Entrepreneur Myths (30 page)

The venture capital process is tedious

Unless your spouse, neighbor, or family member is a VC (see Myth 41), the process of seeking venture capital funding is tedious. You can accelerate the process by using your attorney or accountant (if they have venture capital relationships), or one of your entrepreneur friends who was funded by a VC, to open some doors for you. But even when the doors are open, the process always takes longer than you expect. If you’re raising capital from venture capital funds, expect the process to take four to nine months, if you’re lucky. Hey, VCs are busy people. They’re not just sitting on their asses sipping coffee or playing golf. They have to watch over their portfolio companies, maintain their relationships with their limited partners, and sift through thousands of business plans (not to mention the temperamental entrepreneurs they have to deal with from time to time).

I strongly recommend not sending your executive summary or business plan to a venture capitalist unsolicited. The VC will feel like you’re spamming them along with all the other people on Sand Hill Road.

You’re going to take an equity hit

VCs are in the business to make money. If you’re lucky enough to make it through their due diligence phases and get a term sheet then, depending on the development stage of your startup, be prepared to take a hit on the equity and give up a large share of ownership in your own company if you are located outside of Silicon Valley.

In Silicon Valley, this has changed somewhat in 2009-2011 in some sectors such as software, mobile applications and social media because the cost of development has dropped substantially for those sectors in the seed stage of the life cycle. But you have to be in Silicon Valley to enjoy the bubble-ish valuations in the early high-tech sectors.

Outside of Silicon Valley, it is a different ballgame. You could lose control of your company if it doesn't meet the right metrics such as being cash flow positive or having phenomenal growth with customer acquisition in the market. It will depend on sector, life cycle, amount of capital, etc. If you’re a young, inexperienced entrepreneur, you should consider the equity hit. But if you’re an older, experienced bastard like me, you may not want to lose control.

Whether you want to take an equity hit or not, be prepared that, if you do lose majority control of the company, the likelihood of you being removed from the top dog position is high. In a way, you can’t blame the VCs for putting their own person into the CEO position if they’re risking millions of dollars on your venture. They have to protect the investment and help make the venture successful. You need to be able to move aside if a VC wants to bring someone in with more experience to run the business. You have to understand your true capabilities.

During the first Dotcom Bubble, the Yahoo founders forfeited their management duties and let someone else come and run it. Pierre Omidyar did the same thing at eBay. If you’re the founder of a venture-funded company, most likely at a certain point you will lose the CEO spot. This is the fucking reality. Check out the successful venture-funded companies that still have founders as CEOs. Not everyone is going to end up being CEO like Mark Zuckerberg. He does have help with Sheryl Sandberg as the COO of the company.

It’s okay to lose control if you can’t do it alone. You will get diluted down the road anyway. Groupon CEO Andrew Mason owns only ~8% of the company. The company is worth billions today. So the math works for him.

At what point are you willing to lose control? Bill Gates doesn’t own controlling interest in Microsoft from a percentage perspective, but he’s still one of the richest men in the world. But Bill Gates is an anomaly; he kept his CEO spot until he handed it over to Steve Ballmer in 2000 after a 25-year reign.

I’m the wrong person to ask for advice on taking an equity hit. If you have to lose control in terms of majority shares of your company, make sure it’s done later than sooner. Startups are unpredictable. If market conditions change and your startup isn’t doing well, the easiest thing for any VC to do is bring someone new into the CEO position instead of sticking it out with you. I’ve seen this play out in Silicon Valley more than a few times.

Is your venture venture-fundable?

Here’s the irony I’ve seen many times with inexperienced entrepreneurs. The entrepreneur spends months trying to pitch venture capitalists for money and doesn’t realize his business isn’t even venture-fundable.

Entrepreneurs have pitched me for money, unaware that their idea didn’t match classic venture capital requirements. Pitching me a restaurant idea won’t get me excited unless you can prove it’s going to be the next Subway, Chipotle, or In and Out Burger. The venture must be able to demonstrate substantial potential returns for a VC to fund it. I’m not talking about 3X. Most VCs look for higher returns because they know the reality: out of 10 companies they fund, they are lucky to get one to two big hits, if that. The rest are “dogs with fleas,” as Gordon Gecko called some of the companies in the film
Wall Street
.

Before you spend time and money pursuing VC funding, make sure your venture can scale into a business with a market large enough to warrant the IPO or Googlio exit. Please, don’t waste your time pitching VCs on a lifestyle type of a venture.

Brain Candy: questions to consider and ponder

(Q1)
What do you think the odds are of being venture funded in today’s environment?

(Q2)
What have you gone through trying to get money from a VC?

(Q3)
If a VC funded you, how long did it take and how did it play out? Did you cash out via IPO or Googlio?

Entrepreneur
Myth 44
| Sweat equity is extremely valuable

Being on both sides of the table as an entrepreneur and venture capitalist, my thoughts on sweat equity are mixed. Sweat equity, if you don’t know what it means, is value added to the venture by the entrepreneur that is not related to money. Sweat equity is a function of time and IQ. It can be a touchy subject for both sides of the investment equation. If you’re an entrepreneur, obviously sweat equity is highly valuable. If you’re an investor, you won’t give a shit because you expect the entrepreneur to bring sweat equity to the table.

Entrepreneurs have pitched me with extremely-high valuations, even though the venture had no revenues, because they considered their sweat equity to be highly valuable. Seriously, they had no proof that there was even one asshole out there willing to buy their product or service.  One entrepreneur valued their company at $10 million because they sweated a lot throughout their journey, and wanted me to invest a million dollars for a measly 10% of the business. Hey, I sweated as an investor too. Where’s my sweat equity from an investor perspective?

You see, when you peel back the layers, the entrepreneur's reasoning for a high valuation is that they worked day and night for a year, without getting paid. So what? I’ve done the same many times over. When I ask these “bubblepreneurs” how much money they put into their venture, they mentioned minimal amounts or no cash at all. But they still believe, because of the amount of time or sweat equity they put in, the venture is worth at least $10 to $20 million. Now, that’s some expensive sweat. I dare not tell them to use Old Spice.

My first thought and the first words out of my mouth are always the same, “Are you fucking kidding me?” You should see the looks on their faces.

Let’s do the math. An entrepreneur puts little or no money into their venture, they spend a lot of time working on it (which is expected anyway) and then they expect to give only 1% to 10% of the business in exchange for millions of dollars invested — while the venture has no revenues or customer traction, often because it is using the freemium business model. What’s amazing is these bubblepreneurs believe their own bullshit.

Not everyone is a bubblepreneur. I funded one company that had revenues, and acceleration in the customer acquisition and sales function of the business, because the CEO understood the value of sweat equity vs. reality. Instead of bickering and negotiating for days on the value of his company, he set the stage for a realistic valuation that tipped me over to make a decision to invest $3 million after my second meeting with the management team. The CEO didn’t give away the store from an equity perspective, but his mathematics justified the investment because the valuation was realistic. No bubble there. I ended up with ~45% of the company. Everyone was happy.

Sweat equity does have value. I started ventures where I spent a considerable amount of sweat equity time, but one thing I don’t do when I talk to investors is give them a fucking attitude about how valuable my sweat equity has been to the current progress of my startup.

If you want to impress an investor, when they ask you about sweat equity, just tell them that sweat equity means shit if you don’t get your venture off the ground. Ironically, they’ll actually value your sweat equity more because they’ll know you’re not some fucking bubblepreneur. By the same token, if the investor places no value at all on sweat equity, then don’t sweat it. Simply tell them to fuck off. If they can’t see any value, they suck.

There’s a fine line in regard to sweat equity valuation. Both entrepreneurs and investors should treat it with respect, but the problem is that one side (the entrepreneur) always places more value on it than they should, and the other side (the investor) downplays it too much. There has to be a compromise and it’s up to you to work it out with your potential investor. There is an art to the sweat equity dance, so don’t get emotional when your sweat equity is being negated in value toward your overall company.

Remember, the sweat is in the eye of the beholder, not their nose.

Brain Candy: questions to consider and ponder

(Q1)
How do you value sweat equity as an entrepreneur?

(Q2)
How do you value sweat equity as an investor?

(Q3)
How do you quantify sweat equity?  Is it based on how you got paid before you became an entrepreneur? Or is it based on the function such as marketing, sales, operations, etc.?

(Q4)
How do you quantify the value of the sweat equity involved in developing a revolutionary product or service?

(Q5)
If you discover the cure for cancer while working on it in your spare time on your own dime, what is the value of that sweat equity? (See, sweat equity is not simple to calculate.) The sweat is in the eye of the beholder.

(Q6)
What if you’re an inventor who’s worked for 10 years to develop an alternative energy source without any funding from anyone? You worked it at night, every night, and now you can prove that the automobile can go 300 miles per gallon. What is the value of that sweat equity? Does equity even matter in this instance?

(Q7)
Is sweat equity dependent on the type of product or service? Is it dependent on whether the offering is revolutionary?

(Q8)
If you’re an investor, how do you address the sweat equity scenario with the entrepreneur? Do you discount it heavily because you already expect it?

(Q9)
As an investor, how do you value sweat equity fairly so that you don’t have an entrepreneur who doesn’t sweat leaving the venture if he’s not happy with the large equity dilution you caused when you funded his venture?

Entrepreneur
Myth 45
| Valuation is based on numbers