This article is the first of a multi-part series covering the findings from the Early-Stage Business Financing in Alberta study published by NAIT.
In October 2014, NAIT released a report describing the reality of how Albertan start-ups raise early stage equity financing and what challenges both entrepreneurs & investors face when trying to make deals. This report only crossed my desk recently, and I admit that I only consumed the abstract (as the entire report is over 200 pages), but it contains several interesting pieces of information applicable to all start-ups.
Talent, Not Technology, is Primary
A technology entrepreneur would likely expect that an investor in primarily interested in the functionality and ingenuity of the product/service/invention being pitched. In reality, the opposite is true. Investors are first and foremost evaluating the individuals doing the pitch.
Investors place greatest emphasis on the perceived quality of the founder/management team.
Investors realize that start-ups offering new products to new markets are highly risky. New ventures are likely to fail. A smart investor will bet on the team rather than the product, knowing that in all likelihood, the team will smartly pivot and change the product multiple times responding to feedback from the market before it is successful. In fact, the product that finds success in the market may be completely different than the one investors learned about during the initial pitch. A competent management team knows and expects failure, and as a team, has the creativity and intelligence to overcome these hurdles.
Coach-ability is Crucial
Coach-ability is another core characteristic that investors seek. Not only do investors provide capital for the venture, they also share years of business experience in key markets and understanding of regulatory, technical, and market challenges that the new venture is likely to experience. Investors also usually have a great network of industry contacts built over years of running their businesses. A savvy entrepreneur will take advantage of access to this wealth of information and personal contacts.
A good investor wants to help the ventures they invest in by providing advice and guidance. This is in the best interest of both the investor and the entrepreneurs as both are motivated by the financial success of the venture. To their own detriment, some entrepreneurs are overconfident in their abilities and are uninterested in listening to a wise mentor. For whatever reason, these individuals are interested solely in the cash an investor can inject into the venture. Ironically, a closed-minded entrepreneur will likely discourage investors. After all, would you feel comfortable giving your cash to someone who refuses your council? The best course of action is to think of investors as partners in your business; individuals who can provide both financial and intellectual capital to your start-up.
Do Not Neglect the Business Side of your Venture
After team quality, investors look at the quality of the market opportunity presented to them. This is pretty self-explanatory; after all, investors are ultimately seeking a strong return on their investment (although there are cases where investors fund new ventures mainly for personal interest, lifestyle, or “fun”). The rule of thumb that I tell my clients is that early stage start-up investors are looking for a 500% to 700% return on investment within 5 to 7 years. In some cases, the time period expectation is shorter. At a recent NACO conference, many investors stated they are now expecting a return within 2 to 3 years. For an entrepreneur, this means an investor must be convinced of the size and growth of the market, how well-defined the market is, and the maturity and realistic-ness of both the marketing plan and the financial model.
In my experience, technology entrepreneurs typically overlook the market, financial, and business aspects of their venture. The findings of this report suggest the opposite. Investors value the business factors of the venture far more than the innovative technology itself. Therefore, technology entrepreneurs need to develop the business stream of their venture as much as the technology stream. If they prefer to focus on the technology or have little interest of knowledge in business, then bringing on a co-founder with these skills is necessary.
Have a Realistic, Needs-based Valuation
Many of the entrepreneurs that I advise create wild valuations for their ventures. When probed for details about how these values were determined, founders often describe the “major growth potential” of their venture, or the fact that “start-up x recently received $y million recently”. In fact, it is not uncommon for me to hear an entrepreneur who has sold few or no products to value their company at over $1m.
Investors know better, as stated in the report.
The number one reason for walking away from a potential investment was an unrealistic business valuation.
High valuations create uncertainty for the investor for a few reasons. First, it may reflect that the business is in poor financial shape and needs a large cash injection immediately. Second, it could mean that the entrepreneur is looking to acquire cash to spend lavishly on frivolous items. Lastly, it could mean that the entrepreneurs have no clue about the venture’s current and future revenue and costs, or the size of the market.
Determining a valuation for an early-stage start-up is challenging. While I will discuss more about this in a future article, entrepreneurs should base their valuations on current needs and realistic projections. Do not be afraid to present a small but fact-based valuation to an investor. As stated above, your goal should not only be to acquire capital for the business, but networking opportunities and seasoned business experience. If nothing else, remember these words of wisdom:
“70% of something is worth more than 100% of nothing”.