While there is hope in the startup world (Q2 2010 featured the highest venture-backed IPO volume and amount raised since 2007), the investment community remains very discerning in their allocation of scarce capital. If you’ve caught the startup bug or are just bored of your day job, take a crash course in startup economics so that you can prepare for the hurdles. Learn the following 10 realities of startup economics and then read some more: social entrepreneurship, startup funding, and bootstrapping.
1. The Venture Capital community has shrunk during the recent downturn. Jennifer Rossa, Managing Editor of Dow Jones Private Equity Analyst says “Venture fund-raising was driven by substantial closes by industry stalwarts and renewed interest in smaller venture funds. Many limited partners investing in venture believe the industry has finally found a size that can work for it and that proven managers who cap their fund-raising are worth backing.”
2. Venture Capitalists want significant returns. Jim Flanagan of Valuelytics says, “Typical time horizon is 5 to 7 years until exit. General rule of thumb is 5-10X return on the money invested. With that you can calculate the IRR and range of values. It’s got to be at 30%+ or it doesn’t work for a VC.” A little math can help you get a sense of potential valuations. For example, if you can grow your business to $20 million in 5 to 7 years and sell it at 1.5x sales, that would imply a $30 million sale. If the investor wants 10x returns, you’re looking at a $3 million valuation today. Chances are that at a $3 million valuation, you’re raising in the $1 million range. At that amount, you’ll need to turn to Angels, Seed Funds, Friends & Family, or look your wallet in the mirror. To raise your valuation, launch your product, get paying customers, and build a clear path to profitability.
3. Investors need to actualize returns. In the era of split-second trading, buy-and-hold is out of favor. For VCs that are investing millions in your startup, they need to actualize returns. Since your venture is unlikely to return significant cash flows in the early years and the IPO market is relatively quiet despite its recent uptick, the default for an exit is sale via M&A. Beyond the promise of a sale, there might be other options such as interest and other payments. Of course, if you’re planning to make interest and other payments, you’re going to need to get to cash flow positive rather quickly.
4. 90% of Zero is Zero. If your reaction to #2 was “my business is worth more,” then read on. Too often entrepreneurs have inflated sense of valuation or are unwilling to give up singificant parts of their company. There are many startups that need investment, so if you aim too high, you may struggle to raise money for a cash starved business with stalling momentum. Just remember that you can own 90% of an idea, but if you are unable to achieve revenue and profitability, your idea and business might be worth nothing. Of course entrepreneurs should seek the best terms possible, and ideally hold onto control through the early phases of growth. However you must realize, it’s usually better to have 49% of a $10 million business than controlling stake of a $0 million dream.
5. As you can see, today there is an intense focus on driving revenues and cash flows. You might have grand plans of creating an empire, a comprehensive solution to market problems. Today’s environment demands that you make tangible progress one step at a time. Can you break up the market problem into smaller sets of addressable opportunities? Condense the time to market and become comfortable with a Beta approach of continual product upgrades. Recently, a startup wanted to raise $20 million for a series of related projects that provided great synergy. After 60 days of investor conversations, that same startup is raising $2 million for the most promising and near-term achievable of the projects.
6. This leads me to my next point. Fundraising can take a lot of time. I’ve seen too many entrepreneurs with unrealistic fundraising goals (trying to raise too much at a high valuation without demonstrated market progress). What happens? 6 months of unsuccessful fundraising later, and they’re back to the drawing board. Save yourself the 6 months, and get realistic from the start. Better to focus 6 months of your time making progress on the business than talking to investors who say no.
7. Where to spend that time? Talk to customers and partners. The only way to make money is to bring in revenue. Since you’re going to get your revenue from customers … spend your time networking with, interviewing, research, and selling to customers. If you’re lucky, you might be able to get early customers by offering discounts and the ability for them to shape the product. Even if you don’t land a customer, you’ll likely gain a lot of market intelligence that will make the ultimate product better.
8. Many startups will seek to break the $1 million revenue threshold within 2 years. That’s not an easy task. I recently met with a startup that spent 1 year just in conceiving their product idea. They went through 5 iterations that were ultimately scrapped before confidently greenlighting product development. That product then took 9 months to develop. That’s 21 months from beginning to actual product launch. Fortunately, the entrepreneurs had other jobs and projects which provided the cash flow. They redirected their earnings to this initiative along with $100,000 from friends & family. They still have some money to market launch the product. Get a head start on your venture by starting at night and weekends and redirecting earnings to make progress while gainfully employed. If you think you’re ready to quit, try working your day job another 3 to 6 months. The longer you make progress at night, the better your lift-off will be. Line up self-funding, friends & family, and angel funding to take you as close to the $1 million revenue milestone as possible.
Startup economics have changed dramatically over the past 10 years. But don’t be discouraged. There are still major successes such as Groupon which announced a $1.35 billion valuation in its April 2010 round of fundraising. Build your network and call in favors as you strive for ambitious goals in a difficult startup economy.
Image by jaylopez from Stock.Xchng
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