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You are hosed. But do it anyway!

I recently sat down with a good friend to go through some stats which show the harsh, ugly truth of Angel/Seed/VC funding. It essentially goes like this:

In the first half of 2011 there were about 175,000 startups looking for early stage investments in the US (note that this number is not limited to tech). Out of those, a mere 26,300 received angel and/or seed funding - that’s only 1 in 6.5 (or a 15% yield). Kinda scary if you’re in the position of looking for money. But it gets even scarier - out of the 26,300 startups which received angel and/or seed funding only 7% (a total of 1,850) received series A funding (aka institutional funding from a VC firm). Putting this together - your chance to receive institutional capital is pretty much exactly 1%.

Now - what that tells us is: Your chances to receive funding are slim. You could assume that you’re hosed. But fret not - first of all: There are 1,850 startups which get funding all the way to series A (and are thus well on their way to be successful - at least the odds are stacking up). And probably more importantly - focus on building a product people want to buy - that way you don’t need funding. Or can take funding for accelerating your growth instead of building your product. Which is the best way to do the VC dance anyway - as your leverage is much, much better.

So my friend - fret not! Go, build an amazing product which people love and are happy to pay for. And you will be fine! :)

Quote of the Day

With some deals for private companies “definitely on the expensive side” amid a choppy stock market and concerns over a European debt crisis, Mr. Andreessen said he is looking to invest in fast-growing tech start-ups that aren’t as well known and where “pricing is still under control.

I guess this doesn’t come as a surprise…

Which brings us back to the point of: Focus on building a business, not a frothy, high growth, no-business-model one-feature only product and call it a business.

Quote of the Day

There has been an explosion of incubators in the last few years. Most of them suck. Some suck so bad that the net value created by the program is probably negative.

Incubators are a Ghetto by Andrew Clay Shafer and via What history teaches us about startup incubators by Om Malik

Great rant from both Andrew and Om - and one I, in principal, agree with. But I think you also have to see the flipside - even if these incubators don’t deliver a lot of value, they still get people to become entrepreneurs, try it out, give it a shot and hopefully stick with it. Which is good.

Read my comment on Om’s blog here and join the discussion.

How to not approach a VC (or incubator or angel or seed fund or …)

Every once in a while (and sadly more often than you would expect) I get an email from someone seeking an investment (be it through Mozilla’s WebFWD program, FoundersLink, the VC fund in Europe I am a venture partner at or my own angel investing) which just riles me. Take this prime example (details have been removed to protect the innocent):

Dear Sir / Madam !

Please, examine the project searching for investments.

The ∎∎∎∎∎∎∎∎ project is oriented to USA market and the company will be located in the USA.

∎∎∎∎∎∎∎∎ is the project in the mobile area of business, providing ∎∎∎∎ ∎∎∎∎∎∎∎∎∎∎∎∎∎ ∎∎∎∎∎∎∎∎∎∎∎∎ (∎∎∎∎∎, ∎∎∎∎∎, ∎∎∎∎∎∎∎∎∎, ∎∎∎∎∎∎∎∎, ∎∎∎∎∎, ∎∎∎.) ∎∎∎ ∎∎∎∎∎∎∎ ∎∎∎∎∎∎∎. ∎∎∎∎∎∎∎∎ is going to be an online ∎∎∎∎∎∎∎ ∎∎∎∎∎ ∎∎∎∎∎ ∎∎∎∎∎ ∎∎∎ ∎∎∎ ∎∎∎∎∎∎∎ ∎∎∎ ∎∎∎∎∎∎ ∎∎∎∎∎∎∎. It has more than ten years of experience developing ∎∎∎∎-∎∎∎ ∎∎, ∎∎∎-∎∎∎∎∎ ∎∎∎ ∎∎∎∎∎∎ ∎∎∎∎∎∎∎∎∎∎∎∎. ∎∎∎∎∎∎∎∎ project was implemented as a first attempt to ∎∎∎∎ ∎∎∎∎ ∎∎∎∎∎ ∎∎ ∎∎∎∎∎∎∎∎ ∎∎∎∎∎ ∎∎ ∎∎∎∎∎∎∎∎∎∎∎∎ ∎∎∎∎∎∎∎. Its products are based on ∎∎∎ ∎∎∎∎∎∎’∎ ∎∎∎∎∎∎∎∎. ∎∎∎ ∎∎∎∎∎ ∎∎∎ ∎∎∎∎∎∎∎ ∎∎ ∎∎∎∎∎∎∎∎ ∎∎∎∎∎∎∎∎∎, ∎∎∎∎∎∎∎∎∎ ∎∎∎ ∎∎∎∎∎ ∎∎∎∎∎∎∎∎∎. ∎∎∎∎∎∎∎∎ ∎∎∎∎∎∎ ∎ ∎∎∎, ∎∎∎∎∎∎ ∎∎∎∎∎∎∎ ∎∎∎∎∎∎. ∎∎∎∎∎∎∎∎ ∎∎∎ ∎∎∎∎∎∎∎∎ ∎∎∎∎∎∎∎ ∎∎∎∎∎∎∎∎∎∎∎∎ ∎∎∎ ∎∎∎ ∎∎∎∎∎∎∎∎∎ ∎∎∎∎∎∎∎ ∎∎∎ ∎∎∎∎∎∎ ∎∎, ∎∎∎∎∎∎∎∎∎∎∎∎∎, ∎∎∎∎∎∎∎ ∎∎∎ ∎∎∎∎∎∎ ∎∎∎∎∎∎∎∎, ∎∎ ∎∎∎∎∎, ∎∎ ∎∎∎∎∎, ∎∎∎∎∎∎∎∎∎, ∎∎∎∎∎∎∎∎, ∎∎∎∎∎, ∎∎∎∎∎, ∎∎∎. ∎∎∎ ∎∎∎∎∎∎∎ ∎∎∎∎ ∎∎ ∎∎∎∎∎∎∎∎∎∎∎ ∎∎∎∎∎∎∎ ∎∎∎ ∎∎∎∎∎∎∎∎, ∎∎∎∎∎∎∎∎∎∎∎∎∎ ∎∎ ∎∎∎∎∎∎ ∎∎∎∎∎∎∎∎∎ ∎∎∎ ∎∎∎∎∎∎ ∎∎∎∎∎∎∎, ∎∎∎∎∎∎∎∎∎∎∎∎∎ ∎∎∎∎∎∎∎∎.

Investment costs - $867 549

Please, find Executive Summary of the project below. I will provide any other additional information if necessary.

Thank you for your time and consideration. I am looking forward to hearing from you.

Attached Documents: 3-Page Executive Summary & Financial Forecast

BEWARE - RANT FOLLOWS:

Here’s what’s fundamentally wrong with this email:

1. You clearly haven’t done your homework, because otherwise you would have known that WebFWD is an accelerator program, not a fund. We also focus on open web, open source and social good projects. Thus we don’t invest in companies such as yours.
2. To further point 1 you didn’t do any research on who the right person within WebFWD to talk to is - instead you sent your email to “Dear Sir / Madam”. This just shows that you very obviously sent your email to every VC under the sun.
3. Your investment requirement is $867 549? Not $867 548 or $867 550? That number shows me that you are mostly clueless about financial forecasting. I bet you serious money that your financial requirements will *not* be $867 549 to the dollar. Stating precise numbers such as this is just silly.
4. Your executive summary starts with a unilateral NDA. That’s plain rude. A VC doesn’t sign NDAs - and surely not unilateral ones. Don’t believe me? Brad Feld blogged about this recently. I didn’t read your pitch nor your financial plan but instead deleted them immediately.
5. Don’t send me all this material. I don’t care. Send me a short (!) summary and a one-pager. Focus on making your pitch exciting. Starting your pitch with the fact that your company is in the US is a wasted opportunity - nobody cares where your company is located but WHAT your company does and why the world should care. If a VC is interested, they will ask you for your financial model and all the other documents.

RANT OVER

So - do yourself a favor (and significantly increase your chances that people will actually read your pitch) and do your research, tell us clearly what you do, why we should care and what you want from us.

P.S.: Found my rant a bit harsh? I just don’t want to waste your (or my) time. Read this.

On VC Funding - Food for Thought

And there’s another option for startups that don’t want to go public: Forgo VC and angel investments entirely and fund the company with the profits from your business. That organic-growth option may sound quaint, but it can still be quite successful. Indeed, VC funding is by no means necessary to fund a fast-growing company. In 2009 Paul Kedrosky, a Kauffman Foundation senior fellow and venture capitalist, looked at the Inc. 500 list of the fastest-growing companies in the US for every year between 1997 and 2007—a period that includes the VC boom of 1999-2000. He found about 900 companies in all, of which only 16 percent had VC backing. “Such companies almost certainly could have venture investors, if they wanted them,” Kedrosky wrote in a paper for Kauffman. In other words, the overwhelming majority of the fastest-growing companies decided that they didn’t need VCs.

Good food for thought. And here is the quoted study by Paul Kedrosky.

Incubators don’t work - and it’s fine

A few weeks ago I had the great fortune and pleasure to pick Jed Christiansen’s brain for a good two hours. Jed is probably the one person on this planet with the best data set about incubator and accelerator programs around the world, the companies which go through them and the possible reasons why some incubators are so much more successful than others.

I fundamentally believe that most incubators (which seem to shoot up like mushrooms after a rainy late summer day) are destined to fail - and I also believe that it doesn’t matter.

Let me explain - and start with a disclaimer: The following is especially true if you’re building your incubator outside of the US and more specifically outside of Silicon Valley. With that out of the way - the reasoning is simple: The math doesn’t work.

Most incubators take a rather small chunk of equity for their investment and services (often in the sub-5% range). I believe the reason for this is that some of the super-successful incubators such as Y Combinator have “poisoned the well” by introducing these terms (and they do work for them - more about that later) and forcing the whole industry to follow suit. Also incubators usually take founders stock - i.e. stock without any preferences or protections as are often found in seed and VC rounds.

What happens is this - by the time a company has an exit, they have often gone through a couple of rounds of financing, diluting the original founders shares by 50% or more. Which means that the initial 5% our incubator held become a mere 2.5% or less. Now apply the typical VC logic that out of 10 companies you can count yourself lucky if one or two of them hit it big, three to four do okay and the rest goes under. Now - in most areas of this world a “good exit” is considered something in the $10m range (even in large markets such as Germany there aren’t that many $10m exits). Take into account that a portfolio takes time to mature (somewhere around 5-10 years for the companies to go through their growth phases and come to an exit) and start doing the math, the picture is rather bleak.

Here’s an example calculation: An incubator runs a class of 10 teams, investing $15k into each team and spending 3 months of intense work with them, running the incubator with three people as staff. Assuming that these people have opportunity costs of $150k p.a. (meaning that the people running the incubator could find work at this rate somewhere else) and taking into account costs for office space, etc. you easily have invested $350k into this batch of 10 teams. Five years later you might (this is a risky proposition - no guarantee that anything comes out of it!) make 2.5% on one $10m exit ($250k) and another 2.5% on three $3m exits ($225k), bringing you to about $.5m in returns. Potentially. With a rather high risk. The math just doesn’t work that well.

And that’s precisely why I think the incubator model doesn’t work. To make it work you would need to do two things - take a higher percentage of equity in your first round (much to the grumbling of the founders) and have the ability to protect your position by being able to do follow-on investments (i.e. you invest alongside other investors in the next rounds to prevent dilution of your equity position) - which requires money most incubators don’t have.

Now - why this all doesn’t matter…

Here’s the thing: As much as I think this is bad news for people building and running incubators, it’s perfectly fine for entrepreneurs and the economy at large. The worst outcome of this scenario is a bunch of failed incubators - which in turn have taught and enabled hordes of people to become entrepreneurs. And who knows - even if their first startup didn’t work out, they hopefully learned a lot and will be better off for their next one.

With all that being said - here’s another disclaimer: The well known and established incubators such as Y Combinator, TechStars, 500 Startups, SeedCamp and some others will be fine. They have built their models around these dynamics, have created very specific value propositions for themselves and thus their teams and they have unparalleled access to the market.