November 21, 2011
This post has been rattling around my brain for awhile now, but was finally jarred loose when reading Roger Ehrenberg’s terrific post last week, Fund Raising: Manage the process, don’t let the process manage you. If he and I were collaborating on a series on fundraising (whaddya say, Rog?), what follows would be part two. Or maybe part three. Eric Paley’s post on Convictionshould be required contextual reading for anyone starting a fundraise.
Roger’s post did a great job describing how to manage the timing and flow of interest from a range of investors. It’s very important stuff, and you’ve got to pay attention to it if you want to optimize your outcome while also keeping your eye on the ball in running your business. But there’s another level you can take it to in working and planning to maximize success, and that’s how you plan and work to make due diligence happen on your terms, not on the random terms that investors will dictate if you let them.
Having observed hundreds of financing processes from both sides of the table, there are some clear patterns as to how they play out. One of the more troubling and time consuming patterns is that of the investor who is bumbling through his processes (and I’ll tell you, process is a generous term for what we VCs frequently put companies through!), feeling pretty interested in a company but groping aimlessly in search of that thing that’s going to get him and his partnership over the hump. You can burn a lot of cycles at this stage of the process. And I think it’s frequently completely unnecessary.
So how can you, as entrepreneur, speed things along? My shortanswer to this is to spend some time up front with people who’ve seen these processes dozens of times before (ideally a VC friend or a multi-time entrepreneur) and do the work to anticipate what all those derivative analyses and data requests are likely to be. Poke all the holes you can in your business. Think about your business like an investor will. Go so far as to do your prospective investors’ work for them. Assemble a collection of diligence materials in a Dropbox folder that you can give them access to. Then, when you’re getting into diligence with a prospect, don’t let them get distracted. Drive them through that material.
A critical point to realize here is that there are two competing threads in the entrepreneur-investor dynamic. One is the thread of your story – what is the most compelling way to engage an investor’s interest and describe the problem you are solving and what your brilliant solution is. That narrative is generally best told with a real storyteller’s arc to it.
The second thread is that of the investment recommendation that the VC is ultimately going to write for her partners. That follows a much more plodding and analytic approach. You’d never want to construct your pitch deck around the outline of a VC investment recommendation – you’d bore those investors to tears. But you do need to recognize that it is this framework they will ultimately need to wedge your business into. So you may as well help them do it. Here’s a few key sections of that investment recommendation that you should address:
- High level description of market need and how the product addresses that need (an evangelist’s pitch that is hopefully in your story already)
- Market size – this has to be bottoms up. Not “American companies spend $6 gadzillion per year on software. We address 15% of that market.” Instead, “There are 2.5 million logical potential customers in our market. Our product will cost $2,000/year/customer. That makes for a $5 billion Total Addressable Market.” Beyond that, do anything you can to offer insight on how that market is segmented and which segments are most attractive.
- Business model / unit economics – how does your business actually make money at the level of an individual sale/customer? Price – COGS = gross profit. Then what’s the sales/customer acquisition model? You need to really understand this in a detailed way so that the investor can see how the business builds up into something which, with lots of customers, will clearly cover it’s variable and selling costs, and then corporate overhead, and ultimately drive profits.
- Competition – be honest and expansive. In addition to the obvious direct competitors, give some thought to the other questions investors will ask. “Why couldn’t Google build this and crush you?” “Is this really a big enough pain point that the status quo won’t prevail?” “Can’t big customers just build this themselves?”
- Go to Market Strategy – we alluded to it in the Unit Economics, but this has got to be a believable story about how you acquire customers and, hopefully, do it at ever decreasing costs/customer.
The above may be painfully obvious to some, but there’s nuance within each for any particular situation. Again, I encourage you to get an “expert” on these processes to walk through each of these sections and think comprehensively about how they apply to your business.
Some of this work will result in you tweaking the arc of your story a bit. But much of it will not. This work will become your “back pocket” analysis – things you’ll do the work on and then keep handy, knowing you’re likely to be asked. I can tell you that there are few things that impress a VC more than asking what they think is a brilliant, insightful question and then having the team come back immediately with an answer of “Great question. We’ve thought a lot about that. Let me share some analysis.” If it’s well-packaged and pretty analysis, so much the better. It’s the kind of thing that leads the VC to go back to her partners and say, “Man, these guys are good. We asked a couple of deep dive questions on tough issues andthey were way out ahead of us – they’d already done the work. They’ve really thought through and deeply understand their business.”
You might worry that this could lead to a lot of wasted work, to which I have three responses. First, I wouldn’t advise leaving much of anything in your back pocket, regardless of whether or not you’re asked. If you’re smart about it, you can cleverly find opportunities to proactively slip this work into the dialogue. Done effectively, you can shift the balance of the conversation from the VC saying, “I’m asking you this question because I think it’s critical to your business and you better have a great answer,” to you saying “I’m sharing this analysis, background research, and insight with you because I know it’s what’s important about my business.”
Second, whether or not you spend time talking about it, much of your work is likely to find its way into an investment memo for my partners. When sponsoring a deal, we allwant our recommendations to be as thorough, thoughtful, and data-driven as possible. If you give us more smart stuff, we’ll use it, and be that much better at advocating on your behalf. Make sure that any investor who gets serious about the business gets an invite to that Dropbox.
Lastly, and perhaps most importantly, you should be thinking about this stuff anyway! One real benefit of a well managed financing process is that it forces you to step back and think about the forest for a bit, rather than that tiny piece of bark you’ve been staring at on that one little tree. If you’re thoughtful about which analysis you choose to do, you’re going to learn some valuable new stuff from doing the work, whether or not any prospective investor ever asks specifically for it.
A financing process is a high stakes game upon which the future of your business ultimately depends. You can’t afford to leave anything on the field. So go into the game with a plan of how to control the discussion. Do so and prospective investors will walk away understanding your business better, and with more convictionthat you are an entrepreneur they want to be behind. And that will lead to a competitive process where you end up holding the cards.