We agreed to assist the founder and eagerly awaited a preliminary draft of their business plan for review. When the business plan arrived, we were saddened to find that the company lacked three critical criteria we've found are necessary to attract attention from suitable investors. Unfortunately, this wasn't the first time that we'd had this experience.
Time and time again, we've been approached for assistance from budding entrepreneurs that have significant shortcomings ingrained in their business plans. In many cases, Chi Rho Consulting has been able to help these clients address their shortcomings and strengthen their capital formation strategies. Unfortunately, this was not the case with this particular client.
Investors look to minimize risk by selecting ventures that offer rapid growth potential, a high rate of return and strong management teams. We’ll examine each of these criteria in this article and explain how our client missed the mark on each of these criteria:
1) Your Business Model Must Scale!
As Investopedia explains, a scalable company is “one that can maintain or improve profit margins while sales volume increases.” In other words, a business cannot afford to lose revenue traction in order to produce more goods or services unless it has a well thought out strategy to secure a second round of funding.
Angel investors take a huge risk when they invest in a startup. Consequently, they generally seek a return of 10x or more on every investment. They also want to recoup their investment in a relatively short time period. To receive serious consideration from Angel Investors your ROI should be 30-40% minimum. Also, the payback and dividend period should be no more than five to seven years out.
When we examined the business plan of this green energy startup, they appeared to meet this criterion at first glance. However, when we dug into the financials, we realized that their cash flow assumptions were seriously flawed. Their revenue forecast assumed payment in full for their power plant facilities from municipalities before they planned to break ground. Furthermore, their plan assumed revenue at full capacity the very first day their plants were to begin producing power! When we remodeled their financials, it was evident that they would burn through their anticipated investment well before the first plant could be completed. Obviously, this was a serious flaw in their capital formation strategy.
2) Your Valuation Must Be Reasonable!
As we explained with criterion one, investing in startups is an extremely risky venture. In fact, its estimated that 47% all of angel investments produce zero return for the investor. Therefore, you will be expected to pay out huge returns to your Angel investor when and if your business begins to generate a positive ROI. Serious investors will definitely scrutinize most every financial assumption you’ve made when you formulated your business plan before they place their bet.
Our green energy client envisioned that they would build their first plants in developing nations. As a result, they anticipated that many communities would have access to electric energy for the very first time. These markets, they assumed, offered exponential growth!
Our strategy consulting firm did the necessary due diligence to validate our client’s market assumptions. In a sense, our client was right In their assumptions; the demand for energy in developing nations, particularly in sub-Saharan Africa, is incredibly high at present. That said, our client's financial models were built using American energy consumption assumptions and their revenue calculations were based upon American economic indicators. They assumed that they would receive over $50 in monthly income from their average customers in nations where the equivalent American annual household income hovers around $1,000 or less!
It was clear from our review that our client had failed to provide realistic valuation assumptions in their business plan. They over anticipated their initial market size and also failed to account for the real life economic conditions in their target markets. These mistakes were certain to raise red flags with investors. Worse still, they would most certainly call into question the client's overall business acumen.
3) You Must Have the Capacity and Ability to Execute!
Thirdly, and from our experience most importantly, the quality and experience of your management team are critical in the eyes of investors. As an investor acquaintance of ours once said, "I pass on great ideas all the time. I invest in great people."
The types of people who get potential investors excited include:
- Geeks with deep technical backgrounds
- Entrepreneurs who have sold companies
- Recognized experts in their field or sector
- Sales/Marketing rainmakers
- Teams that have worked together before and shown real success
When we received the business plan, we were prepared to conduct thorough due diligence on the management team and assess their overall strengths and weaknesses. We were surprised to read that the founder/ patent developer was the sole person involved with the startup despite the idea being nearly two years old! Furthermore, our client had had no professional experience in the power industry nor had he ever been involved in a large scale construction project. When we inquired as to why no one else was yet involved with the company, he explained that he planned to hire a management team after he secured the funding to begin his project.
Given his lack of experience in the sector,, we strongly encouraged our client to immediately begin searching for junior managers with complementary skillsets and power industry experience to join his team. We stressed that people are the core component of any business plan urged him to retain commitments before he began courting potential investors. We also suggested that he consider seeking out a cofounder to handle the company's CEO responsibilities while he focused on the day to day operations on the company.
Unfortunately, he was unwilling to consider offering up a sweat equity plan to potential new hires. He also balked at the thought of a onboarding a cofounder who could shore up his shortcomings. As a result, Chi Rho Consulting decided to part ways with this startup despite the compelling patent technology. We wished the founder best of luck in his effort to raise investment capital to begin operations but left the door open in case he had a change of heart.
While this particular example is an extreme case, it does demonstrate why these three criteria are absolutely critical if you wish to gain traction within the investment community. To review: your business plan must demonstrate a degree of scalability, your valuation assumptions must pass the smell test, and the quality of your management team must excite potential investors in order to warrant serious attention.'
If your startup requires investment capital, consider letting Chi Rho Consulting evaluate your business plan before you present your business case to potential investors. For a small fee, we’ll help you leverage you competitive advantages. We'll also provide you with practical recommendations that address any shortcomings in your operating plan. Doing so will definitely shorten the time it'll take you to find a suitable investor for your startup. It will also trengthen your position when you negotiate the terms of the investment.