Thoughts on Advanced Entrepreneurship

Is it technology looking for a market or a market looking for technology?

2012-02-03T15:59:00.000-05:00

Whenever I hear a company CEO say, "We have great technology and we're looking for new applications for the technology," I know this company is heading for trouble. When I hear a CEO say, "We know this market and we're looking for new technology to solve problems that exist with users in this market," I'm interested. So are investors!

It is so tempting for those who have developed a technology to think that there must be a market that can use this technology, that the technology developers lose objectivity and try to start a company to find the market that can use the technology. This company is about 90% of the time doomed to failure. So, why don't the owners/developers get it? Businesses succeed because there is demand (a market) for their products and services not because they have great technology. OK, the most successful companies have great technology AND demand for their products or services.

But, you say, what about a market that will develop in the future and the entrepreneur who has a vision that the market will develop in the future? Well, you've heard that timing is everything. Most entrepreneurs who have a vision of a future market can't imagine how long it takes for a market to develop and exhaust their resources before there is a viable market. Those that enter this nascent market just at the inflection point when a viable market is developing succeed while those who enter too soon fail. This is particularly true for companies that have a new technology.

Don't get caught in the trap of having an interesting technology and believing you can start a company to find a market for the technology. Knowledgeable investors know this is a formula for failure.

Is the cost of complying with SOX worth it?

2012-01-01T12:10:00.003-05:00

When I team-teach aportion of our Business Ethics class in the Rollins MBA program, one of thepresentations by a team in the class is on the pros and cons of SOX. The side that discusses the cons alwaysquestions to cost/benefit of compliance with SOX. After the presentation, I ask the class todetermine the percentage of stock traded, as a percentage of the sharesoutstanding, in a publicly traded company on the New York Stock Exchange in agiven week. I'll suggest a largecompany and tell them to go to Yahoo or some other site for thisinformation. They usually find that thenumber of shares traded in a given week for that company is 2-3% of theoutstanding shares in the company.

Then, I ask theclass to tell me the market cap for that company based on the quoted price pershare at that time and most of the class gets the answer right - the shareprice times the number of shares outstanding.

Then, I ask them topredict the effect on the price per share if the New York Times or the WallStreet Journal has a headline that the SEC is accusing one of more executivesof that company of wrongdoing. Thestudents are usually at a loss at predicting the price decline that will occur,but some find a few companies where that has happened recently and excitedlyannounce that the price per share went down 10-30% in one day resulting in adecline in the market cap by several billion dollars. So, the alleged wrongful (unethical bydefinition) conduct may have reduced the wealth of the shareholders in thatcompany by several billion dollars. Howcould this be?

Because stock pricesare set by transactions at the margin (only 2-3% of the outstanding shares perweek) in normal trading. But, when apublic relations disaster hits, it would not be unusual for more than 5% of theoutstanding shares to be traded in one day driven by institutionalsellers. So, what is the lesson in myBusiness Ethics class?

Unethical conduct byone or more executives in a publicly held company can result in a reduction inshareholder wealth by hundreds of millions (or billions) of dollars when thewrongdoing may only have benefited the executives by a few million dollars orless. So, the value of the increasedoversight by the board of directors and the audit committee caused bycompliance with SOX should by measured by avoiding the reduction in shareholdervalue if wrongdoing is prevented. But,how can shareholders know if wrongdoing is prevented? They can't; but, in my experience, theinvisible hand on the executives of the company due to SOX is a form of insuranceagainst wrongdoing and the premium paid is the cost of complying with SOX. Based on the public relations disasters manycompanies have faced when wrongdoing is discovered, the premium for reducingthe likelihood of wrongdoing by complying with SOX is well worth it.

"Vapor" Opportunities

2011-12-31T15:23:00.001-05:00

I often tell mystudents to be very careful when considering a new business opportunity if youare on the outside looking in with a solution to a problem you perceive toexist. An example would be for someonewith software development experience in, say, customer service software who decides to develop software to automate some aspect of medical records indoctor's offices. He or she talks to afew office managers for doctor's offices and develops a set of features forthis software based on this very limited information.

Our entrepreneurthen induces a doctor's office to be a beta site for the software and, with agreat deal of hand holding, decides that the beta site was a success. This is a disaster about to happen. Usually, the doctor's office in the beta testhas not paid money to use the software and, therefore, didn't have to considerthe value versus the cost of the software product.

Inevitably, thesoftware needs many bells and whistles to handle all the variations"required" by different doctor's offices making it impossible tocharge a price that the doctor's offices are willing to pay that will cover theactual cost of delivering the product. The entrepreneur deceives him or herself into believing the"value-added" by using the product exceeds the price the entrepreneurmust charge and the entrepreneur runs out of cash chasing a "vapor"opportunity.

Compare this to aperson with some knowledge of software who works as an administrator in a large doctors' office who sees the needfor a similar product, but with a simplified set of features that will meet theneed. He or she sees that the productcan be developed, from the beginning, to have flexibility to handle additionalfeatures, if a doctors' office is willing to pay for them. This person decides to team with a softwaredeveloper and designs the software to meet the real needs of a doctor's officethat have subtle, but very important, differences from the needs perceived byour first entrepreneur. The bells andwhistles (that often cost more to develop than the basic product and oftencause more problems for the customer) are offered only as add-ons. This entrepreneur has a real chance ofsucceeding.

What I've describedabove happens very often. The firstentrepreneur conducted a superficial analysis of the problem he or sheperceived to exist and developed a product without knowing the subtle aspectsof the customer's problem that will be the difference between success andfailure of the product. This oftenhappens because of an arrogance on the part of the first type of entrepreneurwho thinks he or she can understand the customer's need and thinks he or sheknows the decision making process the potential customer will use in decidingwhether or not to pay money for the product.

In reviewing abusiness plan, I always look for a section that walks the reader through thethinking process of a potential customer in deciding to purchase theproduct. I very seldom find thisanalysis and, when I ask the entrepreneur to verbally tell me, the entrepreneurcan only give me generalities that are useless. Yet, when I ask someone like the second entrepreneur described above whohas had personal experience in dealing with the problem, he or she can usuallygive a very good explanation of the customer's decision making process. Which of these entrepreneurs is likely toraise capital from investors?

The lesson - team upwith a person with real experience at dealing with the problem you think youcan solve with your product; not by simply interviewing the person, but by making the person a part of your team!

The best way to prepare for a major negotiation

2011-07-06T21:46:00.000-04:00

All entrepreneurs need to be good negotiators. Few are. Why? Because they usually have little experience at negotiating major matters and have no training in negotiation. Negotiation skill is not intuitive, it is learned. I teach Negotiation in the Rollins MBA program and hammer into my students that the key to successful negotiation is preparation. Although there are many aspects to preparation, the one that is most important, yet usually missing, is to develop a good alternative to whatever you are about to negotiate. That is, if you are preparing to raise capital from angel investors, know what angel investors want and the terms to expect. But, more importantly, court more than one angel or angel group at a time so you can turn down an unacceptable deal . The strongest way to negotiate is to let it be known that you have an alternative deal that may be better than the deal the other side is trying to negotiate with you. Otherwise, you are negotiating from weakness and the other side will spot that weakness immediately. OK. Why doesn't everyone do this? Because it is very difficult to develop the relationships necessary to have an angel or angel group take an interest in making an investment into your company. If you follow my advice, you have to develop at least two of these relationships in parallel and manage the process so that you have at least two potential investors or groups of investors with whom you will negotiate at the same time. But, you say, don't all investors or investor groups ask who else is considering an investment in your company and insist that you tell them their names? Yes, this is a common practice by investors, but you have to have the courage to say you won't disclose this information. An investor who walks away solely because you won't tell the investor the name of the investor's competition is an investor who will probably demand unacceptable terms anyway.

So, the best preparation for a heavy duty negotiation is to lay the groundwork to have an acceptable alternative to the deal you are about to negotiate. This takes planning and time.

All major corporations should be inspired by the story of the British Mustang

2011-06-28T15:30:00.000-04:00

A story appeared in Slate Magazine several weeks ago that should inspire all large corporations to encourage entrepreneurial thinking in their organizations. Here's the link http://www.slate.com/id/2293662/

More thoughts on raising capital from angel investors

2011-03-06T21:32:00.000-05:00

Over the past few months, I've had the opportunity to speak to groups about the difficulty in raising capital from angel investors. I always emphasize the need to establish a relationship with several angel investors before asking them to invest. This takes more time than many companies have to raise capital before going out of business. Therefore, most companies have to bootstrap for up to a year while establishing relationships with credible angels and angel groups.

There is a trend toward angel investors forming angel groups. I think this will help companies that qualify to raise capital from angels, but companies need to recognize the time it takes to go through the process of getting money from an angel group. I hope the formation of angel groups results in better access to capital for entrepreneurial companies.

But, it still takes more time than most entrepreneurial companies can imagine to raise capital from angels. I often advise early stage companies that they need to "raise capital to raise capital." Otherwise, the company can't stay in business long enough to develop the relationships with angel investors necessary to raise a serious amount of capital.

Raising capital from non-strangers, not angels

2011-03-06T21:23:00.000-05:00

Over the years, I have counseled clients who set out to raise capital from angel investors that they need to focus on angels with whom they have relationships, directly or indirectly. The probability of raising capital from angels with whom the entrepreneur has no relationship is extremely low. Therefore, logically, the entrepreneur must start developing or pursuing relationships with potential angel investors from the get-go since these relationships are difficult and time consuming to develop.

I've decided to call angels with whom an entrepreneur has relationships Non-Strangers. This seems like an odd name, but it is descriptive of the angels who actually invest in most companies. Yet, most entrepreneurs don't get it. They think that they can simply find wealthy people, present a business plan and some of them will invest. This is usually a waste of time for both the entrepreneur and the wealthy person.

Angel investors should be viewed as customers

2011-03-06T21:08:00.006-05:00

When an entrepreneur comes to me for advice on raising capital from angel investors, I ask him or her "Do you know why angels make investments in early stage companies?" Inevitably, the answer reflects superficial thinking and deserves an "F." Most entrepreneurs do not have the foggiest idea about what it takes to raise capital from angel investors and make little effort to find out. They seem to think that if they have a good business plan and enthusiasm, angel investors will invest.

Any entrepreneur who decides to raise capital from angel investors should conduct as much research on why angels invest as they do on why customers buy their products or services. Few entrepreneurs even read a book on how to raise capital from angels when there are many books on the subject through Amazon. It's no wonder that most entrepreneurs who set out to raise capital from angels fail miserably.

Every angel investor is different, just like every customer is different. But, there are some characteristics that are common to most angel investors. If an entrepreneur would come to me for advice on raising capital and demonstrated the same degree of ignorance about his or her customers as the entrepreneur usually demonstrates about angel investors,I would tell the entrepreneur to find another occupation.

Why is it that entrepreneurs make little effort to find out the same type of information about angel investors, yet will work really hard to find out about the characteristics of potential customers? I attribute this to an underlying sense in most entrepreneurs that an angel investor is not a "buyer or customer" but is a "seller or supplier." An erroneous view is that an angel investor is "selling capital" to the entrepreneur and the price to be paid is an equity interest in the entrepreneur's company. Not true. The seller in this case is the company, selling an equity interest to the angel investor who is buying, not selling. If an entrepreneur would only take this view of angel investors, the entrepreneur would do extensive research into the characteristics of the angel investor market. How many angel investors will the entrepreneur have access to, what is the decision making process for an angel investor, who influences the angel investor to make the investment, what is the competition for the angel investor's funds, what will it take to get an angel investor to seriously consider the entrepreneur's opportunity, etc. These are the types of questions the entrepreneur would seek answers to for his or her customers; why not seek this information about angel investors?

Finding out the characteristics of the angel investor market is difficult, but not impossible. It is inexcusable for entrepreneurial companies who set out to raise capital from angel investors not to know as much about the angel investor market as they know about their potential customers.

Why don't angels invest in early stage or seed venture capital funds?

2010-05-23T13:52:00.001-04:00

The vast majority of angel investors make investments on their own or follow other angels into deals. Few angel investors conduct due diligence on their own. Why? Because they don't have time and most don't have the needed expertise unless the investment opportunity is in the field of the angel's experience. Further, most angel investors don't have expertise in negotiating early stage investments. So, why do angels invest in early stage deals in such a haphazard way?

I'm not aware of any studies on why angels invest in this way, but I've represented many companies in their capital raising efforts at the early stage and have observed how angel investors typically behave. Most angel investors base their decisions to invest in early stage companies on the charisma of the founders, not on a thorough analysis of the products, markets and management skills of the founders. Yet. some early stage investments by angels pay off handsomely. How can this be? Frankly, I believe it is mostly luck.

I have a rule of thumb for seed stage investing - invest in 10 companies because 8 will fail (or you will lose all of your investment when later investors squeeze you out), one will make a 2-3 times return and, if you're lucky, one will make a 5 - 10 times return (maybe higher). Of course, the losses will occur in the first few years and the winners will take 5-7 years to achieve success for their investors. Most angels lose patience after five years.

In my experience, most angel investors do not invest in at least 10 early stage deals because they do not have sources for qualified deal flow. As a result, most angel investors get discouraged after investing in deals for three to four years and stop investing, almost assuring a loss on their investments.

If angel investors knew this pattern, why would they invest in a 3-4 deals expecting each one of them to be a 10X winner? In my experience, investors who are new to angel investing don't know about these odds or about the probability they will be wiped out by later investors when their companies have to have "down-rounds" with more sophisticated investors to stay alive.

I've blogged before about why angel invest (based on my experience). They invest for the "fun-of-it," not because they need to increase their net worth. Yet, they hate to lose money. If this is the motivation of most angel investors, it's understandable why they don't do due diligence, don't structure deals smartly and don't cultivate quality deal flow. It also explains why they don't invest in early stage or seed venture capital funds. A fund like this results in little or no contact by the investors with the investment opportunities and with other investors in the fund. In other words, the "fun" is taken out of the hunt for seed investment opportunities.

If angel investors wanted professionals to find the early stage investment opportunities, do thorough due diligence, negotiate favorable deals and offer guidance to each company after the investments are made, early stage/seed venture capital funds would spring up to meet the demand by angel investors to invest in these funds.

As an alternative, angels might band together to form angel investor groups hoping the group could engage a professional to do the due diligence and deal making for them with an approval process that would involve the angels in the decision making. These groups have been formed and some are purportedly successful in their investing missions, but my observation is that most angel groups fall apart after short periods of time due to the need for volunteers to do most of the work.

If angel investors were primarily motivated to invest in early stage companies based on potential returns, they should invest in early stage/seed venture capital funds. Commentators have recently been reporting that the smaller, early stage venture capital funds have provided greater returns to the investors. But, if an angel investor is primarily motivated to invest in early stage deals for the fun-of-it, that angel won't be interested in an early stage/seed venture capital fund because the fun is taken out of the equation and the investor will basically be a passive investor.

If a new, early stage/seed venture capital fund could offer some way to make it fun for angel investors to invest, that fund should succeed in raising capital from angels. Otherwise, a new, early stage fund will have to raise capital from institutional investors who are not into having fun, but into achieving the highest possible returns.

The key to attracting angel investors

2010-03-26T09:32:00.000-04:00

As a corporate and securities lawyer for 35 years, now as a professor of entrepreneurship and negotiation, I've worked with many young, technology companies in their efforts to raise capital from angel investors. Almost all of these companies initially thought they could simply present a good business plan to several potential angel investor who they've never met before and get a commitment from each of them to invest several hundred thousand dollars. Those that ultimately raised capital learned the hard way that they had to establish a relationship with potential angel investors before they would invest.

A few of my clients followed my advice and the advice of others and started a year in advance to establish relationships with potential angel investors before attempting to raise capital from them. This took planning and perseverance since most young companies can't wait for a year to raise capital unless they can bootstrap for that period of time.

But, think about it, doesn't common sense tell you that angel investors are not stupid and won't invest unless they have direct or indirect relationships with the companies they will invest in? Every angel investor has many, many investment opportunities. The smart angel investor invests in companies the angel investor knows more about than he or she learns from a business plan. Or, he or she has a friend (usually another angel investor) who has a relationship with the company and intends to make an investment. This is what I mean by a direct or an indirect relationship.

I can't remember a client who raised capital from angel investors who were total strangers. Usually, one of the angel investors had a relationship with the company for a period of time. This investor acted as a lead investor and brought in friends to the deal. The friends trusted the lead investor's judgment because of the relationship he or she had with the company.

So, the key to raising capital from angel investors is to establish a relationship with one or more angel investors so the angel investor can become a champion with other angel investors he or she knows. I know this is easy for me to say and very hard to do when a young company is trying to survive for up to a year while establishing these relationships. But, those who are able to do this, who have dynamite business opportunities, management with experience and business plans that are believable can raise capital from angel investors.

Are advanced entrepreneurs good negotiators?

2010-02-12T20:10:00.002-05:00

Not ususally. But, they don't realize they are poor negotiators. So what?

In order to capture the attention of advanced entrepreneurs, I often point out that entrepreneurial businesses make life or death decisions several times per year (sometimes per month), while a large company may make a life and death decision once every five years. Therefore, the liklihood of making a mistake that leads to the entrepreneurial business feeling compelled to be acquired or worse, going out of business, is very high.

Many of the mistakes result from a failure to successfuly negotiate a strategically important transaction or relationship. Why is this? First, most entrepreneurs, like most executives, believe the ability to negotiate effectively is a natural talent (which is not true). As a result, they fail to take courses to develop negotiating skills. Second, the entrepreneur fails to follow the number one rule in negotiation - be better prepared than the other side!

Every entrepreneur will be involved in heavy duty negotiations with people on the other side who are more skilled at negotiating than the entrepreneur. Yet, the entrepreneur believes his or her common sense will be enough to do well in the negotiation. Not even close!

Hiring a lawyer or other expert to negotiate for you is expensive and, often, not very helpful since the lawyer or other expert probably does not fully understand the context in which the negotiation is taking place. Only you have a keen appreciation of the trade offs you may make to get the deal or transaction done. It is easier for you to learn how to negotiate than it is to bring the lawyer or expert up to speed about your business.

Every entrepreneur should take a mini-course in negotiation from the local university or one of the firms that advertise in the airline magazines offering weekend programs on negotiation. This will be one of the best investments of time and money an entrepreneur can make.

Economic gardening is a good thing, but ......

2010-02-09T09:04:00.000-05:00

Many state and local governments are promoting "economic gardening" as a means of stimulating growth in their economies and employment. This is a good thing. But, a key ingredient is missing - access to capital for growing entrepreneurial companies. Capital is in short supply by definition. Only those businesses that can convince investors and lenders that they can produce increased value for investors or meet their debt obligations for lenders deserve to obtain capital. The programs for economic gardening seem to focus on helping the growth stage companies deal with growth issues in order to make them more attractive to investors and lenders. This is a good thing also, but needs to have an added dimension.

How can governmental entities make capital more available to deserving growth companies in their geographic areas? Not by promoting venture capital firms to focus on a their geographic areas and not by trying to educate angel investors on investing in entrepreneurial companies. I urge all governmental decision makers to read a new book by Josh Lerner, a Harvard professor, Boulevard of Broken Dreams: Why Public Efforts to Boost Entrepreneurship and Venture Capital Have Failed--and What to Do About It, The Kauffman Foundation.

So, what can be done? Can angel investors be induced to make more investments in these companies? Probably not. Can growth companies be educated on how to raise capital from angel investors, resulting in more capital being invested in these companies? Perhaps. Can founding entrepreneurs of growth companies be convinced they need to make changes in order to be much more attractive to angel investors? This is the biggest impediment to attracting capital from angel investors. Yet, most entrepreneurs running growth companies cannot accept the realities of valuations of their companies, management changes needed, giving the investors some degree of control (through veto powers, not the power to force the company to take certain actions) and having boards of directors that are not rubber stamps for the entrepreneurs.

Entrepreneurs who have the courage to accept these realities have a much better chance to raise capital from angel investors. Those companies that raise capital from angel investors and make significant progress in developing their companies can become candidates for venture capital financing. Creating the environment where companies can raise more capital from angel investors is the best way to promote investments by venture capital firms in the future. My conclusion - economic gardening can make a difference if the economic gardening programs can help the entrepreneurs running these companies deal psychologically with these realities .

Entrepreneurial Finance is not about capital raising

2010-01-27T15:05:00.000-05:00

I'm teaching Entrepreneurial Finance in the Rollins College MBA program this term. The obvious approach to this class is to focus on different means of obtaining capital. But that is not what Entrepreneurial Finance is about. Let's refer to Entrepreneurial Finance as EntFin to shorten this blog. EntFin is about mobilizing resources to take advantage of an opportunity identified by an entrepreneurial company.

For a product, the basic resources to take advantage of the opportunity are marketing and sales resources, working capital and capital equipment. One way to obtain these resources is to raise capital and buy them. But, there are many other ways to mobilize these resources. Since it is usually very hard to raise capital, entrepreneurial companies must be very creative in getting others to provide these resources.

As an example, a start-up company making widgets that use a new technology that has been patented can license others to use the technology to make the widgets relying on the licensees to find the marketing and sales resources, the working capital needed and the capital equipment necessary. Or, the company could make only the component of the widget that uses the company's proprietary technology and sell the component to OEMs who make the widget. The OEMs have to find the marketing and sales resources, the working capital and the major capital equipment to make the widgets (the company may have to purchase some capital equipment to make the components and must acquire the working capital to fund a small inventory and accounts receivable from the OEM).

Or, the company could joint venture with a large company interested in making the widgets by contributing the company's technology to the venture for a share of the profits. The joint venture partner would provide the marketing and sales resources, the working capital and the capital equipment to make the widgets. There are other ways to use other peoples money to provide the necessary resources to take advantage of the opportunity.

So, EntFin is the study of ways to mobilize resources, not just ways of raising capital. Each of these ways have advantages and disadvantages and some of the ways may not be doable. My goal in teaching EntFin is to open the eyes of the students to ways of mobilizing resources that includes, but is not limited to, raising capital.

Is an entrepreneur who failed an "advanced entrepreneur?"

2010-01-23T10:26:00.000-05:00

We all know the saying, "We learn from our mistakes." Most people claim they learn more from mistakes than they do from successes. I don't believe this is true. Instead, I believe this is usually a way for a person to "psych" him or herself up after making a mistake that is very costly. Too often, an entrepreneur who started a business that failed blames the failure on outside circumstances or forces, not on mistakes made by the entrepreneur.

On the other hand, most entrepreneurs who have a successful business can readily state the decisions or actions taken by the entrepreneur that caused the success. An entrepreneur who has the courage to face up to mistakes made that caused a failure is likely to be a success the next time around.

For this reason, knowledgeable investors appreciate an entrepreneur who admits mistakes he or she made in the past and states clearly what was learned from these mistakes. Further, an entrepreneur who suffered through a business failure and has the courage to try again is my kind of entrepreneur. This entrepreneur is an "advanced entrepreneur" just as much as one who succeeded the first time.

Are entrepreneurs really risk takers?

2010-01-10T11:02:00.000-05:00

I've often said that, in my experience, entrepreneurs are not risk takers. Instead, they don't know most of the risks they are taking. There is a disconnect between the risks that experienced entrepreneurs, looking back on their careers, realize they took versus the risks that new entrepreneurs think they are taking. Why is this?

First, newbie entrepreneurs don't know what they don't know. When I ask a new entrepreneur to list the risks he or she is taking while in the start-up mode, the entrepreneur is often hard pressed to list more than two or three risks. This list is not even close to the kind and number of risks the entrepreneur is taking. This explains the frequent comment experienced entrepreneurs make that, "If I really knew what I was getting into, I probably would not have started my company."

Even when I or others point out risks that the entrepreneur is taking, the entrepreneur usually denies the existence of the risks or assumes the risks can be easily managed. It takes courage to admit that there are major risks that are being taken and that some of the risks, if they come true, may cause the business to fail.

I often remind my students that no one "knows what they don't know." If an entrepreneur knows what he or she doesn't know, then the entrepreneur can research the matters and come up with answers. But, when they don't know what they don't know, they are operating blindly and will usually be surprised by challenges that jump up and threaten the survival of their businesses.

Most entrepreneurs don't know the risks they are taking. The best way to know is to ask questions of those who have "been there, done that."

More myths about angel investors and venture capital firms

2009-12-12T13:24:00.000-05:00

Myth - Entrepreneurs generally succeed in raising capital from angels who have no prior relationships with their companies based on the merits of their business plans. Mostly wrong. An angel investor invests primarily based on a prior relationship the angel investor has with the entrepreneur or with another angel who represents he or she will invest because of the merits of the deal and his or her established relationship with the company. The key for a company in raising capital from angel investors is to establish relationships with potential angel investors long before asking them to invest in your company. In other words, a precondition to starting a company which will need angel investment to get past the first year is to "prime the pump" so to speak in order to have a lead angel investor when the time comes to raise capital. Almost all entrepreneurial companies start with family and friends money, hoping to achieve a few milestones that will make the company attractive to angel investors for "just in time" capital from these investors. Inevitably, it takes much longer than contemplated to raise capital from angel investors and the company runs out of money. The reason for this is that entrepreneurs almost always underestimate how long it takes to raise capital from angel investors who are strangers. They wait too long to begin the process of establishing relationships with potential investors.

Myths about Angel and Venture Capital Investors

2009-10-28T14:21:00.000-04:00

Most entrepreneurs have been exposed to myths about angel investors and venture capital investors. Let me dispell some of these myths:

Myth - Venture capital investors invest in technology, not the people. Wrong. Venture capital investors invest in the management team far ahead of the technology that is the basis for the company. Their experience is that a highly qualified management team will engage the market, react and change the product or service the company offers as needed to succeed. Since most companies don't succeed with the first version of its product or service, a management team that can assess the market and make changes will more likely succeed.
Myth - Angel investor groups act quickly when presented with an investment opportunity. Wrong. There is a trend toward angels forming groups to evaluate investment opportunities, select from the many opportunities they see, negotiate the terms of investment and make the investment. However, in most groups, this takes an inordinate length of time, especially if the angel group does not have a paid managing director to keep things moving. Most angel groups don't have a paid managing director. The reasons for the slow moving process is that the group often only meets once per month, a single naysayer in the group often causes the process to stop until others in the group override the negative opinion and the group has a preferred set of terms that may not be acceptable to advanced entrepreneurs, slowing the process down to get the group to accept other terms. It's not unusual for a company to make a presentation to an angel group one month, come back the next month to answer questions, begin negotiations lasting 30 days, then waiting another 30 days for the legal documentation to be completed before a closing occurs. Is it any wonder advanced entrepreneurs don't want to deal with angel investor groups? On the other hand, early stage entrepreneurs often have no choice but to raise capital from angel groups and don't realize how long the process will take.
Myth - Venture capital investors want to control your company from the start. Wrong. Professional venture capital firms do not want to take control of companies when they make their first investment. First, they aren't staffed to exercise that degree of control over the companies. Second, if they have to have control in order to make the investment, they have concluded the management team is incapable of running the company which should lead to the decision not to invest. On the other hand, there are individuals and groups out there who hold themselves out as venture capitalists, but who will only invest if they obtain control. These individuals and groups are not true venture capitalists and advanced entrepreneurs should usually avoid them.
Myth - Angel investors invest to make money. Usually wrong. Most angel investors are successful entrepreneurs who have cashed out. They invest to "be in the hunt" or to join with other angels who they want to be associated with or to have the opportunity to watch an entrepreneurial company go through the growing pains and, hopefully, succeed. Since, by definition, angel investors are wealthy, they don't have to make highly risky investments to increase their net worth. But, they HATE to lose money. Yet, angels will lose their entire investment in most of the investments they make in young companies. How do angel investors reconcile the risk-taking with hating to lose money? It's a mystery.
Myth - Angel investors bring good advice to the table for the entrepreneur in addition to money. Usually wrong. The best thing an angel investor can bring to the table other than money is relationships, i.e relationships with potential investors, relationships with investment bankers, relationships with potentially large customers, relationships with law firms, accounting firms and banks, etc.

I've run out of time today. I'll continue this another day.

Business Development Companies can fill the gap between angel funding and VC funding

2009-10-22T07:58:00.000-04:00

A gap exists between angel funding and venture capital funding for qualified, second stage companies. Very few angel funded companies will ever obtain VC funding before being acquired. So, a second stage, angel funded company has no choice but to grow with internally generated capital after exhausting the angel funding. But, this results in a lower rate of growth than could otherwise be achieved if growth capital were available. Yes, a company at this stage will probably be able to obtain a line of credit from a bank secured by accounts receivable or an equipment line secured by equipment, but bank borrowing is insufficient to fund a high growth rate. Alternatively, companies in this stage may seek to be acquired earlier than they otherwise would if they had access to growth capital, partly at the insistence of the angel investors who want a liquidity event.

There is an opportunity for business development companies to fill this gap and achieve attractive gains for its investors while filling the need of second stage companies for growth capital. A business development company is a special animal under the securities and tax laws. Essentially, a business development company is a publicly held, closed-end mutual fund that must invest primarily in privately held companies. A BDC that makes equity investments is basically a publicly held venture capital firm. A BDC differs from a venture capital firm in that it has the ability to raise capital from time to time as it makes investments through public offerings. A typical venture capital fund has a finite life and once it is fully invested, it liquidates its investments and distributes the net proceeds to its investors. The principals who run the VC fund then form a new fund and start the process over.

Unlike a venture capital fund that is privately held (as almost all are), a BDC is transparent to its investors and the public due to being publicly held. While this can be a burden on the BDC, the transparency is what all investors want and deserve. The biggest problem a BDC has with transparency is how to value its investments in privately held companies. But, a VC firm has the same problem in reporting its status to its investors, but doesn't have the SEC looking over its shoulder.

There is only a handful of BDCs that make equity investments in second stage companies, but there are many BDCs that only make loans, usually secured loans, acting essentially as finance companies. Why don't more equity oriented BDCs get formed? Well, the dynamics of the market can make it unattractive for an investment banking firm to underwrite the initial public offering for a BDC and it is expensive to start a BDC. Let's start with the expense of starting a BDC.

A founding management team has to be formed to start and manage the BDC. This team must have sufficient capital to bear the substantial legal and accounting fees necessary to prepare, file and process the registration statement for the initial public offering and the other expenses associated with the offering. The team must find and convince an investment banker to manage and underwrite the IPO. This process can take as long as one year and the members of the team must have the resources to devote almost full time to this process for that period of time. The reward for the team is to have the opportunity to share in the gains made by the BDC in its investments, similar to the "carry" available to the management team of a VC firm.

If a team can obtain the resources to form a BDC, the challenge is to convince an investment banking firm that the price of the stock will increase over the IPO price and increase over time as the BDC makes investments. Historically, the price of the stock has declined after an IPO for closed-end mutual funds of this type because there is little after-market demand for the stock. No underwriter will knowingly underwrite an IPO if it believes this will happen. So, the challenge for the management team is make a convincing case that it has the opportunity to make very attractive investments and that the BDC can keep the interest of investors while it takes several years to invest the proceeds raised in the IPO.

I believe there is an opportunity for BDCs to form while the gap bewteen angel funding and VC funding exists. I also believe that potential investors in an IPO for a BDC can find this an attractive way to invest in growth companies where the capital invested by the BDC into second stage companies causes these companies to grow. Further, unlike an investment into a VC fund, an investor in a BDC has a highly liquid investment since there is a public market for the stock of the BDC.

A case can be made for a BDC to have a $30-40 million IPO. The BDC should be able to fully invest the proceeds in 3-4 years, then have a subsequent offering assuming its investment portfolio is showing an attractive increase in value.

A management team will probably need to have $1-1.5 million to start a BDC and, the underwriter will probably require the management team to obtain commitments from private investors to invest up to $6 million in the IPO before agreeing to manage and underwrite the IPO. Quite a challenge.

The "gap" between angel funding and venture capital

2009-07-31T16:38:00.000-04:00

Does a gap really exist between angel funding and venture capital funding? Yes, but the gap also exists between venture capital funding and IPOs. The two gaps are related. When we had a market that accepted, even demanded, early stage IPOs, venture capital firms (VCs) were motivated to invest at the stage before the IPO. Otherwise, they missed the opportunity to invest because most VC funds are not permitted by their investors to invest in publicly held companies (the institutional investors who invest in VC funds can make those investments without the help of VCs).

Now, we do not have a market that supports early stage IPOs largely because there are no securities analysts who will follow small, publicly held companies. Why? Because the securities analysts can't get compensated for promoting these companies within their own organizations. So, VCs aren't very interested in making investments at the early stage of a company's life. In addition, the VCs have so much money to invest that they can't make small investments of, say, $1-3 million because the small investments won't make a difference to a portfolio of $200-500 million. Further, for a $200 million fund, a 10 to 1 gain on a $2 million investment (yielding a $10-20 million gain) produces the same fee to the managing partners as a 2-3 to 1 gain on a $10 million investment. It is a lot easier to invest in companies that make a 2-3 to 1 gain over several years than it is to invest in companies that will make a 10 to 1 gain.

With the non-existence of an early stage IPO market and the growth in the size of the VC funds, a layer of capital is missing for attractive, early stage companies that have made it through the startup stage and are poised to grow if capital were available (second stage companies). What is a company in this stage to do? Can this company obtain bank financing to grow? Yes, but only to marginally grow the accounts receivable or inventory, not to fund more product development or marketing campaigns.

Why doesn't our market system take care of gap between angel funding and VC funding? Primarily because of the unintended consequences of added regulation pertaining to broker dealers and the effects of Sarbanes Oxley (making it very expensive to be a publicly held company). Still, our market should find a way to invest in companies at this stage.

Maybe, investors will wake up and realize that investing in the stock market is only a "market play" and does not result in high growth potential companies receiving capital. Shouldn't investors want to invest directly into companies with high growth potential so that the capital invested causes the high growth? But, the securities laws, mostly written in the 1930's, make it difficult to spread risk among many investors in non-public companies. Instead, the securities laws force the risk of investment in privately held companies to be concentrated among a few investors. This is upside down.

One answer to this is to invest in business development companies, a special animal under the securities and tax laws. A BDC is basically a closed end mutual fund that can raise capital from investors in the same way that a closed end mutual fund raises capital. A BDC is required to invest in non-public companies, usually early stage companies. A BDC is essentially a publicly held VC firm, but with the transparency of a mutual fund. There are a handful of BDCs that invest in early stage companies and quite a few that are essentially finance companies making secured loans to companies who can't borrow from commercial banks. BDCs that focus on making equity investments in early stage companies could fill the gap between angel funding and VC funding. But, it is hard to launch a BDC. I'll write more about why it is hard to get a BDC launched in another blog.

Why do young businesses have to go through hoops to succeed?

2009-07-29T08:01:00.001-04:00

In order to succeed, a young business (from startup to high growth mode) must go through many hoops. Why? Should our government (federal, state or local) eliminate some of these hoops? My view is - No. A market driven economy has an "invisible hand" that allocates success among the many young businesses at each stage of their existence. As with any scarce resource, success is hard to come by. Can government pick winners and losers? Hardly.

The "invisible hand" customizes the hoops that each young business has to go through. If the business makes it through these hoops, then more hoops are presented. It's the way our market driven economy disciplines businesses. Each set of hoops is different, but most of the types of hoops can be predicted such as finding a product or service for which demand exists (not just a perceived need), finding a good (although not perfect) mix of people to run the business, obtaining capital (directly or indirectly), staying focused (but on the right things), etc. When a business makes it through the hoops, it deserves to grow and, possibly, thrive. If it doesn't make it through the hoops, it deserves to fail or become part of the living dead.

So, one of the jobs of an entrepreneur is to know the hoops that he or she will have to go through and, then, to acquire the skills and resources to go through the hoops. But, entrepreneurs "don't know what they don't know." So, how can they possibly anticipate the hoops let alone be able to get through the hoops?

Frankly, most entrepreneurs who make it through a set of hoops are lucky. But most of them don't make it through the hoops because they are blindsided by the hoops and, when a hoop that wasn't anticipated is presented, it's too late to change direction or gather more resources to avoid the hoop or overcome the hoop. This is why smart investors want to invest in serial entrepreneurs - they have been through the process and are smart enough to know most of the hoops or to get "just in time" advice,to tackle or avoid a major hoop.

The hoops are the best filters our system has to pick the winners and losers. Government should stay out of the way and not try to eliminate the hoops. Our economic system is much better at determining the necessary hoops than bureaucrats who are just like entrepreneurs. They usually "don't know what they don't know."

The best way entrepreneurs can find out what they don't know is to ask others who have been there. Yet, one of the weaknesses of most entrepreneurs is an unwillingness to seek advice (or listen to advice). The hoops will take care of entrepreneurs who fail to seek advice.

Advanced entrepreneurship and an MBA

2009-07-25T08:53:00.000-04:00

I teach Entrepreneurship and Entrepreneurial Finance as an adjunct instructor in the Rollins College MBA program. As a lawyer for 34 years working with entrepreneurial companies, primarily high tech companies, I've been part of the growing pains that these companies go through. I also have an MBA and worked as the CFO for a startup company that went public (before I decided to go to law school).

Having an MBA is incredibly useful when your company has the resources to do things that MBAs are skilled at doing. That is, researching the market, developing a strategy, finding and arranging for the infusion of new capital, managing the supply chain, developing sales channels, etc. all require a minimum amount of resources just to consider these matters. Startups are always severly resource limited and have to be very clever at using other people's money to get to a sustaining level of business.

I've seen only a handful of startups where one of the founders had an MBA. But, the skills taught in an MBA program were not really applicable to the startup. Not until the company reached a level of revenues of $5-10 million did the company have the resources to even consider doing the things a person with an MBA could suggest.

So, my observation is that a person with an MBA usually has a greater impact on an entrepreneruial company at the stage where the company has reached a level where it can obtain resources such as investor capital or bank borrowings to use to grow the business. Companies at this level have the potential of making a much greater impact on the local community than startups because they can grow rapidly with the use of resources that are not generally available to startups.

Advanced entrepreneurs must be global entrepreneurs

2009-05-04T17:02:00.000-04:00

Most entrepreneurial businesses that are technology based must have a management team that is comfortable with doing business globally. The Orlando Sentinel newspaper reported today that a company located in Central Florida had raised $15 million in venture capital financing from foreign sources. This same company has its manufacturing operations in South Korea, its R&D operations in Finland and its headquarters in Central Florida. The largest market for its products will be in the United States.

This company is a great example of how advanced entrepreneurial companies will operate in the future:
- It is taking advantage of the critical mass of engineers in South Korea for its particular product in order to make the product in South Korea.
- Its product will be a component of cell phones. Where better to have R&D than in the country where Nokia is headquartered?
- Its largest market will be in the United States. So, locate the headquarters where your largest market is.
- It obtained its early stage funding from foreign investors. This company undoubtedly found that venture capital in the United States has shifted its focus to later stage deals to reduce risk, yet also reduce potential gains. On the other hand, non-U.S. institutional investors have a greater appetite for investment in earlier stage companies than U.S. institutional investors because they typically have a longer term view and believe in achieving investment gains based on the increased value of companies they invest in rather than on gains based on financial engineering (i.e derivatives or roll-up acquisitions).

In order to execute this kind of strategy, the entrepreneurial company must have a management team that is capable of operating in the global environment. A critical component of being able to operate in this environment is the ability to collaborate using the collaboration tools that are now available using the Internet. These tools will get better and become even more important to entrepreneurial companies in the future. Further, entrepreneurial companies will be able to implement these collaboration tools must faster and more effectively than large companies.

But, where and how will CEOs, CFOs, CMOs and CTOs learn how to operate in the global entrepreneurial environment? MBA programs will have to evolve to provide the critical thinking skills necessary for managers to understand the strategic advantages of starting and managing entrepreneurial companies that are global enterprises.

Advanced entrepreneurship

2009-03-07T21:07:00.000-05:00

Entrepreneurship covers a broad spectrum of business activity. Most entrepreneurship programs focus on startup businesses. Yet, the greatest impact that training in entrepreneruship can have is on businesses that are well beyond the startup stage. This is especially true for entrepreneurship programs that are part of MBA programs.

So, why don't MBA programs focus on "advanced" entrepreneurial businesses where having an MBA can truly make a difference to those businesses? Think about it. The characteristics of a successful startup entrepreneur are very different than the subjects covered in the MBA program. My observation is that most people who get an MBA don't have the characteristics to be a successful startup entrepreneur. However, they do have the characteristics to develop an entrepreneurial business once it is of a size that it has the resources to employ an MBA and the resources to implement changes in the organization and strategy recommended by the MBA.

Most entrepreneurial businesses don't have a member of senior management who has an MBA until it decides to engage a COO, CFO or CMO with an MBA. Shouldn't the MBA entrepreneurship programs provide thought provoking courses that prepare the MBA for these positions?

Why?

2009-01-02T13:47:00.000-05:00

When large companies have layoffs in a recesson, some of the most qualified employees worry that they will be next. Some of them decide to start new companies. The perceived threat of a layoff provides the push needed. Recessions end. If a new company can survive for about one year during the recession, it can emerge as a rapidly growing company. A blog I saw elsewhere noted that large companies have to withdraw from small or emerging markets during a recession giving small companies a chance to penetrate these niche markets.