Venture Finance in the (New) New Economy

Forget the debate over the Old Economy versus the New Economy. As high-flying Internet stocks crash to earth, and cash-strapped start-ups hunt for additional financing, the rules of the New Economy are already being re-written. Fundamentals are back, tailored for the speed and intense competition of the technology marketplace.

There’s no shortage of capital. Venture finance firms are awash in cash and still hungry for quality investments. But the speculative bubble of the past few years has quickly given way to a new focus on business issues. Entrepreneurs looking for funding in the "new" New Economy face tougher scrutiny of their business strategy, venture partners, and market savvy. Before laying cash on the line, funders are taking the measure of entrepreneurs and probing their business plans with a simple question: how will you make it pay?

Business Plans

The business plan is where it all begins. A solid plan is not only a road map for launching a successful venture, but also the key tool for attracting investment capital. Unfortunately, only 1 in 200 business plans truly provides a crisp, exciting grasp of the company’s product and market potential. Even promising ideas often fail to garner attention because the entrepreneur hasn’t invested the time and care to develop a credible plan for translating an innovative concept into a profitable enterprise.

What are the most common weaknesses in business plans?

They’re poorly written. Too many plans are laden with buzz words or dense, technology-heavy product descriptions. Instead, the plan should cleanly and succinctly review the product and market. This isn’t easy. Distilling complex concepts and core ideas into a clear, persuasive document takes considerable effort - but the result is a superior plan.

They’re too long. Most venture capitalists won’t take the time to wade through excessive detail. While some entrepreneurs think they will impress potential funders with sheer volume, they’re more likely to lose the power and punch of their message. Be concise, and always include a one- to two-page executive summary. In all likelihood, only the executive summary will be read.

Even professionals who should know better forget the importance of brevity. One entrepreneur submitted a 120-page business plan with a 25-page executive summary. Ironically, his experience included serving as an adjunct professor at a local college - teaching people how to write business plans!

They focus exclusively on the product. It’s not a technology plan - it’s a business plan. While the value and uniqueness of the product are important, the key issue for funders is how the product can be marketed profitably. That means addressing market demand, marketing strategies, competing products, competitors’ resources, production and distribution costs, pricing, revenue goals, and potential partnerships.

These messages may seem like common sense, but in reality, they are widely ignored. Many entrepreneurs fail to get professional help in thinking through business issues or in crafting the plan itself. The lack of adequate counsel shows. Entrepreneurs are rarely experts in all the components of building a business - and venture capitalists don’t expect them to be. But as with all other aspects of developing a successful business, entrepreneurs need to know when to get outside help to supplement their own expertise. A "do-it-yourself" mentality isn’t likely to impress funders.

Choosing Partners

You have a plan. Now what?

Developing the right professional contacts is critical in selling the business plan itself. Publishers always say they read their slush piles of unsolicited manuscripts. Some venture capitalists say the same thing about unsolicited business plans. But the fact is that material sent over the transom gets little attention, and the odds of getting funding simply by sending in a business plan are very long. What you need are partners who can open doors for you and get your plan in front of the right people.

Few things say more about the quality of a business than the people around it. Your funding partners, advisers, and professional colleagues all testify to the credibility of your venture. It’s also a self-selecting process: if you can gain the confidence of the right partners, they in turn will attract other partners, particularly funders, to sign on. The corollary is also true: missteps in identifying and recruiting partners can derail even a quality business plan.

Here are some basic principles to remember in building partnerships:

Choose angels wisely. Although some venture finance firms will invest smaller sums, many firms aren’t interested in deals under $10 million. As a result, entrepreneurs often turn to angel investors and seed funds for the money needed to get started. But be careful. Venture capitalists looking at your next round of financing are often reluctant to invest in deals where angels are unsophisticated or too closely tied to you or your product. Similarly, having too many "little" shareholders potentially creates a cumbersome ownership base that can’t respond quickly when the capital structure needs to be changed. Most funders want a clean and nimble corporate structure.

Look for more than money. The value of partners goes beyond their investment. You should look not only for funders willing to participate financially, but also those who can bring added value to the business, such as contacts and experience within the industry, connections to potential Board members, and a track record launching similar businesses.

Don’t assume that luminaries will impress investors. Some entrepreneurs try to recruit "big names" to serve on the company’s advisory board. But such high-profile individuals may commit little personal time to your business. Their value is limited if they cannot provide you with real leadership and advice, and their name alone is not particularly useful if they cannot speak knowledgeably about your company and why they chose to become involved.

Don’t misrepresent relationships. The funding community is small, and most players know each other. Don’t imply that you’ve signed on partners, when in reality you may have had only preliminary or tentative discussions that haven’t been finalized. It’s easy to let your enthusiasm carry you away - but if a potential funder finds you’ve exaggerated a relationship, your credibility will be severely damaged.

Remember that partnerships go beyond investors. The same principles apply when identifying lawyers, accountants, Board members, and other professionals who can deliver services and support to your business. Like investors, these professional partners have strong contacts throughout the venture capital and investment banking community and can be invaluable resources in getting funders to take you and your venture seriously. The lesson is to involve substantive partners early in the life of the business.

Doing Business

Potential funders aren’t looking solely for the next great idea. They’re also looking for an entrepreneur who has the business savvy to understand the market and the determination to make the tough decisions necessary to make the business work.

What do venture capitalists expect from entrepreneurs?

Bring in experienced management. One of the hardest lessons for company founders is realizing that they can’t and shouldn’t do everything, even though it means giving up control. Recruiting experienced managers to help in marketing, accounting, human resources, and other areas is an essential part of growing a successful business. (But it doesn’t allow a founder to ignore business realities - see below.)

Understand financials. Even though a founder may end up focusing on the product - and bringing in outside professionals to assist in operations - there is no substitute for grasping the financial dynamics of the business. If a founder defers to an accountant to talk about financials in a business pitch, it suggests that he or she doesn’t understand the business strategy. Venture capitalists look for entrepreneurs who understand and can articulate the path to profitability.

Understand the market. Similarly, entrepreneurs must understand the trends within the market and how to establish and sustain market share. As recently as six months ago, e-commerce theory held that web sites should first build a brand and drive traffic and worry about monetizing users later. No longer. Now brand is less important than an earnings plan - and don’t even think about a strategy built entirely on banner ad sales.

Similarly, "first in" to a market space no longer has the value it once did. Instead, potential funders want to understand how the business will use distribution channels, patents, infrastructure, and other barriers to ward off competitors who may enter the market with better contacts or capital. (If you’re looking to develop an e-business related to automotive parts, for example, how do you propose to compete with the resources of the big automakers?)

Be prudent with cash. E-commerce companies have become legendary for their ability to burn through large amounts of venture funding through excessive marketing budgets (think Super Bowl ads). Most funders now expect rational budgeting, as well as strategies for developing channels to provide immediate cash flow to the business.

Show Me The Money

Entrepreneurs thrive on great ideas, such as new technologies to make business more efficient, new medical devices to improve human health, or creative new concepts to lure diners and shoppers.

But venture capital firms are about money. They invest their assets, often in high-risk enterprises, and they require a healthy return.

So here’s a little secret. Venture capitalists want to work with entrepreneurs who are in it for the money. If that sounds crass, it’s actually realistic. An entrepreneur who is focused on money will usually make the hard choices necessary in order to make the business succeed. If a founder needs to be the CEO to satisfy his or her ego, or is more interested in the power of the idea than its profitable potential, those are red flags for funders. After all, would you buy stock in a company that wasn’t fully committed to increasing the value of its shares?

For start-up companies seeking venture finance, the "new" New Economy may look a lot like the old one. Fundamentals matter. Profitability matters. A sound business plan wins the day. But even if the standards for funding have become stricter, there’s plenty of venture capital to be found. Investors make money by investing. If they can’t find a reason not to do a deal, chances are they’ll do it. But they’ll look for a lot of reasons.