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Restaurant (Photo credit: Wikipedia)
Getting a business off the ground takes a great idea, a high-quality team, a boatload of passion, lots of?hard work, and an infusion of capital. Whether that capital comes from a venture investor, a micro grant, a bank loan, a line of credit, your personal savings, or crazy Uncle Charlie, it?s a must-have. The first question a new CEO must resolve is where to secure the needed capital. Many people think of venture capitalists first, but in reality, most concepts and business plans that lead to amazing, profitable businesses make for downright awful VC investments.
LIFESTYLE BUSINESS. A city isn?t a city without its restaurants, yoga studios, hair salons and other lifestyle businesses that define neighborhoods and establish distinctive flavors for each district. All of these establishments are valuable ? not just to their patrons but also monetarily to their owners. Many of these businesses will go on to become gold mines; however, they lack scalability, a crucial component to any venture deal. A venture capitalist will assess her ability to achieve a minimum 10x return upon an exit, which most lifestyle businesses aren?t able to achieve.
LACK OF URGENCY. A venture capitalist is placing a big bet on a company, so a founder?s ability to hustle is paramount. Oftentimes, this ability to get things done is exhibited by experience ? in the midst of adversity, a great leader finds a way to make it work and still triumph, rising above obstacles. Young founders (who haven?t established a track record of success yet) can present a venture capitalist with a conundrum: they?ve got no proof of longevity, but bring fresh perspectives and agility that can outweigh the inexperience in certain cases. The true nail in the coffin here is conservatism ? playing it safe and stagnating with any sign of success. To truly make an impact, a company?s leader should use success as a catalyst to set the bar that much higher, continuing to innovate and improve, rather than accept the status quo.
LIMITED MARKET SIZE. Think of a set of concentric circles, representing potential customers for your new business. Jared Stasik, a DVP associate, utilizes an absurd example, clearly illustrating this key concept. First, envision all the people in the world. Then, all the people with pets. Next, all the people with hamsters. One more step to people with hamsters that only have three legs. Now, if your business involves prostheses for hamsters, you?ve got a great chance to capture a large percentage of this market, becoming a dominant player. However, the market itself for consumers with three-legged hamsters nicknamed ?Tripod? willing to invest in a prosthetic limb for their pets is inherently tiny ? in fact, too small to generate a 10x return, much like lifestyle businesses. The market share percentage you?d need to capture varies widely from one business to another, but the market in totality has to be big enough that your slice of lemon makes the juice worthy of a squeeze.
LACKLUSTER GROWTH. Typically, a venture fund is open for seven years, requiring a return to its limited partners after ten years. Because of this fiduciary responsibility to investors in a fund, a venture capitalist must have deals close within this ten-year span. For example, agricultural businesses are not a good fit for a VC firm: first year involves clearing the land, then planting, then five years of initial growth, then initial crops and repeated cyclically for years to come until a farm would be profitable enough to return an investment, potentially decades from that point. With limited partners expecting their payouts, it?s impossible for a VC to wait around for 20 years to watch a business grow.? Again, this doesn?t mean farms aren?t amazing businesses.? They often are.? They are just not the right fit for a VC.
LONE WOLF. A company must fit into a VC?s investment thesis. If it doesn?t match, that firm won?t fund it ? though it?s not to say another investor wouldn?t fund it. For example, Detroit Venture Partners (my firm) utilizes an all-digital strategy to invest in early stage companies committed to the city of Detroit. ?If an entrepreneur comes to us with an earth-shattering idea in pharma or green energy, they will receive our awe and admiration, but not our check. When limited partners invest in a venture fund, they essentially give the venture capitalists free reign to gamble their money ? using the strategy set forth in the limited partnership agreement. Because of this contract, VCs are required to stick to this jointly pre-determined plan and are contractually prevented from having even one lone wolf in their portfolio, no matter how sexy that wolf may in fact be.
Funding is one important piece of a huge puzzle when starting a company and getting it off the ground ? it is often what allows the other pieces to fall into place.. If you?re gung ho about opening a restaurant, that?s amazing news. While I can?t wait to eat there, I won?t be funding it.
Might be time to phone Uncle Charlie.
For more insight on creativity and innovation, visit JoshLinkner.com.
Article source: http://www.forbes.com/sites/joshlinkner/2012/08/23/5-reasons-why-your-dream-business-is-a-venture-capitalists-nightmare/
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