A few months ago I decided I wanted to have a more direct sense of how the founders I meet with each day, my customers, felt I was doing. What did they think of the SneakerheadVC product? Was it worth their time to sit down with me and help me learn about their business?

I said the VC product was broken for 99% of founders and began collecting feedback in a simple survey that I send people after every meeting.

Here are some results after more than 100 meetings.

VC’s are “always late” and spend some portion of the remaining meeting time describing how busy they are as a form of apology. I hate late and do my best to avoid it. As you can see, not good enough.

My sense is most investors, especially early stage investors, do not spend the time to dive into the pitch decks or summary plans prior to meeting with a company. Most meetings start with the open ended, “so, tell me what you do and give me a little background on the team…” Having spent days putting together summaries and pitch presentations for my companies, I think a meeting that starts like this is already headed in the wrong direction. With a little effort up-front I have found first meetings cover the ground of a first and second meeting and regardless of the outcome in terms of investment, I feel like I am able to be more helpful when I am more prepared. Again, still not perfect,but I am psyched to see more than 65% say I at least understood the business before the pitch and almost 20% say I was extremely prepared.

It is one thing to be prepared, another to add value. I also ask if people feel the time they spent with me, instead of building their business, was worth it. Time is a founder’s most valuable resource and if you give me an hour, I want to make sure you walk away feeling like it was well spent. It is great that most of you do, and interesting that  the percentage (4.55%) who feel it was not worth is the same as the percentage of meetings where I was late…

Thanks to everyone who spent the time to respond to my survey. I have some more data on my Net Promoter Score and the sources of my meetings that I am putting together for a future post as well as some of the free form feedback that i get in answer to “what could i do better” that is actually the most valuable part of the whole project for me.

If you have thoughts on better questions to ask or other feedback on the survey, please leave it in the comments or send me an e-mail.

Avoid the long, drawn out maybe

Raising money can suck. It is a distraction from running your business and selling your dream is exhausting. When I did it, I counted on lots of introductions from advisors and friends as well as referrals from attorneys, accountants and other service providers. I had a list of potential investors and hustled to get in front of them. Due to timing and the length of the process there were times where I got multiple introductions to different people at the same firm. When this happened, and the second person agreed to meet with me, it felt like a second pass over the same target…This was not the case and I quickly learned the problem with crossing the streams.

Typically my second contact had no idea I had already met with another person from their team and what I assumed was a second meeting was actually a waste of my time. Each of these meetings ended with the same next step: “Thanks for coming in. I’ll talk it over with (insert person you already met with here) and let you know where we end up.”

Now that I am part of an investment team, I see this from the other side of the table and hate it just as much. I do my best to avoid this type of confusion, but invariably it happens and I am writing this because it happend the other day. However, in this recent case, the founder did me a huge favor and created a ton of value for both of us. After being introduced, they wrote me the note below (with a few changes to protect the innocent):

It’s a pleasure to e-meet you, and I’m ecstatic to hear you are a fan!

I also want to tell you that I met with Josh Kopelman a few weeks ago to ask for advice on our pitch, and he mentioned (a specific risk) would be a concern before investing.

We are quickly evolving the product based on our beta user feedback and have made progress around (specific risk) since we spoke with Josh. Regardless of where First Round comes out as an investor, it would be wonderful to meet you and get your honest thoughts on what we are doing.

I’d certainly be interested a call next week, if you think it would be worthwhile.

In this simple note, they help me understand my colleague’s concern about the business as an investment and encourage me to get his perspective as part of my decision to move forward with a meeting. They also made it clear that they would find value in meeting with me regardless of First Round’s position as a potential investor. The note could just as easily say they would only like to meet if First Round is interested in an update as a potential investor.

There have been times where the business has evolved and a second meeting resulted in an investment. There have been times where I share my colleagues’ concerns after the update. But in every case, knowing that a founder has already met with someone else from our team and having the opportunity to get their perspective is helpful.

The transparency adds value to the process and we all move toward a decision rather than a maybe.

I argued that the Lean Start-up movement is about leveraging platforms and because of this today’s investors need to build platforms that make company building more efficient. Optimization of these platforms will force firms to focus by stage and partners to invest in helping entrepreneurs get maximum leverage from their firm’s platform.

(I also talked about how this impacts the value of brand, but will save that for another post.)

The talk was 20 slides over 5 minutes. Here are a few of the most relevant slides with commentary below each one:

Today’s entrepreneurs are not only innovating on the products and services they are building, but the best are innovating on the way they build, scale and bring these products and services to market.

This reality creates a disconnect between investors and entrepreneurs that is especially painful when ideas got funded and then do not work. The old VC playbook says when an idea doesn’t work, you write another check. If it still doesn’t work, you fire the CEO and then write another check.

You can do more experiments or bigger experiments, but you cannot buy better results from the market because product-market fit is not for sale. This is the root of the disconnect.

Capital will continue to slide toward commodity status as entrepreneurs leverage platforms to build more and more for less and less.

For investors, the combination of cheap options and potential for explosive growth of a few companies has created an environment where there is more risk in not funding something than in funding a little bit of everything.

But there is hope because the lean start-up is a return to old school company creation and investors are learning. Entrepreneurs continue to compress the innovation stack, remove commodity steps in the company building process and focus on creating the unique elements of their products and services.

The most innovative investors are building platforms to support this new type of entrepreneur and this new/old company creation process.

With the best entrepreneurs leveraging platforms to build companies more efficiently and forward thinking investors building platforms to support these founders, I think we are starting to see a convergence around how best to create enterprise value.

When everyone has access to the same pieces, the same building blocks, the same library, creativity in the use of the tools becomes critical and the primary source of differentiation and defensibility.

 The best entrepreneurs will choose to build on the platforms that are tuned for their specific stage guided by a partner focused on their specific needs. The best investors will build platforms to accelerate companies between specific inflection points in their growth.

The market will recognize that companies with 0-4 employees vs. 4-40 vs. 40+ have divergent needs and cannot be supported by a single platform in a meaningful way.

I hope this will force a return to equilibrium with investors and entrepreneurs aligning platform, partner and capitalization level with stage of company and state of product market fit.

I believe choosing the right source of capital all comes down to the two parts of every e-mail address: the letters before the @ and the letters after the @. The letters before the @ identify an individual. The letters after the @ represent an institution. From my experience raising money as an entrepreneur and working to help entrepreneurs think through funding options in my role at First Round, finding alignment with the letters before AND after the @ is critical when it comes to choice of investors.

This choice will have a dramatic impact on the trajectory of your business and with so many options available here are two mistakes to watch out for:

1. Over estimating the individual’s ability to move the institution
2. Over estimating the value of the institution relative to the individual

In the first case, you fall in love with the perfect individual. They have all the things you are looking for and even though your company does not fit the core model of the institution, you discount this because you believe the individual will support you as an exception or, even worse, because the individual is leading a new direction or initiative within the institution. I have found that it is really hard for an individual to move an institution and ultimately, no matter how strong the letters before the @, the individual will fall back to focus on the core business of her firm.

In the second case, the individual is not a great fit for you, but the institution has a fantastic brand and your company is core to what they do in terms of stage, industry and approach. You discount the short-comings of the individual in order to be associated with the institution. This is a challenge because even the best platforms often require an individual to activate them. If the letters before the @ create friction rather than removing it, you will struggle to capture maximum value from even the best institutions.

Investors are looking for outliers, but at the start of a partnership, founders should find a comfortable place in the fat middle of what the institution and the individual do day in and day out. The founder’s job is to find an individual investor that shares their vision, has experience or expertise that will add a unique perspective and who can activate a network that will accelerate the company’s path to success. However, as a founder, you also need to understand the institutional business model. In the end, it is up to you to make sure that the letters after the @ represent an institution built to enable the letters before the @ to deliver given your stage, sector and needs.

Alignment with your investors is crucial. Adjustments are available if you ask questions before you sign the term sheet

When you are fund-raising, your job becomes getting cash into your company. However, the best entrepreneurs don’t just get funded, but find funding alignment with their investors in terms of values, vision and approach. Since joining First Round Capital I have met with hundreds of entrepreneurs and many of them never ask me any questions about our process or our approach to working with our portfolio.

I know the fund-raising process is really, really hard. It is an emotional roller-coaster. It demands 100% of your energy, your time and your heart but you should be asking questions, interviewing your potential investors, and choosing your investors.

It is important to know you have alignment in terms of financial interests and that you are not only working toward the same outcome but also have agreement on how to get there. If you do this, you will experience many of the commonly listed benefits of chiropractic treatment:

1. It is completely safe

There should be no penalty for asking questions and if there is, you probably don’t want to work with those guys anyway.

2. Allows better sleep

The fundraising process is hard for many reasons, but the thing I hated most was being evaluated over and over in a process where I felt I had little to no control. Asking questions about your investor’s expectations and approach put you in the driver’s seat and will help you feel comfortable when you accept the term sheet.

3. Corrects the cause of pain rather than treating the symptoms

Treating the symptoms of misaligned exit expectations or disagreements around strategic vision is always painful to you and to the company. Don’t set yourself up to suffer through the distraction and pain of on-going treatment of symptoms. Correct the cause of the problem by asking questions prior to accepting the investment.

4. Relieves stress and tension

Alignment with your investors on values, vision and approach allows you to build trust and treat your investors as partners with no hidden agenda. You will get much more strategic value as you work to build your business and steer your company to success if you are not fighting the people who backed you along the way. It will also be much more fun and probably more successful.

5. Improves posture

Your investors will become one of the most powerful signals about your position in a market, your prospects for the future and the overall quality of the operations of your business. Alignment of interests will create a powerful posture for your business and insure you are all pulling in the same direction when it becomes time to get back on the roller-coaster and raise your next round.

The benefits of Chiropractic treatment are touted by some and dismissed by others, but when it comes to raising money, I am a believer. Take your VC to the chiropractor and find alignment or keep looking for other sources of capital.

If you have benefited from alignment with your investors or have suffered through the opposite, I would love to discuss it in the comments.

****************************************************************************************************

I joined First Round Capital as a Principal knowing I would have a voice on the investment team, not a vote.

Keeping you out or fighting to keep you in? Gate keepers can do both...

I have a specific approach to meetings with entrepreneurs and work hard to add value to each founder who takes the time to meet with me. Some of this value is strategic. It is based on my experience as an entrepreneur, as a consumer-focused product development and marketing guy, and pop-culture loving sneakerheadVC who loves to talk with smart people building great stuff. Some of this value is tactical. It is based on my position within First Round, the visibility I have into our deal process, our portfolio and the time I spend with our partners and my peers.

For the founders who are friends with a partner (and I do not mean you have their e-mail address from the bio on our website or some tangential LinkedIn introduction, but real, call you on your mobile on a Sunday to discuss some aspect of cohort analysis and strategies to reduce customer churn type friendship), you don’t need tactical help and talking to me prior to meeting with a partner is a waste of time.

For everyone else, I can help.

I spend my time between Philadelphia, New York and Boston meeting with entrepreneurs who are building companies that are intriguing to me and working with them to see if First Round would be a good investment partner. Some of these companies are introduced to me by a partner at First Round and some of them come from my personal network.  I learn a lot from each of them.

Just like a partner, I try to figure out if I believe the market is big, the team is kick-ass and the approach is differentiated. Just like a partner, I need to understand if our model is in alignment with the entrepreneur’s goals and if our approach is likely to support the evolution of their vision. I have to identify a fit with our investment focus (Internet technology), the stage we invest (seed stage), and the structure of deals we participate in (equity investments).

Different from a partner I also try to decide if I think a specific partner will share my view and if together, we can build passion for the business across the investment team. Each week I participate in pitches with the partnership and spend time talking to them about the deals they are reviewing. I dig into the questions they ask and understand each business that they are evaluating and what is driving their point of view on each investment decision. When I read a plan or meet with an entrepreneur, I usually know how each partner will react to the pitch, what areas they will be excited about and the concerns they will have about the model, the market and the team.

This pattern recognition is valuable for entrepreneurs and I am happy to share it.

Visibility into my thinking and what I have learned from Josh, Chris, Howard and Rob based on the thousands of deals they have seen in their careers will improve your pitch and may help you think about the business differently, identify a larger opportunity or have a better chance of capturing the opportunity you have already identified. The partners trust my judgment and know that I help founders shape their story to resonate with the partnership, provide clarity around the entrepreneur’s hypothesis and define the needs and the opportunities represented by the business. My knowledge of our investment thesis is better than virtually any other deal source and because of this, my conviction around a deal, my voice, is an extremely strong signal for the members of the investment team who do have a vote.

It is natural to view us junior people in the VC world as gatekeepers to the real opportunity. When you are building a company, time is your most valuable resource and if you can be more efficient by going directly to a partner, it is very appealing.

Non-partners on the investment team are friction in the system, but if we do our job well, we can be the friction that keeps you IN, rather than the force that keeps you out.

If it is "Deal or No Deal" it will be Dismal

Since reading Fred’s post on meetings (after running into him at the Coffee Shop) I have been thinking a lot about my own meetings. Like Fred I have between 7 and 10 meetings a day in person or by phone and feel that more than 2/3rd are really good. These meetings are not all with entrepreneurs, and those that are will only rarely (less than 1%, really) result in funding.

I do my best to prepare for every meeting (I have written about this before here) and to learn from everyone I meet. I want to engage with the ideas, not the deal because a career that is focused on getting to an answer that is “no” 99% of the time is going to suck. Saying “no” sucks almost as much as being told “no.” When VC’s focus on “The Deal” they make it dismal for everyone, one meeting at a time.

Glenn Kelman’s piece on TechCrunch recently confirmed that good questions can help move a business forward regardless of the investment that follows. You know when these moments occur in a meeting, the moments that add value for all involved. A statement that sparks a new thought in a founder or investor; some pushback on an assumption that exposes a dependency before it hurts the company or shows an investor the new dynamics of a market; a question that feels like it might have an obvious answer but turns out to surface a key gap in the logic of a product design or go to market plan all represent opportunity.

The fact that I get paid to meet incredibly smart people who are working on amazing projects is genius. The ability to engage in the business and learn about the challenges, offer advice and help an entrepreneur iterate is awesome. I have the opportunity to do this in EVERY meeting – as many as 10 times a day so long as I do three things:

• Prepare and focus on the idea, not the deal
• Ask tough questions that may not have immediate answers
• Be transparent and never waste an entrepreneur’s time

If I can engage in the business, connect with the entrepreneur and add value to their process 70% of the time that will be far from dismal. This is my goal and it dictates how I approach my meetings. If we get the chance to meet, I hope you will see this in action and if you don’t, I hope you will call me on it.

If you have examples of great questions, great meetings or the opposite, please leave them in the comments.

Know what you are fishing for...

Following the recent meme on sources of seed funds with contributions from Chris Dixon, Charlie O’Donnell, Mark Suster and Brad Feld and the related topic of We need to own baloney from Fred Wilson and Josh Kopelman has reminded me of some advice I got after my first company failed.

A good friend and the founder of AND 1 told me you get to make three choices as an entrepreneur:

1. You get to choose your idea
2. You get to choose your business partners
3. You get to choose your investors

I happened to be one for three because I did not invest the time to do more than a cursory reference check on my business partner and my investors. Everything that I discovered as my business disintegrated, was discoverable prior to building and funding my business. I just didn’t ask the questions.

There is no recipe for success in these choices, but learning as much as you can about your prospects is a good start.

To be clear, when you decide to take on outside investment, you are bringing a new partner into your business. Their business model and approach will have a significant impact on your business, your strategies and your prospects for success. No matter how many times Fred “calls bullshit” on VC’s who say they “need to own x percent,” fund math is real and there will always be investors who push out value added syndicate partners in order to “own enough” even though they hurt the entrepreneur (and the business — including their investment) in the process.

Mark and Brad offer excellent perspective on seed investing in their posts (links above). The type of questions Brad encourages founders to ask of their investors and the diligence Mark recommends (including contacting existing portfolio CEO’s) are exactly right and I wish I had this advice years ago. This process is difficult, but crucial because for each entrepreneur, there is a different ideal investor. For some, taking seed money from a large fund and the “freedom” that comes with a passive investment may be ideal. For others an extremely active angel who does not plan to participate in later financing may be a perfect source of guidance and capital. For many the balance lies somewhere in between and future participation is based on meeting specific milestones that should be well understood by both sides of the table.

I don’t believe is possible to say one funding path is superior to another, but I do believe your choice of funding is one of the most important decisions you will make and you should know what you are signing up for prior to signing the term sheet. Investors should be chosen based on their alignment with your interests and vision for the company. It is critical to understand the investor’s expectations and ability to assist you in living up to these expectations prior to accepting funding and allowing them to join you as a partner. You should ask each investor you meet with to articulate their investment model, their ability to add value to your business and force them to pitch you on accepting their money and their advice. Similar to choosing your business partners, complete reference checks and look at their past actions in both successes and failures. If you sense that you do not share a vision or an approach to managing your business, as hard as it is, keep looking for other sources of funding.

There is no i in team, unless you are talking investment

There are two sections from Brad’s post that apply to the entire curve

a)    Team

b)   Fit with the fund

Team:

Once an investor understands the business and has formed conclusions about the biggest potential pit-falls, the next step is to identify the members of the team who have experienced similar challenges in the past and learned from them. When practicing your presentation around team, try to match the strengths of your team with the areas of concern or weakness in your plan. Your investor knows that you will need to adjust along the way. The strength of the team is the key to identifying the proper time to adjust and the new path to follow. The discussion of the team is also a time to show your prospective investor that you know what you do not know and a plan for the learning process.

WHO IS YOUR MANAGEMENT TEAM?

-Who is the management team?

-What is their experience?

-What pieces are missing and what is the plan for filling them?

The numbers may be a waste of time, but the calculations are not

Fit with the fund:

As a founder the most valuable resource you have is time and fundraising can be a massive drag on this resource. It is extremely important to maximize the efficiency of this process and select potential investors to target based on a sense of how well your company fits with the fund. This includes understanding the portfolio as a whole, the specific investments that a given investment professional is involved with and the expertise of a firm or specific investor. Understanding of the shape of your curve and a sense of how close it is to other investments that the firm has participated in historically is a good filter as well. This analysis starts (and often ends) with an answer to the question, “How much are you looking to raise?” Brad’s list on fit is below, and I have added one to the end.

HOW DO YOU FIT WITH THE PROSPECTIVE INVESTOR?
- How does this fit w/ the investor’s portfolio and expertise?
- What synergies, competition exist with the investor’s existing portfolio?

-**Does the shape of your curve match those of the investor’s existing portfolio?

Friends who read this blog have told me that this series is too wonky and that what is really important is great entrepreneurs with big ideas. It is also true that at the early stage where I focus my time at First Round, every number in a financial projection is going to be wrong – either high or low – and so detailed projections are often a waste of time for founders who could be focused on building cool product. While this is true, ultimately the investor is buying shares in a company, not the consumer product or service and must believe in your ability as an entrepreneur to deliver a shape that fits the fund by focusing your energy in the space you have chosen for your innovation.

The view is unknown, but understanding the possibilities can help you choose your path to the top

For the fifth entry in this series of posts about why investors ask the questions they ask I am focusing on competition and other things that could erode the value you have worked to create. To start from the begining, please go here.

The defensibility of your business speaks to its long-term value as a stand alone entity or as an acquisition target. As you are building a company, it is important to know what is on the other side of the cliff you are scaling. Building a business is one of the hardest and most rewarding thing you can do professionally and thinking about the view at the top while you climb can help you choose the best path. Your strategic decisions will be different if you believe you will enjoy green fields at the top of a mesa or be faced with a steep and dangerous decent forcing a traverse along a knife edge ridge (aka – Pivot).

When you speak with a potential investment partner, competition should be well researched and conclusions about the strategy they will pursue should be supported with historical evidence or facts about their dependencies. When an investor is asking about competition and other surprises that may exist in the business they are looking for both specifics about your business as well as your general knowledge and approach to the industry.

WHAT IS YOUR VISION?
- What is your big vision?
- What problem are you solving and for whom?
- Where do you want to be in the future?

WHO IS YOUR COMPETITION?
- Who is your existing & likely competition?
- Who is adjacent to you (in the market) that could enter your market (and compete) or could be a co-opted partner?
- What are their strengths/weaknesses?
- Why are you different?

WHAT PARTNERSHIPS DO YOU HAVE?
- Who are your key distribution and technology partners (current & future)?
- How dependent are you on these partners?

OTHER
- What assumptions are key to the success of the business?
- What “gotchas” could change the business overnight? New technologies, new market entrants, change in standards or regulations?
- What are your company’s weak links?

As an entrepreneur it is your job to see what others do not and to innovate around your vision. A business strategy is a best guess, and honesty about this, knowing what you do not know, is good. If you can also articulate a plan for learning what is currently unknown while keeping your options open, this is even better.

**My friend Jon Steinberg has written about this in the past and I agree with his push for execution and product focus, but would include potential consumer shifts such as the healthy trend that hurt Coke as one of the red arrows in my diagram above.**

For the last post in this series I will talk about the two areas investors care about that apply to the whole curve, team and fit with the portfolio.

Blazing a trail to the top

This is the fourth in a series of posts written to expose the analysis behind investor questions and to propose a simple framework to help entrepreneurs guide pitch meetings more effectively. I invite you to read the first, second and third posts as well.

The size of the opportunity and your ability to capture it are the drivers of investment and are the primary focus of my conversations with entrepreneurs. When we have both done our homework, this is the most enjoyable part of my day because I get to learn about a new technology or service that may change the world from the person who is passionate about making it happen. When I was out raising money, this was my favorite part of the pitch because I got to talk about my passions and the cool thing I was building.

Investors will typically lead with these questions because the opportunity size is a primary screen. If the market is not big enough, there is no need to evaluate the risks of a given investment or come to any conclusion about the ability of the team to capture it.When you pitch, you know that accurately sizing the market and understanding the key drivers of customer adoption help frame the opportunity for an investor. Because of this, clarity about what you are building, how you will sell/distribute it and comfort with both top-down and bottom-up estimates of the market are extremely valuable. Starting off a meeting by showing that you are attacking a big ass market with a kick ass team (Rob Hayes’s “two asses” theory) is the best way to frame the conversation. Your excitement for what you are doing and the reasons you have been compelled to build a company around your idea needs to carry you through the parts of the meeting focused on evaluating the investment risks. This is your time to shine as a founder.

DESCRIBE YOUR PRODUCT/SERVICE
- What is your product/service?
- How does it solve your customer’s problem?
- What is unique about your product/service?

WHAT IS YOUR VALUE PROPOSITION?
- What is your value proposition to the customer?
- What kind of ROI can your customer expect by using buying your product/service?
- What pain are you eliminating?
- Are you selling vitamins, aspirin or antibiotics? (I.e. a luxury, a nice-to-have, or a need-to-have)

WHAT IS YOUR MARKET OPPORTUNITY AND HOW BIG IS IT?
- How big is the market opportunity you are pursuing and how fast is it growing?
- How established (or nascent) is the market?
- Do you have a credible claim on being one of the top two or three players in the market?

One you have chosen a path and climbed the mountain, staying on top, defending the business from competition and copy-cats through continued innovation and customer loyalty will become the primary focus. The next post in this series will look at some questions investors ask to understand your approach to maintaining the value you have created.

How are we going to take this hill? How will you know when it is time to go to plan B?

Investors will usually ask what you believe it will take for the business to achieve the transitions from revenue generating to cash flow positive to monthly, quarterly and annual profitability and the key development milestones along the way. The actual outcome has a significant impact on the type of investment the fund is making, but your sense of the road ahead is the most valuable piece of information. It is impossible to predict with much accuracy so understanding the team’s approach to discovering the optimal path for the business (i.e. is it lean start-up?) is the goal of these questions in an early stage meeting.

When learning about a new business, questions about the business model and the market should really illuminate the entrepreneur’s approach to learning about the market and the customer and adjusting to create product/market fit.  The projected period between funding and revenue and the associated product milestones can reveal the emphasis being placed on market feedback and iteration as well as the ability to identify appropriate pivot points. As most start-up successes come from the pivot, not the blueprint that was funded, clarity around the process for discovering market fit and potential revenue models is key to evaluating the risk in an investment.

As you answer the questions below, imagine crossing a river with your investment partner by jumping rock to rock. With each question, he is trying to judge the distance to the next rock and decide if the team can make it without falling in the water. He is also trying to see how you choose your path and how you learn from your previous choices.

WHAT STAGE OF DEVELOPMENT ARE YOU AT?
- What is your stage of development? Technology/product? Team? Financial metrics/revenue?
- What has been the progress to date (make reality and future clear)?
- What are your future milestones?

WHO IS YOUR CUSTOMER?
- Who are your existing customers?
- Who is your target customer?
- What defines an “ideal” customer prospect?
- Who actually writes you the check?
- Use specific customer examples where possible

HOW ARE YOU SELLING?
- What does the sales process look like and how long is the sales cycle?
- How will you reach the target customer? What does it cost to “acquire” a customer?
- What is your sales, marketing and distribution strategy?
- What is the current sales pipeline?

In part 4, I plan to talk about identifying the opportunity size. This is where the investment conversation typically starts.

How deep is the hole?

one quetsion before I jump...How far down is it?

Early stage investing is about the excitement generated by a big idea in a big market being built by a great team. But it is also about understanding how much capital the company will require over its life and what this means for the value of the current investment in terms of dilution (or required follow-on to avoid dilution). These questions also helps set reasonable expectations for the entrepreneur’s ability to de-risk the business with the current financing. For example, a business currently raising 10% of its total projected capital needs may not be able to significantly de-risk the business prior to raising additional capital and may want to think about getting a little more runway to be able to make more progress before raising more money.

The outside capital needs of a business help investors assess the level of “fit” that the business has with the investment model. In my time with First Round, I have seen lots of great ideas that we were not able to fund because of the long-term capital needs of the business or industry.

When an investor asks some of the following questions from Brad’s post, they are really peering down a hole and looking for the bottom.

WHAT ARE YOUR PLANS FOR FUND RAISING?
- What funds have already been raised?
- How much money are you raising and at what valuation?
- How will the money be spent?
- How long will it last and where will the company “be” on its milestones progress at that time?
- How much additional funding do you anticipate raising & when?

HOW DO YOU ACQUIRE CUSTOMERS?
- What is your cost to acquire a customer?
- How will this acquisition cost change over time and why?
- What is the lifetime value of a customer?

WHAT IS YOUR REVENUE MODEL?
- How do you make money?
- What is your revenue model?

As an entrepreneur, targeting potential investors who are comfortable with the capital requirements of your business and have knowledge of the industry you are entering will make this part of your meeting much more successful. You will find the fit with someone who understands why you are raising the level of your current round, agrees with how you plan to utilize the money and the time you are allowing your team to iterate and learn in order to show meaningful progress prior to the next round of fund-raising begins.

The next step is figuring out how long we will be working to climb to success and if the core methodology of the team will allow for the learning required to discover product/market fit. Eric Ries has written about this here and here.  I hope to add to this conversation when I put together my thoughts on the climb toward sustainability tomorrow.

If you force the fit you may lose the feel

Over the past few months I have looked at hundreds of potential investments and I have had to say no to all of them. I knew this would be the case when I made the transition from entrepreneur to investor (see Josh Kopelman’s thoughts on this here). In a meeting with an entrepreneur last week, he told me that another VC had described their job as saying no. I disagree. The job is to say yes, but finding the right fit is difficult. Over the years many people who are much smarter and who have much more experience as investors have written about the questions that an entrepreneur should expect from a VC and I have linked to my favorite example from Brad Feld, here. I love what Brad wrote and have looked to it as a guide for my meetings with founders. But after I have answers to these 15 questions, in the work after the meeting, the analysis and decision making, I am really focused on five questions that determine how well a given investment opportunity fits with our model at First Round.

1. How deep is the hole we are climbing into?
2. How long will it take us to climb out (to sustainability)?
3. How far to the summit?
4. How is the view?
5. Is it a match?

The first four questions are loosely based on the return on invested capital curve developed by David Wessels in his book on valuation.

Return on Invested Capital = (Net Income – Dividends)/Total Capital and is reported as a percentage. The goal of investments is to generate ROIC that is higher than the weighted average cost of capital (hurdle rate or WACC). Andy Metrick’s research (chapter four in his book) suggests that the WACC in VC is about 15% and so I have labeled the graph that way, but this can be anything north of the risk free rate in reality.  The curve below illustrate the ROIC over the life of a company assuming outside equity investment and long-term success.

It's a hell of a ride

I will try to group Brad’s 15 conversational questions with by the five investment analysis questions over the rest of this week in separate posts. I hope the series of posts serves as a form of translation tool and helps provide incremental transparency into the VC decision making process for entrepreneurs. I also hope it helps founders think through how to sell investors on the value in their company, not just the product or service the company is selling.

@peHUB said “Allocation” percentages to VC don’t matter nearly as much as does what that allocation means in terms of real dollars

I responded: @peHUB: Disagree. Allocation speaks to expected returns and LP mind-set on value of liquidity while total dollars is macro baseline

@peHUB responded to me:@phineasb But allocation % often gets determined by hard dollars. That’s basically what’s happened with CalPERS.

I believe allocation percentages do matter and matter much more than hard dollars for those working in the VC industry and for the entrepreneurs that depend on venture investment to build great companies. The aggregate hard dollars allocated to the venture industry should fluctuate just as most other markets experience expansion and contraction with the business cycle. But, a shift in the allocation to alternative assets in large portfolios is much more significant because it represents the institutional view on the risk adjusted returns that will be generated by the asset class and specifically the value that is currently being placed on liquidity – a proxy for the level of risk in the economy. This type of shift is analogous to the shifts in consumer tastes that destroy industries (away from SUV’s for example).

LP’s like CalPERS have capital requirements that must be met over a foreseeable time horizon. Their investment strategy is driven by three factors:

1. The size and timing of capital inflows from outside contributions
2. The size and timing of capital inflows from current investments
3. The projected disbursements the endowment must support

I have never managed an endowment, but it seems likely that the endowment manager happens to be is managing the sum of the uncertainty in 1 and 2 to support requests/projections for 3. Additionally, the manger has more control (or the perception of more control) of the risk she is taking in 2 than in 1. As the macro-economic environment shifts, impacting the absolute dollar levels of 1 and 2, she will shift her dollar allocations to maintain the prescribed balance in her portfolio and to meet the demands of 3. This does not imply a strategic shift in allocation, but does imply dollars flowing from one asset class to another. When this occurs, the fund raising environment for alternative asset class fund mangers will be more difficult and this higher hurdle will trickle down into the ecosystems in which they invest. The fat will be trimmed and the industry, the entrepreneurial ecosystem, will be healthier, less crowded and will resume generating excellent returns and experience growth as the economy rebounds. This is my reading of Bill’s argument and I agree with his analysis.

As Bill points out, the total allocation to venture by institutional LP’s was traditionally as small as 2% of the institution’s overall portfolio (10% of alternatives with an allocation of 20% of the total portfolio) but in recent years this commitment grew to as much as 5% as the allocation to alternatives increased from 20% to north of 50% in some cases. Given the illiquid nature of alternative assets, this implies much larger ratios of (1+2)/3 than had been seen in the past and this was supported by the growth in the economy and particularly the stock market between 1990 and 2007 (acknowledging some significant blips).

If the recent crisis has caused institutional money managers to rethink the allocation scheme of their portfolios this does not bode well for the venture industry in the long run. While it is possible for some alternative assets to shift toward a model that provide shorter terms liquidity options for LP’s, the venture industry is dedicated to investing in ideas that must be developed and commercialized. The most valuable resource we can offer an entrepreneur is time, making our investments inherently illiquid and therefore vulnerable to such a shift in thinking by limited partners. A shift in allocation will imply a shrinking of the industry, initially resulting in a healthy trimming of the fat, but without the expected recovery as the economy begins to expand. This could result in an industry with an un-stabilized market size of less than the $15B a year that Bill describes. At a much smaller scale, the industry misses many opportunities and cannot generate the required returns or support the vibrant ecosystem of innovation required for success on both sides of the funding table.

In the limit, a declining level of investment, due to shifts in LP portfolio allocation will result in limited innovation and declining returns leading to extinction for the venture industry and the innovative companies we support. Contrast this with a contraction in absolute dollars that is part of the broader business cycle followed by growth driven by the strongest investors and entrepreneurs and it becomes obvious [to me ] why allocation percentages matter more than absolute dollars in this industry.

The key to being fully present

When I was fund-raising for my fitness video game company there was nothing more frustrating than talking into the vacuum of the mute button or hearing a keyboard in the background. Other than being late, there is nothing more disrespectful than not being present. My solution to being present in each meeting of the day is to mind the gaps between meetings and protect them by starting and ending on-time every time.

With so much in-bound information and the reality of needing to prepare and re-focus for each entrepreneur that I speak with I have started creating 15 minute gaps between meetings. Without these gaps, I find it difficult to properly prepare and make the most out of the time I have with an entrepreneur. First, I am unable to spend the 5-10 minutes needed to digest the conversation from the previous meeting and second, I am unable to re-acquaint myself with the material that will be covered in the upcoming meeting. The result is that both end up taking place during my next meeting instead of on my time. This is a dis-service to the entrepreneur and to First Round as it makes me less effective in my efforts to learn about the business and to understand the investment opportunity.

With this in mind, and with the goal of being fully present in each moment of the work day, I am going to try to be very strict about my calendar and the time allowed for each task throughout the day. It may mean that I look at the clock more while listening to a new investment pitch or that I schedule time in the future to continue a conversation rather than extending a call for 10 or 15 minutes, but I think it will make time that others choose to share with me more valuable to them and ultimately to me as well.

This new effort is inspired by another verse in the start-up I Ching and I think it applies to both sides of the investment table.

FOCUS. FOLLOW EACH TASK TO COMPLETION. The urge to do many things at once is very strong. The danger is the partial completion of many tasks at the expense of completing any one. There is no value in this approach. You will be faced with complex situations that do not have a simple solution. You must be willing to break large challenges into manageable pieces to avoid indecision and a loss of self-control. Confusion will not last if you are able to recognize reality and visualize your goal. You must identify each integral part of the solution and focus on each one until it is complete to realize the broader victory.