Nivi · January 21st, 2010
Thanks to FastIgnite, a startup advisory firm, for sponsoring Venture Hacks this month. This post is by Simeon Simeonov, the firm’s founder and CEO (and formerly a partner at Polaris Ventures). If you like it, check out Sim’s blog and tweets @simeons. – Nivi
“Prediction is very difficult, especially if it’s about the future.”
By penalizing entrepreneurs who are humble and honest about how their companies will grow, many investors cause entrepreneurs to over-promise (and later under-deliver) when they’re raising money.
The histories of some of the best-known technology companies demonstrate the power of luck, timing, the mistakes of incumbents, and solid execution.
Execution is the main tool under a startup’s control but it’s often under-valued by investors.
So it’s not surprising that most entrepreneurs come to pitch meetings armed with very precise statements about a very uncertain future and a list of proven strategies guaranteed to make their company successful. While sitting through these pitches, I sometimes wonder which is worse: the entrepreneurs who know they’re spinning tall tales or the ones who “got high on their own supply.”
VCs and entrepreneurs collaborate to lie about the future
Instead of bringing entrepreneurs back down to earth, some investors push them further into orbit. Some VCs ask a seed-stage, pre-product startup for a detailed five-year financial plan. When I was a partner at Polaris Ventures, I saw many of these spreadsheets built “for fundraising purposes.” We didn’t ask for these spreadsheets — entrepreneurs had usually built them after meeting other, less early-stage, investors.
I find the process of planning — and understanding how a founder thinks about a business — educational and valuable. But pushing the exercise to the point of assumptions layered upon assumptions is not just wasteful, but dangerous, because it sets the wrong expectations.
After a few pitches, entrepreneurs realize that the distant future is safer territory than the immediate. It’s easier to boast about 30 must-have features your product will have in three years, than to show the three must-have features in the current prototype. It’s easier to talk about how you’ll recruit world-class CXOs when you’re big and successful, than to show a detailed plan for bringing in an amazing inbound marketing specialist, when everyone on the team is getting paid below-market rates to conserve cash. The examples go on and on.
I’ve co-founded four companies. The two that most quickly and easily raised money did it with nothing but slide decks. Both were funded by Polaris, which has a lot of experience with very early stage investing. We didn’t waste time over-planning the future in those two companies.
And for good reason. Both startups ended up quite different than the fundraising presentations promised — for solid, market-based reasons that were invisible during diligence. Plinky acquired a new product line and became Thing Labs. 8th Ring failed quickly and cheaply, only seven months after funding. The CEO and I decided the execution risk was too high. And, in retrospect, we were right: our only competitor had an unexciting exit a few years later.
Over-promising causes startups to throw away money
Over-promising is not a problem when it comes with over-delivery. But the overwhelming majority of startups fail to meet the promises they’ve made during fundraising. After years of observing this pattern, I’ve come to believe that over-promising can actually cause under-delivery. Entrepreneurs over-promise to raise money easily and set themselves up for pain down the road.
How? The reasons have to do with information signals, expectation setting, and the psychological contracts between entrepreneurs and investors. It’s very hard to pitch one story today and then change it the day the money hits the bank, especially if you’ve drunk the Kool-Aid.
An overly rosy pitch leads to expectations and fateful commitments that downplay the variability of the future. Decisions are made based on assumptions rather than tested hypotheses. The burn goes up earlier. The sales team is hired much too soon. In venture funds, over-promising also spreads from the investing partner to the rest of the partnership. It can also spread from the company to its customers and partners, further extending the reality distortion field.
If you’re Apple and you’ve got Steve, that’s awesome. For everyone else, it can get rough. I saw this play out with one of my companies that was expanding internationally (the reason why the company had raised money). The world was going to be our oyster and, before the reality that our go-to-market strategy wasn’t as effective as everyone had hoped set in, we had burned through a good chunk of capital.
Find investors you don’t have to lie to
How should you choose between being honest (and hearing “no” a lot) vs. amping up the pitch and risking the anti-patterns above? I give two answers to the CEOs I work with at my startup advisory firm FastIgnite.
First, I strongly advise startups to go to venture firms where the decision process is more collaborative and less “salesy.” One of the main reasons a VC will push an entrepreneur to over-promise is his need to sell a deal internally.
Second, pitch investors with a track record of valuing a team’s ability to execute, over any specific strategy or execution plan. While most firms pay lip service to this cliché, few do many investments this way. Here are some examples from my experience in the past few months:
- On the smaller side, Betaworks and First Round Capital get this. Their portfolios and their philosophy show it. I look forward to working with them some day.
- Among VCs, General Catalyst has repeatedly backed companies like Brightcove, m-Qube, and Visible Measures very early — with the understanding that many important questions will have answers only after months of execution. I’m actively partnering with them at FastIgnite.
- Surprisingly, at the very high end, a private equity firm like Warburg Pincus can be a great place for the right early-stage entrepreneur. Last year, a Warburg entrepreneur-in-residence incubated Better Advertising, a company where I’m a co-founder and acting CTO. Better Advertising’s market and business model required a backer with staying power that exceeds most other investors’.
The firms above practice a form of agile investing by (1) not forcing entrepreneurs to over-plan for an uncertain future and (2) following the principle of minimizing wasted effort. Ultimately, it’s the investors’ responsibility to reward honesty with trust and cash. And I think that’s a win-win. I’m looking forward to discussing this with you in the comments.
If you like this post, check out Sim’s blog and his tweets @simeons. And contact me if you’re interested in supporting Venture Hacks. Thanks. – Nivi
Topics Pitching · Plans · Sponsor · VC Industry
The thing though, is that for every company that is honest about their prospects that gets funding, there are thousands getting funding with b.s. numbers.
It’s part of the game now. You want funding? Well you better promise the world.
Andrew, I agree with you about the behavior but fundraising does not equal success. Nobody makes money during an early-stage financing. Money is made on exits and exits can be affected by the promises made during fundraising.
Some companies may in fact grow in a way that exceeds even the overly-optimistic projections made during fundraising but this is extremely rare. As the saying goes, there comes a time to pay the piper.
After 20 years and four companies I totally agree with you. You can’t predict your next quarter let alone the next 4 years. So why bother. Be honest and focus on execution that drives customers and revenue and it will show the “real” investor that you’re serious.
It always takes longer than you think (because you can’t time the market or the customer) and therefore will cost more than you think. Focus on meaningful customer feedback that drives the product into becoming a “sustainable solution” for a large customer base. Only expand when you are sure that you have repeatable revenue. Until then conserve capital and execute.
Excellent article. As a lawyer, there’s only so much wordsmithing I can do in the financing documents to protect founders from their own promises that reflect unrealistic assumptions. Of course most financing rounds never lead to litigation, but if things crash and burn, and finger-pointing and recriminations ensue, I’d rather not have excessively rosy five-year financial plans floating around as Exhibit A for the plaintiffs’ lawyers.
Antone, that’s a great point I hadn’t considered in writing the piece. Thanks for the insight.
This is a great point. I find it pretty absurd that somebody even asked for five year financial projections. In all the interactions I have had with investors, financial projections is the least of their considerations. Market positioning and some way to verify that customers are buying the value proposition is mostly what they want. My hypothesis that these investors are some Ivy League greens who are clueless about venture investing. No wonder profits in the VC industry are an average of just zero.
Azeem calls this post “the entrepreneur’s dilemma.” I like that.
https://twitter.com/azeem/status/8039293204
I am the founder of a start up and have been working on raising capital. My company is generating revenue and is in the early stages of sales. My challenge has been that most investors want to see a long term plan yet we haven’t perfected the model for repeat and long term sales.
We have big name customers and a good name in the industry. Our problem has been that I refuse to tell investors numbers beyond a year as the model still must be proven.
This challenge has been with us for a few months now and we most likely will need to stop raising capital and focus on business. Maybe the BS is worth it but I won’t go down that road.
I am in the same boat startupguy. It doesn’t feel right to speculate and project the prettiest numbers possible when, if you’re honest, you know that things change day to day and only after enough time can you have an accurate forecast. And what annoys me the most is that if you ask for too little you are a joke regardless of if you are sure you can make 5-10x that back.
It seems the game is ask for alot, promise the world, and worry about it later.
I personally decided to start another little side venture that’s a faster moneymaker to fuel the longer term business. This way a. I don’t feel like I’m BSing and b. it solves my problem easier than having to hunt and pitch which is a job in itself.
Maybe I just still don’t understand the game though.
The point about asking for a lot has to do with the business model of investors. A 10x return on so little invested that it doesn’t move the needle isn’t something most investors will go for.
You have to understand that you are not competing with an abstract notion of what a good investment is. You are competing with the other teams that saw the investor that week.
To an investor, it costs about the same in terms of time to make a big or a small investment. Given the same risk/return expectations, they’d prefer the large investment most of the time.
This doesn’t sound right, if you are generating income why is it so hard to raise capital? Please email me at gosuri at gmail dot com, I may be able to make few introductions.
Seems like you are going to wrong kind of investors. If you have customers, you should be able to get an investor with relative ease. We are getting one with our IP. Did you try Keiretsu Forum? There are enough people around there who will listen to you even if you don’t want to incur the expense of getting your proposal examined by the Forum members.
I think bootstrapping is very important for both entrepreneurs and for VC’s. In my experience, the only way to have a meaningful conversation with VC’s is when we are already shipping products. I usually don’t even prepare a separate PowerPoint presentation. Instead I start the company by saying, “Let me show you how I convince customer ABC to buy our product”. Life is good after that.
Pitching with your customer presentation is a strategy that often works well for an initial meeting.
Great post!
I have seen (done) this several times myself — specifically, psyching yourself, your team, your customers and your VCs into a “best case” schedule.
One of the worst byproducts of this pattern is the rush to hire a big team to execute everything in parallel and meet the optimistic plan. The critical path (now only 20% of the operation) rarely keeps up — then you are burning lots of cash and may not have hired the right people, especially if you need to pivot.
As you write, it takes a VC with the right mindset — knocking down critical risks with minimum cash before beginning the ramp to riches. Works very well for SaaS… not quite as well for optical/semiconductor components.
Very true. Some businesses, by their nature, have large capital requirements. In those cases it is particularly important to have honest estimates because it can mean the difference between building a two- or three-handed syndicate, how much partnerships reserve, etc. Make the wrong decision in the beginning and you can end up in a situation where it’s extremely hard to raise a follow-on round.
Wait… were you sitting in the room with us or something? 😉
I was two down on the right. 😉
There’s a Simpsons episode where Homer tells Marge that “it takes two to lie, Marge, one to lie, and one to be lied to.”
Why do VCs expect entrepreneurs, who never had a previous successful exit, to make the determination of whether or not its investors will have the 5X, 10X, or whateverX exit?
Wouldn’t a VC who’s been there and done that be better able to make this kind of determination for entrepreneurs? That is, instead of having entrepreneurs make projections themselves, why not simply have them provide the VC with data, and then have the VC make the financial extrapolations?
Nwokedi, good investors know it is the entrepreneurs’ job to know their business better than the investors.
In my business plan I have three sets of numbers:
– minimal break-even sales
– moderately plausible top-down sales (how much pie can I claim?)
– probably unrealistic bottom-up sales (how much pie is claimable?)
You don’t have to commit to any projections. The investors just want to know a) if you have a chance, b) if you’re responsible enough to track the numbers as you go.
Right, much of the exercise is about understanding how the entrepreneur thinks. In other words, it’s about the process and not the result. However, in my typical experience, less attention is paid to the process than the result.
I like your point, Jeff. So you are saying that you don’t need to promise, you just show the possible upside and let the VC decide if they want to bet on it.
The pertinence of forward looking sales projections depends on the stage of the business. If you raise capital from investors who pretend not to understand this, you will be setup for financial incongruity.
Consider 5 distinct business stages:
1. Incubation
2. Build Product
3. Early-Adopter Success
4. Repeatable Sales
5. Scale the business
In (1,2) sales projections are useless, the time to prepare them is wasted effort. In (3) sales projections are presumptuous; you have yet to comprehend WHY and HOW the buyer will commit. In (4) sales projections become essential to internal planning.
Raising capital between stages 3,4, a 1-year plan is valuable, surfacing the right questions/equations within the business, and with potential investors. A 3-5 year plan is chimerical until stage 5 and the shift preceding it.
George, good points. Thanks for chiming in. Also, I’m going to start saying “chimeric projections” from now on. 😉
This is good stuff. The one thing I’d take issue with is your discounting the value of building a 5 year model at the onset of a venture… forget about numbers you’re selling to investors… this exercise serves as a gut check to founders insofar as it forces you to say (“okay, $30M in year 5…if I want to do $30M in revenue… ever… that translates into 10,000 transactions a month… if I’m honest with myself, can I ever envision a world where 10K people are doing x every month, or do I need to modify my rev model?”
As for the “realistic” investors you highlight… having worked at General Catalyst for two years, I can agree, they are willing to bet on a star with more questions than answers… I’d add to your list Rob Stavis at Bessemer Venture Partners… also takes a collaborative approach in the investment process, very grounded…
Lastly, the concept of not lying applies well beyond interaction with investors. I wrote this blog post last week: “5 Reasons Why Lying is Stupid in Startups (and life)” http://bit.ly/5paXXd
An analogy.
The founders of a new startup talking about its 5-year business plan.
The parents of an infant discussing what she will be when she grows up, where she will attend school, where and with what sort of person she will grow old with.
Agreed on the model. I always build models because I want to understand the key levers that make everything work.
You can always describe the future as we’re driving to hit X% conversion at $Y/unit with sales productivity of $Z/salesperson, etc. The focus is then on understanding the key drivers that will make the core assumptions work, and de-risking those key drivers as early as possible.
By being very conversant in how the model works, you can have a great dialogue with investors about those risk points and how you will address them.
Right, the process is the most valuable part of the exercise.
Jordan, you make a good point that it’s important to have a level of understanding of the economics of the business in the future. When I work with entrepreneurs on this, I tend to focus on one or two key business model drivers, e.g., per-unit economics as opposed to trying to build a plan. It’s also important to know what accuracy you are aiming at.
Also, I sometimes flip the model over and attempt to “solve” for the assumptions I’d otherwise make, e.g., rather than assume a certain rate of cost decline of Amazon S3 I would calculate what the rate of decline of Amazon S3 would have to be, other things being equal, for me to get 80% gross margins. Just an example.
All this talk about funding in an early stage startup makes me so glad we decided to stop wasting time with investors and start talking to our customers. We’re two co-founders selling and creating and refining our health IT/service product. We scrapped our entire 5 year proforma that I wasted years creating. I built a new one that is realistic, still a 5 year ballpark, but focusing on one year at a time. What I found out was that our overhead has all but gone away, due to a tech partnership and sales channel partnership we created and we will break even with our first ten customers over the summer. Thanks to Eric and Steve and all the customer dev/ lean startup crew and @garrytan @rashmi for assisting our sales process.
Best to all and I enjoy reading the posts.
Great topic. I’d be interested in hearing more responses from VCs.
Reminds me of a story about a good friend – a seasoned leader who took over the reins of a multi-series funded tech company. After spending a few weeks spending time with customers and staff, he rounded up the leadership team and shared “I’ve determined that this company’s only core competency is its ability to raise unlimited amounts of capital”.
Simeon, this is a great reminder that funding is just a means to an end, not the end game itself.
Thanks, Paul.
Great point, Sim, about investors making entrepreneurs hype things up so the Monday partner meeting “sell” will go smoothly.
I can always tell the difference between an investor who can act rather independently and confidently (i.e. very senior partner, or a small firm, or an investor with close and relevant experience, or a strategic investor who does not have LP’s) and one who is more junior, or in a nasty partnership, or investing way beyond his experience. The former delve into our team’s thought processes, test/learn experiences, failings, and overarching assumptions and strategic drivers. The latter dive immediately into the numbers and look for ones that even a monkey could sell to a hostile audience.
BUT… I do value, at least for my current venture, our five year plan. The first 12 months are a very detailed operating plan, the second 24 months a little less so and the last three assume a measure of accuracy of the first two years, and are extrapolations. I recognize the potential flaws, but I use the last three years to look for huge “gotcha’s”… scale numbers that assume something ridiculous in market share or executional capacity or supply chain capacity. I need to know I am building for achievable scale, even if Plan A turns into something else. Plan A is what I am testing.
Hey, Jules. I hope Daily Grommet is doing well.
I mentioned in this comment that there is value is looking forward but only to do the type of assumption/gotcha/ballpark testing I think you are doing also. The cone of uncertainty is too wide that far into the future.
Thanks Sim. A lot came together for us in Q4. Thanks for asking. I think 2010 will be our year to really soar. We spent 2009 taking so much risk out of the business, and proving the theories on how we will use capital.
Hi Simeon, Fascinating post and comment set. You mention a few firms in your post who take the “right” approach to early stage but they are U.S. based. Do you know of any in UK/Europe who fit the mold?
I haven’t worked with many European VCs, only a few. On the positive side, the ones I worked with did not explicitly push entrepreneurs to over-promise. On the negative side, they had poor strategic and market insight and, therefore, couldn’t see when the team was over-promising.