Pitfalls to raising venture capital

Jeff Donahue is a good friend and battle-scarred veteran of venture-backed and private equity-backed companies. He has raised over $275M of funding for early and later stage startups and has been CFO of 10 emerging growth businesses. He's worked across the table from leading investors like GRP (now Upfront Ventures), Invesco, ComVentures (now Fuse Capital), Allegis CapitalAlta-BerkeleyInvisionSteamboat Ventures and many more. I'm thrilled that he's offered to write a Venture Financing Series. Without further ado, here's episode two. You can read episode one here.

Entrepreneurs can get ahead in the fundraising game by paying attention to these twenty three factors that make VC funding easier, but pre-determining a successful raise requires more than that. In this second episode of the Venture Financing Series, I highlight some of the key pitfalls to watch out for.

  • Part-time entrepreneurship. You never will attract funding from a VC if you say, “As soon as we get funding we’ll quit our day jobs and dedicate ourselves to our start-up.”
  • High customer acquisition costs. At the other end of customer acquisition cost spectrum is viral customer adoption, which is close to heaven.
  • Barriers to customer adoption. These can include usability/user experience, complexity, extended time horizons, and disruptive changes to operational models. Why start out behind the 8-ball in the first place? 
  • Long technology development cycle. Investors back products, not technologies. A shorter development cycle is always better, and the VC model has morphed away from intensive development spending.
  • Sequential funding requirements. Optimize for cash flow breakeven as early as you can. Again, this is less problematic as long as VCs signed up to sequential funding rounds in the first place. VCs hate unpleasant surprises and will make you pay for them.
  • Modest market opportunity. Ideally, you do not want to be a small/niche play manifest in little or no scale and scope and underwhelming revenues/non-geometric revenue growth. Fundamentally, you want to ride big horses in big markets. 
  • Elephant hunting business model. This makes you dependent on a small number of very large customers. Be especially careful in the realm of hardware manufacturing and complex software applications. This is ameliorated if you have a long-term lock on at least one elephant.
  • Unproven/inexperienced management team. Funding will be easier if you and key members of your team have made VCs a lot of money in prior incarnations through execution.   
  • Crowded/competitive space. This translates into forfeiture of first or even second mover advantage. Lots of undifferentiated players in an anathema to VCs.
  • Pure execution play with little or no intellectual property. Social media is a great exception because many social media undertakings typically are land grabs where first-mover status is paramount.
  • Complex and/or cost-heavy sales channels. VCs can be turned off by:
    • Heavy reliance on indirect channels and channel partners (channels take a great deal of time and money to structure, educate, motivate, and manage).
    • Heavy reliance on a direct sales force that doesn’t scale.
  • Rigid technology. Be careful if your technology doesn’t have more products/applications beyond what is immediately at hand. VCs like to see extensible technology.  
  • A service provider business model, a consulting-oriented business model, a custom solutions business model, or a government contracting business model. There are a host of reasons these are very difficult to fund, and I will comment further on them in a future guest post. 
  • Complex ecosystems for the product. Watch out if the economic pie is divided many ways among established players and relationships. Mobile is an example – the ecosystem includes technology providers, application developers, carriers/network operators, MVNOs, MVNEs, content providers, content aggregators, integrators, handset manufacturers, chipset manufacturers, SIM card manufacturers, network equipment manufacturers, and last but not least the subscribers/customers who pay.
  • Disproportionate reliance on assumptions that cannot be tested. This also applies when tests provide debatable/questionable results. The opposite would be a business plan that can survive rigorous revenue haircuts and still be viable.
  • Revenues that follow investment. You don’t want revenues to lag behind investment in terms of risk profile and timing regardless of the development cycle.  An example is an investment where a lot of money has to be spent over a long period of time to acquire customers.
  • Hardware, as opposed to software. Hardware is just more complex and capital intensive (see “elephant hunting” above). If hardware is your solution or is part of your solution, you’ve moved the risk needle toward the red zone.
  • Having to build “infrastructure.” Do you need to proselytize your product’s application or your industry? This is akin to having to invest in creating demand in a situation where you believe people want your product for whatever compelling reasons but just don’t know they want it. There are no returns on building infrastructure. Your future competitors will piggy-back on it, and you will have made them successful at your expense.
  • Using more than one of the top ten lies of entrepreneurs (modified with respect and thanks to Guy Kawasaki):
    • “Our projections are conservative.”
    • “McKinsey says our market will be $50 billion by 2010.”
    • “Google and Amazon are likely to partner with us soon.”
    • “Apple and Samsung are likely to buy us in 2 years.”
    • “Key employees are set to join us as soon as we get funded.”
    • “No one is doing what we’re doing.”
    • “No one can do what we’re doing.”
    • “Microsoft is too big/dumb to be a threat.”
    • “Our patents make our product totally defensible.”
    • “All we have to do is get 1% of the market.”
At the end of the day everything boils down to the customer. Your  product is something people want and are willing to pay for because it alleviates their pain, solves their problem, enhances their experience, gives them instant gratification, etc. Beyond that, you simply must make your product easy to adopt and maintain. User experience is so important…

You need to give meticulous attention to the array of customer cost metrics embedded in your product beyond the cost of customer acquisition. These include customer provisioning costs (i.e. getting your product up and running with the customer), customer service costs, customer retention costs, and customer development costs (i.e. costs of upselling your customer). Of course, the flip side of customer service costs is having a product that customers want so intensely they are willing to pay for support.

The pitfall list above is ideal in the context of things that encumber securing venture funding, much as my previous guest post dealt with ideal factors that make raising venture funding easier. In terms of what to avoid, I never have been in or seen a startup that does not have some hairballs. Pitfall-wise, it is just a matter of how high up the hairball index you are. That completes the circle with my favorite subject, risk management.

Read episode one, Taking the pain out of raising venture capital.