The worst possible way to finance a start-up is to take venture capital. The best? Profitable products that customers are eager to buy. Nevertheless, if venture capital is the only way, there is a time and a way to do it that will allow the business to make the best of it.
First, consider why VCs are bad news compared to the alternatives. Simply put, entrepreneurs crave control and when a start-up takes venture capital, the founder hires a boss — a boss who is in a position to fire the founder. On the other hand, if a start-up can finance itself through customer profits, generous terms from suppliers or founder’s capital, the founder can retain control.
That’s why start-ups seek outside equity capital only as a last resort. In raising outside capital, entrepreneurs are well-advised to sequence their capital raising with the achievement of their short-term goals. For instance, start-ups should:
• Boot strap — e.g., live off Ramen noodles and credit card borrowing — to find a business model;
• Raise money from Angel investors — wealthy individuals who write five- and six-figure checks — and friends; and
• Seek venture capital to add to the start-up’s product line and expand geographically.
Making the Pitch
When making the pitch to the VCs, follow these six tips:
1. Connect emotionally with the VCs. To do this well, learn about the individuals you’re pitching. Maybe they went to the same school or have the same hobby. One of the best ways to break through the emotional barrier separating a would-be borrower from the VCs — who are likely to turn you down — is to do something that makes them laugh.
2. Give a working demonstration of the product. One way to get a laugh out of potential financiers is to provide a working demonstration of the product that will amuse and delight the VCs.
3. Highlight related work success. Even if the first two items are accomplished, VCs will never invest a dime unless they perceive a winner. To that end, draw on your entire life experience to highlight passion and ability to win — this could be in sports or academics, or better yet, in starting and building new businesses. The more successes generated, the greater the VCs’ fervor to invest.
4. Admit immediately what you don’t know. Never try to bluff your way around a question. If you don’t know, admit it right away. Inability to answer the question will not help the case — especially if it’s something that should be known. But faking an answer will cause one’s reputation to go up in smoke.
5. Make sure the business plan explains why customers will use the product/s. The difference between the successful and failed start-ups is that the winners really cared about how they were going to get individual customers to use their product by interviewing potential customers.
Most VCs want to invest in companies going after big markets, but the market size estimates are generally made up. The real opportunity is in finding unmet customer pain and relieving it.
6. Prepare to be rejected or ignored. The most frequent technique for rejecting an applicant is to ignore him or her (such as when resumes are sent). This is quite popular with VCs who may talk to hundreds of entrepreneurs a year and invest in one or two.
In some ways, no response is better than a VC who keeps requesting more information and tweaking to the business plan — and may be using you to help out their competing venture. Prepare for this outcome by getting warm introductions to about 10 venture capitalists; the odds of getting some feedback from one or two are pretty good if the above instructions are followed.
If successful at raising venture capital, recognize beforehand that you will be hiring your boss in the partner who is representing the VC firm. This decision is the most important one to make. So speak with at least 10 other entrepreneurs who have worked with this individual and ask tough questions, such as how the person reacts in a board meeting to bad news and under what circumstances the person will replace the founder.
If the right choice is made, the VC partner will not only provide capital but also give the business, the customers and partners useful help to achieve a shared goal of realizing a profitable future for the start-up.
Peter S. Cohan ([email protected]) is founder and president of Peter S. Cohan & Associates, a management consulting and venture capital firm. He is also author of 11 books on business and investing, most recently Hungry Start-up Strategy.