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10 reasons investors don’t invest in start-ups

Monday, 22 November 2010 | By Jack Delosa

Entrepreneur Jack DelosaA common refrain from start-ups and small business groups is that we are currently in a funding drought, with banks, venture capitalists and business angels all unable to finance the next generation of Australian businesses.

 

However, the truth is a little more complex than simply a lack of money in the post-GFC system.

 

Sentiment from the VC community is that money isn’t the problem. The problem is finding suitable businesses to invest in.

 

So how are start-ups failing the funding test and how can entrepreneurs ensure their business is investor ready?

 

1. Inexperienced management team

Start-ups often can’t afford a good management team. The smart investor realises, however, that clever entrepreneurs will have three or four mentors who make up the company’s advisory board. An advisory board offers the “grey hair effect”, bringing experience and intelligence to a team that may otherwise lack both.

 

To do: Engage mentors and construct an advisory board with experience in what you are trying to achieve.

 

2. No proof of concept

Many business owners don’t go to the trouble of proving the concept of the business model prior to asking for money. Even though this can be done with a free blog, through Facebook or with an inexpensive market research campaign, it’s hardly ever done.

 

When 19-year-old Nikki Durkin decided to launch 99Dresses www.99dresses.com.au she created an event on Facebook explaining the concept and inviting people to join the event if they liked the concept.

 

Two weeks later she had 40,000 people saying, “do it”. Concept proven.

 

To do: Find inexpensive ways to test and measure each layer of the business model before investing excessive amounts of money.

 

3. No cashflow

Often, start-ups go to market asking for $100,000 before they’ve made a sale. This means that the valuation (see point four) an investor will come in at is going to be significantly lower than if there is historical sales.

 

Rather than raising $20,000 now, getting some sales, and raising the rest later (perhaps from the same investor), business owners will often go after the whole amount now. Which means they either don’t get an offer, or they do and it’s going to cost them 75% of the business.

 

To do: Raise as little money as possible in the beginning. Prove the concept, establish a higher valuation, then raise more for less.

 

4. No understanding of valuation

Entrepreneur: “I want to raise $100,000 and I’m happy to give up 10% equity.”

Investor: “So that values your company at $1 million?”

Entrepreneur: “Um… yeah… Yes it does.”

 

Many business owners think valuation is an outcome of how much money they want versus how much equity they want to give away. Both these factors are, in many ways, irrelevant to the investor.

 

The business owner needs to have a clear indication of what the business is worth and this needs to be backed up by a clear valuation methodology.

 

To do: Engage an advisor who understands how to value a business and understands business strategy.

 

5. No clear path to exit

The investor wants a return. However, most entrepreneurs fail to outline how the investor is going to get their money back. Having shares in the business is not a return for the investor, it is simply their security so that when the business reaches a certain trigger point, or goes to exit, the investor can see a monetary return.

 

If this path is not clearly defined, it’s obvious to the investor that taking their money is more important to the business owner than giving it back.

 

To do: Decide what your end game is and communicate this to the investor.

 

6. The business in its current form is not scalable

Investors need growth. If the business is dependent solely on the business owner, or has a very time intensive way of generating revenue, it will not be an attractive growth opportunity.

 

The best businesses are ones that make money whether the owner is there or not. Although this may not be achievable in the early stages, there needs to be a clear growth path that allows the business to make money, even while the owner sleeps.

 

To do: Systemise, productise and automate your business where possible.

 

7. No strategic value

Cashflow is important. What’s also important is strategic value. Strategic value is the assets of the business which one day may be saleable. An example of this is Facebook’s valuation of $15 billion while it was still losing $1 million each month. Its strategic value? Its database.

 

Strategic value might come in the form of a technology, a patent, a database, a brand, an exclusive client list or a first to market brand.

 

To do: Identify the components of your business which are valuable beyond the cashflow they deliver.

 

8. Lack of focus

Many start-ups look at industry leaders who are doing several activities and try to replicate a diversified business model. If we look at Virgin for example, they have over 400 companies operating in a diverse range of industries all over the world.

 

What is often not recognised is that from the time Virgin begun in 1970, they were solely focused on making and selling records for 10 years. It wasn’t until 1981 that they begun to diversify into other markets.

 

Start-ups that stick to a niche have a much greater chance of dominating. Once you own that space and are operating profitably, diversification may be worthwhile.

 

To do: Focus on your core business and only your core business.

 

9. Growth path not identified

Often the entrepreneur will have a vision but little data or support material to add weight to the proposed growth path.

 

As entrepreneurs we need to make the future ‘real’. Any well researched and projected marketing strategy, that outlines specifically how the company plans to grow, will go a long way to making the future real.

 

To do: Think about what sort of supporting evidence you can provide to investors to demonstrate you know where you’re going.

 

10. No understanding of points one through to nine


Capital raising, like any other business strategy, is a skill and therefore education is crucial.

 

One book which was recommended to me by Siimon Reynolds, who has raised tens of millions of dollars, was Enterprise and Venture Capital by Christopher Golis. Tom McKaskill also has a number of e-books on the subject, which can be downloaded for free.

 

To do: Keep learning.

 

Jack Delosa has been listed in the Top 10 Entrepreneurs Under 30 in Australia. He heads up The Entourage, a firm offering education and advisory to entrepreneurs.