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.

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.

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.