This is my first post of hopefully others where I try to share my thoughts on what I have seen in the industry and how I think things can be improved. Stay tuned for random rumblings of an aspiring VC.