The Great VC Con Game

The Great VC Con Game

I speak every week with people looking for funds to start or expand their business. With investment crowdfunding, the process has actually become relatively easy and inexpensive. Most people come to me to use crowdfunding as a first choice to fund their business. They appreciate the opportunity to fund their business on their own terms.

Sadly, some report that they spent upwards of $25,000 and more than a year flying around the country attending conferences and pitching to dozens of venture capitalists. If they had called me sooner, I would have told them to save their money.

Pitch Decks

There are a plethora of books and articles and an industry of vendors hawking “pitch decks that work”. Few actually do. When I see a pitch deck I can often tell which “guru” it is trying to follow. 

Unfortunately, most of these experts know nothing about what motivates investors to write a check. One in particular who seems to post on LinkedIn every few hours actually offers the worst advice that I could imagine. 

Logically, investors in your company should really want your company to succeed.  If you want their money, it would seem natural that you would tell potential investors what you intend to do with their money in order to make more money.  Yes, it really can be that simple.

Compare that to the pitch decks that follow the “find a problem and solve it” template. They often minimize the focus on projected revenues and profits. They often leave out the details of how the company will execute its business plan to get there. From an investor’s point of view, return on their investment (ROI) rules.

VCs actually fund a very small number of businesses (in the low 1000’s) every year. Most of the money available for venture capital investment is concentrated into a handful of large funds. Some of the available capital will flow to “serial entrepreneurs” because venture capital is a fairly closed network of people and money.

I was introduced to my first venture capitalist when I made my first visit to Silicon Valley in the mid-1970s. There were a lot more trees and open space on the way to Sand Hill Road back then.

At that time VCs in Silicon Valley were a very small group of very smart people. Many were MBAs or had MBAs on staff to crunch and re-crunch the numbers. This was no small task in the years before VisiCalc.

These VCs were using their own money and the money of a select group of wealthy investors to help small tech companies get their business up and running.  Their goal was to hand these companies over to the investment bankers specifically for a public offering. 

Investment bankers wanted these companies to be profitable before an IPO.  After the offering, research analysts affiliated with the investment bankers were going to project growth in earnings per share. That assured that the IPO investors were almost always going to make a profit from their investment post-offering.  Everybody would win.

San Francisco

I moved to San Francisco in 1984 to work with a law firm that represented a London based VC fund. The fund was making investments in 1980’s era hardware and software companies, companies with cutting edge ideas and those in more traditional businesses as well.  I sat through a lot of pitches. Very few of those companies got funded even though the pitches were well thought out and supported by real facts and research. 

I remember listening to one of the partners in Sequoia Capital being interviewed on TV discussing what they liked about Apple when it was still at the venture capital stage.  I recall that it was more about Steve Jobs’ focus on the design and packaging as it was the tech.  It was more about gross profit than market share.  

Today it seems like “gross profit” is a curse word in the venture capital community.

Investing has always been rooted in mathematics. Today’s VCs have chosen to ignore the traditional math and have created a new math, to line their own pockets, even as the companies in which they are investing continue to fail.

Dotcom

Beginning in the 1990s and especially as the dotcom era heated up, a lot of people who worked in around Silicon Valley, thought that they should become venture capitalists. Some had been founders of the earlier tech companies. Some claimed to have the connections and insight to bring more than money to these portfolio companies. 

The net result was a de-emphasis on the actual, achievable projections of income and how a company might execute to get there. It was replaced with a mindset that said “this is a great idea; millions of people will come to our website and buy our product”. Translated, that means: “Profits? We don’t need no stinking profits?”  

The investment bankers bought into this because it enabled them to make a great deal of money. They took a lot of companies public without real earnings. They then used convoluted reasoning and research to predict share prices in the hundreds of dollars. 

The analysts looking at the dotcom companies created a metric called “growth per share”. I asked one of the prominent tech analysts if they had ever seen that metric in a peer-reviewed journal. Of course they had not.

In the current market bull market post-2008 the VCs have moved the goal posts even further to feather their own nests. Rather than find more and more good companies to fund, they are increasingly conducting multiple rounds of financing on a smaller and smaller group of companies. Most are destined to failure because they cannot operate profitably.

Venture Capitalists

VCs like other money managers get an annual % of the amount of money invested in their fund. The best way to attract new investors is to demonstrate success. If a VC invests in a company at $1 per share and the company goes public at $10 per share then the VC’s success is easy to calculate. If none of the companies in a VC’s portfolio actually go public, the VC’s success is harder to demonstrate.

To solve the problem, VCs have created a metric called “pre-revenue or pre-earnings valuation”.  You will not find it in peer reviewed journals. It is the closest thing finance has to an oxy-moron.

It works like this. Ten VC funds each invest in a seed round of 10 companies. Then some will invest in a Series A round of some of the companies in the other VC’s portfolios, then others will invest in the Series B round, etc. In the end, these VC funds have cross funded each other’s deals at different levels.  Each level is priced higher than the one before.

In the seed round a VC invested $10 million for 10 million shares of the outstanding shares of each company.  By the Series C, D or E round those shares are being sold to the other VCs and now cost $50 each. 

Does that make the original shares purchased in the seed round worth $500 million?  If the company has now issued 200 million shares, is the company worth $10 billion? Not in the real world and especially not if the company is still not profitable.

However the VC can now claim that its original investment is worth much more and use that “fact” to attract more investors into its fund. The VC will receive a % of the amount invested yearly for a decade or more. 

WeWork and the other unicorns will be the subject of business school case studies for at least the next generation. They are the most recent example of what may be the oldest theorem in finance: you can fool some of the people all of the time.  

Capital for new and smaller ventures is essential to the entire system of finance.  Investment crowdfunding is actually a response to the failures of VCs in the dotcom era. The arrogance displayed by VCs in this current market has probably done more to cement the place for investment crowdfunding than anything else. It is up to the crowdfunding platforms and professionals not to make the same mistakes. 

If you’d like to discuss this or anything related, then please contact me directly HERE

Or you can book a time to talk HERE

The Cold Hard Truth About Funding Start-ups

Contrary to what a lot of people seem to believe, it is not that difficult to fund a start-up. Funding a start-up is a process.  It requires a plan and time, effort and money to execute the plan.  The process varies depending upon where you intend to procure the funds. That decision is most often determined by what sources of funding are or are not available .

More often than not the availability of funds depends upon the attributes of the company being funded.  Who you are, how far along your company is and the realistic chances for success are usually the determining factors.

If you believe the blather that successful start-ups must disrupt an existing market or must solve a problem that the market may not know it has, you are making it harder for yourself, not easier. Lenders want the loan principal returned with interest and investors want their capital returned and a return on their investment. You need to adopt that mindset if you want to attract funds.

A great many small businesses receive funds from the Small Business Administration (SBA) which has been making loans to start-ups and small businesses for decades. Like most lenders the SBA wants collateral for the loan and will review your business plan to satisfy itself that you will have the cash flow to make the payments.

The SBA will assist in the process and provides mentoring for businesses before they apply. There are also private SBA loan brokers in every major city in the US. Not every small business qualifies, but many of the SBA loan brokers will provide guidance and assistance if the company is close to the qualifying line.

Venture capital funds (VC) or angel investor groups seem to be the choice for most start-ups. VC’s can provide management and other assistance in addition to funding. The bulk of venture capital money goes into second round financing and many of the funds specialize in tech or bio-tech companies only.

Most venture funds are willing to take a calculated risk on young companies. That calculation includes their ability to recoup their funds with some type of post financing liquidity transaction, like a merger or IPO.  Consequently, a great many companies do not qualify.  In truth, VC’s only fund a very limited number of smaller start-up companies every year.

There are far more companies that are chasing venture capital than there are venture capitalists. Consequently, the VCs usually get to fund the best companies they see.

The world is full of stories of companies that pitched dozens of VCs before they got funded and even more companies who repeatedly pitched VCs and never got funded. There are a great many books and consultants who will tell you how to make your pitch better but the truth may be that your company is just not as attractive as the others competing for the same funds.

I would hope that it would be obvious that it is easier to find funding for a company with a well thought out and well prepared business plan than a for a company whose business plan looks like it was written on a napkin by a couple of drunken frat boys.

Investors will certainly want to know if your product works, whether or not it can be sourced, whether or not people will purchase it and at what price.  You can show them with spreadsheets and marketing studies or you can start selling your product and generate some revenue.  An operating company should always be easier to finance than a company that needs funding to begin operations.

This flies in the face of the idea that all an entrepreneur need do is develop a minimum viable prototype (MVP) and then shop it around to venture capitalists. I have known a lot of VC’s over the years and almost all would tell me that they fund businesses not prototypes.

Investors also legitimately want to know exactly what you intend to do with the funds that they give to you. They also want you to use their money efficiently.

Several years back I met with a young code writer who was working at one of the larger Silicon Valley companies. He and a few of his co-workers had an idea for an APP. They wanted my help to raise $1 million so that they could quit their jobs and spend a year working on it full time.  Once the APP was developed and tested they would have had no money left for marketing and no one with any marketing experience to help them.

I suggested to him that it might easier to raise the money if their plan was to have the code for the APP written in India for a lot less and use the difference to package and promote the finished product. That way he and his cohorts could keep their day jobs and they would have a sufficient monies to hire a real marketing pro to help sell the product once it was developed.

I might as well have suggested that they enlist in the Army. They wanted the entrepreneurial experience paid for by someone else.  A good VC will see through that attitude and as far as I know that particular group never got the funds they were seeking.

Crowdfunding`is the financing tool that is the foundation for my belief that funding any start-up is not that difficult. If you follow this blog you certainly know that I continue to be concerned about the absolute disregard for investors in this market. But executed correctly, a good crowdfunding campaign should obtain the funds it seeks almost every time.

I recently had a beer with a long time friend is a lot more cynical than I am.  His thought was that since you could fool some of the people some of the time, I should just embrace that fact and come around to the thinking that any start-up could get funded if it spent enough money advertising its offering in the right way.

My friend was thinking that a good advertising company could put lipstick on any “pig” of an offering and sell it to investors on a crowdfunding website because most investors in this market really had no idea what they were doing.  While I personally decline to assist bad companies looking for capital, many in the crowdfunding market will simply list any company that shows up on their website.

I have a little experience in advertising and a lot of respect for people who do it well.  Selling securities usually takes a different approach than selling a product but my friend was thinking in more generic terms.  The point here is that selling securities is often referred to as a “numbers” game.

Advertising is about “eyeballs”.  If you want to sell shares in your company to 500 people, then a lot more than 500 people need to see your advertisements for the offering.

When someone comes to me with the desire to crowdfund an offering, I always recommend that a good marketing company is essential.  Several marketing companies that work in the crowdfunding market are careful to follow the rules. Many more are not.

Whether you are selling a loan package to the SBA or equity to a VC, angel or crowdfunding audience the operable word is sell.  Selling is not free. The old saying that it takes money to make money is true here as well. It takes money to raise money.

If you want to fund a new business you should be prepared to spend money for a professionally prepared presentation. I know a company that sent e-mails and their presentation to a list of one thousand VCs and Angels six times before one responded. They then flew cross country, made a presentation and got nothing.

With crowdfunding, I again recommend that you hire someone to prepare a professional presentation, a good lawyer to help you prepare the paperwork and budget enough money to drive potential investors to your offering. If you want to raise funds for your business, it will cost you money to do so.

I speak with a lot of people who essentially bootstrap their business until they are ready to bring it to market and then seek funding. Many are stymied because they are essentially broke at this point and do not have the resources to pay for lawyers, business plans, videos and a marketing campaign.

A lot of people wring their hands and feel sorry for this group. I,however, am not among them.  I believe that any company good enough to seek funding from strangers, should be able to borrow enough from family, friends, neighbors and college roommates to pay for a campaign to raise more funds.  If your Uncle Fred who has known you since childhood is not willing to invest in you, why should you think that my Uncle Fred or anyone else’s would?