Startup Acquisitions: Exit Strategy

We recently put together our "thought piece" on the dynamic world of startup M&A.  The premise is that for many startups, it is actually more profitable for founders to raise a small amount of capital and sell early to an acquirer like Google or Zynga, than it is to raise multiple rounds of VC (with accompanying dilution) and aim for an IPO or mega-acquisition.

See below for our presentation, which can also be found on Slideshare.

If you like it, please share it or tweet it. Thanks!

Also, it is an evolving 'work in progress'...please send along your feedback or tips from your own experience with startup acquisitions.  We'd love to hear from you.

Startup Exit Strategy Thought Piece V7.6

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When Is A Startup "Venture Fundable?"

I spend a healthy chunk of my time helping startups think through their capital raise strategies.  Part of this work involves assessing whether a company is “fundable” given its current stage of development, traction and business plan. 

Being strategic about when to raise capital is important, since a full-court investor press takes a huge amount of time and effort to do right.  Fundraising essentially becomes a full time job, and can easily become a distraction for founders who should be focused on growing their businesses.  I’ve seen worst-case scenarios in which the fundraising becomes so consuming that important business milestones slip, which then derails the fundraising—a dangerous spiral. 

To try to bring some clarity and structure to the critical decision of when to raise capital, I have attempted to boil down the basics of what constitutes a “fundable” company in today’s market.  In a nutshell, the main factors are: 

1.  The “Big Idea.”  A good first filter is to honestly and objectively assess whether your startup is doing something truly novel.  Novelty and originality are surprisingly rare traits; many startups are highly derivative-- a slightly better mousetrap or an incremental improvement over what’s being done today (think: Groupon clones).  While a better mousetrap can certainly be the basis for a profitable niche business, it is not usually venture fundable (or at least, not easily fundable—it becomes more so, with #3 below).

By contrast, pitching something truly unique, big, and audacious—what Mike Maples calls the “thunder lizard” startup—creates an entirely different response from investors.  I’ve worked with startups doing something interesting but not game-changing, and I’ve worked with startups with ideas that seemed crazy—but if they worked, they’d be huge.  

The latter situation is much preferred, and makes the tiring work of raising capital exponentially easier. A really cool technology with the “wow” factor or a big, audacious, disruptive concept is almost magical in the way it can cut through the noise and generate buzz amongst jaded investors. At a minimum, VCs will take a meeting to hear what the hell you’re talking about.

2.  A Story, Well Told.  While the Big Idea is the cornerstone of the foundation, the pitch is what gets people to stop and take a closer look.  Investors are pitched by literally thousands of good companies each year; an outstanding pitch will break through the noise and set your company apart from the unwashed masses.   

A solid pitch neatly packages the company, vision, and deal in a compelling manner (typically via your slide deck, exec sum, and model), with a narrative crafted to appeal to the nuances of what investors are looking for.  It involves telling a clear and exceedingly simple story, so the message is frictionless and can be circulated among the partners at the VC firm and among other VCs in a syndicate.  In other words, the pitch is portable (and often somewhat “viral”).

A solid pitch also includes polished and practiced Q&A, and an overall story that strikes both rational (how do I make a return on my investment?) and emotional (why do I want to be part of this vision?) chords.  Bringing all these elements together is surprisingly difficult, but when done well it is a beautiful thing.  

3.  Supporting Evidence.  This is the clincher, and the one most startups miss.  VCs fund businesses, not concepts.  A concept alone is not fundable--startups must get the fire lit; venture money fuels an already-burning fire. Or, to put it in other terms, VCs typically want to see most of the technology risk and at least some degree of the business risk removed before doing a deal.   

In the absence of some special factor (for example, a founder with multiple successful exits under the belt), startups need to generate some evidence of "market validation"—e.g. initial traction, early customer adoption, or a monetizable proof of concept--before approaching investors.  In short, startups need data showing the beginnings of a growth curve.  


Fortunately, it only takes a few data points to show a pattern. I’ve seen startups with just 3-4 months of live customer data get a lot of investor interest.  Investors recognize that the delta between a startup with "deal in hand" and one that "will have a deal, if  we raise funding" is very large, and they use this gap as a filtering mechanism.     

This is why designing and presenting startup metrics plays such an important role--metrics like engagement (MAU, DAU), stickiness & retention, upsell / conversion rates, virality, etc.  In a perfect world, you can show—even with just an initial, limited data set—that your average revenue per customer is greater than your cost to acquire said customer.  In such conditions, an investment is a no-brainer; this is what closes venture rounds.  

While I’m a huge proponent of “pitching the numbers,” qualitative evidence can be useful as well, such as blogger support, press and journalist attention, rabid Facebook fans, evangelistic Twitter followers, etc. Regardless of the form, it’s a powerful combination when you can start your pitch with a right-brain lead-in (i.e., an emotive, visionary angle) and finish with a left-brain close (rational, unambiguous data). 

Those are the three foundational pillars that offer startups at least a fighting chance at raising venture capital.  Keep in mind that raising external funding is significantly “harder than it looks”—estimates from the SBA and Angelsoft show that only around 2% to 5% of startups seeking angel or VC dollars actually get funded.  The bottom line is that being strategic about it— getting your sh*t together, and timing your investor outreach for when momentum is building around (and within) your startup—will greatly improve your odds of success.  

Analysis of Common Mistakes

The most common mistake, in my view, is trying to pitch too early without any supporting proof / evidence / traction / metrics.  Without any data, you’ll tend to get a lot of false positives-- meetings that just lead to  “let’s keep in touch” responses. This is a huge time sink, and it is often hard to re-ignite the conversation weeks or months later when you finally do have some data points to show.   

Indeed, there is a direct correlation between customer traction/momentum and the speed at which a deal gets done.  Thus, one of the key success factors in getting funding is that founders somehow get their startup trains moving—by bootstrapping, doing consulting work on the side, tapping friends and family or "dumb money,”—and come at Sand Hill Road from a position of strength.  The alternative is just too frustrating and draining.  

Another common mistake is going out with a rough-around-the-edges pitch. The people you are pitching probably sit through 10+ pitches each week, and a confusing or overly complicated message won’t stand out, or worse, is quickly forgotten.  Clear pitches—the kind, as Sequoia puts it, that can be elucidated on the back of a business card—enjoy a “halo effect;” muddled pitches are weighed down by their own inertia.     

One more note: if you’re missing one of three key components described above, then, like the guy driving next to you in the large Corvette, you’d better have an oversized version of something else to compensate.  No real traction, but your concept is so big—so truly disruptional—that if it works it will be the next Zynga or Facebook?  You might have a shot, if you can adequately tell/sell the vision in your pitch.  Or, no pitch developed, but your unique monthly visitor growth on Compete.com is going hog wild?  You’ll probably have VCs (or at least their associates) calling you.

(**Just to be clear, there are many, many other things that are important, and that can make or break a deal—things like the team, defensibility, IP, advisors, partnerships, market size, relative degree of customer need, and so on.   This blog post isn’t a comprehensive summary of every factor; rather the aim is to set an initial threshold of what needs to be in place so you’re not wasting your time on a fruitless money hunt.) 

So that’s it in a nutshell.  Big idea + attractive story + supporting evidence = fundable deal. 

Have you got it?  If not, what can you do today, tomorrow, and next week to get it? 

Startup Business Development Strategies: 7 Tips For Putting Together Stellar Deals

Business development is fun.  Putting together partnership deals requires a special combination of hustle, strategic thinking, technical chops, project management, and sales and negotiation skills.  It’s a bit like a triathlon, in that it stretches your abilities in multiple arenas.

Business development is both creative and analytical—left brain and right brain—and done well, business development deals can be the purest representation of the equation “1+1=3” to drive growth.

A few tips for startups doing deals:

1.   Focus on the right targets. 
Any meaningful partnership deal will require a significant amount of time and attention from your management team.  This places a real constraint on the number of potential partnerships you can chase down at any given time, especially if you’re trying to simultaneously keep the business afloat, hire staff, raise money, and manage all the other critical-path activities that startup founders are responsible for.

As such, the “shotgun strategy” does not work well for startups; you’ll waste time fielding exploratory tire-kicker meetings that lead nowhere, or worse, you’ll find yourself paying attention to the firms who respond to inquiries quickly only because of some underlying flaw in their business (for example, they are struggling and desperate for something to move the needle—an ‘adverse selection’ problem).

Since a founder’s time is his or her greatest constraint, it becomes critical to instead take a “sniper’s approach,” and carefully select a short list of partners who will deliver the most bang per bullet.  Strategic targeting—instead of being reactive to those chasing you—front-ends the bulk and burden of your work, but ultimately delivers a better investment return on your time and effort.  Selective hunting keeps you focused on the game that really matters.

2.   Come to the table from a position of strength.
Startups are often at a disadvantage when forming partnerships with larger companies, due to the simple fact that they are startups.  There is a natural bias against working with firms that are unproven, underfunded, and still developing and/or evolving.  The best way to compensate for the ‘startup stigma’ is to bring something special to the table—an asset that cannot be easily replicated by another firm.

An “asset” can take many forms, both tangible and intangible: it could be an innovative technology that plugs a critical gap in your partner’s product line; it could be access to a market segment or demographic that you have been able to crack, but others haven’t; it could be the brand and “buzz” that you are generating with your business; or it could be a combination of all three.

It is remarkable how much attention a startup can garner when it has something noteworthy, and how frustratingly little a startup can get when it is another minnow in a school of similar-looking fish.  The two situations contrast starkly with one another:  the challenge of the first is not being able to handle the avalanche of in-bound inquiries; the challenge of the second is that your emails are never returned and your phone calls never answered.  There is rarely a middle ground here. Thus, if you don’t currently have something noteworthy as your ace card, go back and continue developing or marketing until you do, so as to avoid a slow, painful drain on your time and resources, and motivation.

3.   Get creative. 
One of the best things about being a startup founder is that you (generally) have the leeway and latitude to write your own script.  Contrast this to a partnership deal between two well-established companies, where there are already formalized processes and procedures—in short, “rules”—for doing deals.  As a startup, especially if you’re in a new or emerging space like social media or online radio or video, you have the ability to make it up as you see fit.

Indeed, the best business development deals are often those that break new ground and introduce new models for doing business.  Follow the rules of brainstorming, where no idea is a dumb one, and explore all sorts of possibilities; as long as the contemplated deal structure benefits both parties, it’s worthy of consideration. Set aside your predilections and constraints and get creative.

4.   ”Ask not what your partner can do for you--ask what you can do for your partner.”
Before pursuing any deal, it is useful to get inside the mind of your target partners, and view a potential deal from their perspective.  What is it they are lacking?  Where are they falling behind?  What keeps them up at night?  This takes research and an ability to connect the dots of an often-complicated mosaic of market trends, products, competitors, company culture, and other factors.

Once you’ve established a pain point—for example, a competitor is eating their lunch in a new market segment—craft your pitch and business case from the perspective of how you can solve their problems for them.  Bonus points if you can do so in a way that connects directly to increased revenue, profit, market and mindshare.  In this way, you will find that the gap between your companies is small, and the deal will go exponentially smoother and faster.

5.   Introduce competition into every deal.
This is a key point, and perhaps the most powerful technique of them all.  In every situation, getting some competitive heat on the deal will give you negotiating leverage, increase the tempo of discussions, and greatly raise the odds of a successful outcome.  Even if you’ve followed the advice from point #1 and zeroed in on your dream partner, opening up a dialogue with their competitors is well worth the effort. In addition, you should skillfully and subtly let your target partner know you are having talks with other firms.   This is the “art of the reveal,” and weaving in the knowledge that their rival may sweep the deal out from under them greatly helps level the playing field.

For example, I once worked with a mobile startup that needed to source both a carrier partner and a wireless chip vendor. We brought to the table dual assets of innovative technology and a ton of press buzz.  We initiated parallel discussion paths with two carriers and three chip manufacturers, even though we knew exactly who we wanted to work with from the outset.  The benefits of this strategy were clearly evident in the tempo of every meeting and in the tone of every term sheet. The deal was still a challenge—we were fighting the startup bias, after all—and there were a few heart-stopping moments where it looked like it would all fall apart.  But in the end, we got favorable pricing from our preferred partners, and did the deals in an accelerated timeframe.

6.   Be operationally ready to do a deal.
Startups are notoriously under-funded, under-staffed, and over-stressed.  Before going too far down the path with a partner, ask yourself whether you really can support the deal from both a business and technical perspective.  Can you spend weeks hammering out technical details and timelines?  Do you have the bandwidth and attention span to turn around multiple drafts of an MOU or LOI?  And of course, do you have the engineering bandwidth to actually implement the JV technology and nurture it through the launch and post-marketing support phases?

To note, this is a classic balancing act; being “operationally ready” at a startup is almost an oxymoron.  Many startups have struck game-changing deals before they were really prepared to handle them, and then hustled like hell to successfully pull things off.  Indeed, startups need a healthy level of outsized bravado in their DNA.  But if your answers to the several of the above questions are clearly “no” it may make sense to get a little further down the path before sinking time into partnership endeavors.

7.   Know when to cut bait and run.
This is a tough one to do well, but it’s a critical skill nonetheless.  Sometimes your company’s goals will shift, taking a proposed deal off the critical path.  Other times, you’ll be two-thirds of a way through the partnership negotiations when you realize it is not a strategic fit. The initial enthusiasm fades as you get into the details, and you realize that the technology integration hurdles are massive, or that your partner’s marketing channels are not as strong as they appeared.  Sometimes it’s simply cultural or personal—the thought of spending years with a partner who doesn’t “play well in the sandbox” gives you night sweats.

The challenge here is twofold.  First, it can be difficult to discern between deals where there is truly not a fit, and the normal struggles, politics, highs and lows that accompany any deal.  Second, in many cases you’ve already sunk a ton of time and money into the process, and it is emotionally draining to accept that it was all wasted effort.  However, time is the enemy for startups; the clock ticks faster when your funding is running out and markets are evolving rapidly.  Do the analysis, but trust your gut—if it’s clearly not going to work out, consider your efforts as sunk costs, extricate your firm as smoothly as quickly as possible, and move on to the next deal.  

In sum, business development is fun—happy hunting!

Startup Valuation: How Much Is Your Company Worth?

Part of my job description involves prepping startups to raise capital. One of the most common issues that concern entrepreneurs is how to address the "Valuation Question."

I understand this concern; raising money puts a very un-ambiguous stamp of “worth” on what you’ve worked so hard to create. Thus, it is logical that entrepreneurs want to approach the negotiating table with a bullet-proof spreadsheet detailing and supporting their valuation down to the last dollar.

Which is exactly why they hate my answers to the question, “what is our valuation?”:

• Startup valuation is an art not a science; and,

• Your company is worth is what the market will pay for it.

They hate these retorts for several reasons; for one, it essentially means that valuation hinges on their negotiating skills (which is daunting since they’re going up against professional investors / negotiators). Second, these are fuzzy answers— not what they expect from a CFA with a graduate degree in finance.

Unfortunately, I cannot make it much less fuzzy. It’s not because I don’t understand valuation; on the contrary, I spent the first few years of my career doing nothing but valuations of technology companies.

But the challenge is that none of the traditionally-accepted valuation methods really apply to early stage startups. Let’s briefly review why:

Discounted Cash Flow Model: A DCF model “feels” the most robust because it is very quantitative and analytical, and it results in a single valuation number. In a DCF, we forecast several years of revenue and expenses, and then discount the resulting cash flow back to the present using a “venture capital expected rate of return.” The models are beautiful, sophisticated, and complex. They dazzle.

But here’s the problem: a skilled Excel wizard can make a DCF spit out any valuation they want. Because there is no (or very little) historical financial data with most startups, forecasts are pure conjecture and fantasy. In addition, the model is extremely sensitive; adjust the discount rate down slightly and our growth rate up, and suddenly your valuation doubles. No serious investor would ever pay much heed to this.

Cost-To-Recreate Model: This is just as it sounds—we back into an estimate of what it would cost to duplicate or recreate the company with one of like utility. It is analogous to a make-vs.-buy decision, and the premise is that a prudent investor would pay no more for an asset than its replacement or reproduction cost. As one simple example, we might estimate the cost in terms of the number of man-hours of programming required to write a comparably-functional software program. While this method also spits out a tangible, “hard” number, it doesn’t fully capture the future potential of a business, and it doesn't reflect the value of intangibles like the brand (which can obviously be quite valuable).

Market Multiple Model: This is the most robust method and it is actually used in the venture world. With the market approach, we value a company by looking at recent sales or offerings of comparable companies, then we adjust the multiple to reflect specific characteristics of our company. This gets us closest to the answer above that “valuation is what the market will pay.”

However, here’s the catch: it is very difficult to find accurate data on truly comparable startup financings. Not only is it hard to find apples-to-apples comps, but funding valuation data is often kept close to the vest. While some companies report this—usually when they get a huge valuation round—most startups do not, and as private companies they are not required to do so. (To clarify, many companies report how much they raised, but not at what valuation they raised it at). Even some of the very powerful databases we use such as Capital IQ do not always contain this data.

So, having crossed off traditional valuation models, what do seed and series A startups do? How do we best approach the question of valuation? Here are three methods:

1. Use Stage of Development As A Proxy: A startup’s path from idea to IPO can be charted as a series of major milestones (as well as hundreds of smaller stepping stones). At each milestone, a startup’s valuation rises as more and more risk has been removed from the business. Thus, one way to assess valuation is to look at where your company is at, and match it to typical valuation ranges for each stage. For example a funding-path for a web or software business may be as follows:

Different types of investors play at each round, and if the company is executing to plan, there is generally a sizable jump in valuation at each stage. For example, the increase in valuation between stages 1 and 2 – where we’ve eliminated most of the technology risk—is usually relatively slight. Between 2 and 3, we’ve proven that a market exists—someone will buy the product. A much larger segment of investors are interested at this stage. Between 3 and 4, customers are piling on, which leads investors to pile on—thus creating astounding valuations like we see with Facebook or Twitter.

2. Tell A Really Good Story: Because there are few really solid quantitative ways to value a startup, estimates of a company’s worth often come down to perception. This, in turn, comes down to how well you present your company in the form of your investor pitch and pitch deck. My rule of thumb here is simple: present the company in as favorable a light as possible, without misrepresenting it in any way. This includes how you position your company vis-à-vis the competition, what you choose to emphasize or call out with respect to opportunities and strengths, and so forth. As in sales, it pays to focus on the attractive and compelling parts of your business and the value your company brings. Pitch it with passion, while addressing any issues or ‘warts’ candidly and honestly (they will come out in due diligence anyway).

A corollary note is that presentation matters. How you present the company to investors in the form of your pitch deck and business plan is a signal of how you will present the company to the outside world, and to future investors in later rounds. To elucidate this, I use the example of selling a car. A few simple things like a thorough cleaning, detailing and a good polish can spark an emotional response in the buyer and raise the valuation far more than the cost of such services.

The converse is true as well: a messy, unattractive, or problematic car will turn off most buyers; or, if buyers are still interested, they will use such flaws to beat down the price. This analogy carries through to due diligence: fixing a $20 rattling door handle preemptively removes that obstacle to a sale, just as cleaning up your startup’s capitalization table and IP assignment rights in advance will ensure the funding process goes that much smoother. In short, make it attractive and make it easy for the buyer to buy.

3. Put On Your Best Poker Face And Just Ask: Let’s assume that you have a SaaS company that has built a decent first version of the technology, launched it, and generated a base of initial customers (and corresponding metrics). You’ve eliminated most of the technology risk and some of the market acceptance risk, and you only have one or two gaps to fill on the management team.

Looking at the table above, you determine that Series A deals for companies with similar characteristics often fall into the $5 to $15M range. Your customer pipeline is filling up, and VCs have been receptive to your meeting requests; your pitch and slide deck are polished, and overall, you’re feeling good about your funding prospects. Thus, at the end of a pitch meeting, when asked what you think your valuation is, the best approach is to either avoid the question (saying you’ll let the market decide), or to state simply and without blinking, “we’re looking for a $12 to $14 million pre” (with "pre" signifying pre-money).

From my experience, if the ask is within the range of reason, there is usually not much further discussion. The VC takes note of it, and files the information away as a point for future negotiations. After all, it’s not like we’re demanding a certain valuation and trying to justify it. We’re simply stating what we’re looking for. Continuing with the analogy of selling a car, the buyer probably knows the general price range for cars like yours, and if you’re within the relative range, then it comes down to how much he really wants the car. Whether he accepts the price you’re asking also comes down to how many other buyers are interested, which brings us to the next point…

3. Get Other Buyers In The Game: This is the biggie. The level of interest in a deal is the single most important factor influencing valuation (and for that matter, for negotiating everything else on the term sheet). In short, if you have just one investor interested, he or she sets the price, and you are free to accept it or walk—you are a price taker. If you have multiple investors interested, then your leverage increases tenfold, and you become a price maker. In such situations, we have effectively created a “market” for your stock—and in some cases, this can escalate to become a heated auction environment (which is the reason why some valuations catch fire and go through the roof).

In sum, a little knowledge (of comps and ranges), a little confidence (the “art of the ask”) and the ability to generate demand from multiple parties are your best tools to manage the valuation discussion and term sheet negotiations.

Remember: your company is worth is what the market will pay for it. Create a market for your startup, and you will have the leverage to get what you feel it is worth.

In Praise of "Dumb Money"

I am frequently contacted by startup founders seeking help raising an angel round of capital. I give an explanation of what angels are looking for, point out a few of the various formal angel groups, and describe the growing army of “super angel” investors like Ron Conway or Aydin Senkut that has emerged in recent years.

And then I gently shatter their hopes and dreams by telling them there is no way in hell any angel will fund them; I tell them they are not ready to raise outside capital from professional investors.

I do this because of a common disconnect, a misperception of angels as mythical creatures willing to shoulder all the financial risk in a startup. Granted, angels are opportunistically driven by a desire to get in early. But the reality is that they are still highly risk averse (especially since it’s their own money) and seemingly becoming more so (according to a recent NY Times article, total angel funding fell by 27 percent in the first half of 2009, and the average deal size shrank by 30%).

The point I try to drill home is that although angels play early in the game, they rarely invest in pure ideas or business plans. Instead, they tend to invest in entrepreneurs who have been able to get the ball rolling through their own hustle, creativity, and chutzpah. You may not have solved all the technical or market risks, but angels want to see that you are sufficiently resourceful to have built enough of “something” that they can see the shape it’s taking, and kick the tires a little.

So what do I suggest for those who are not ready for angels, and who don’t have enough personal savings to launch the business?

I tell them to seek dumb money.

This pejorative term comes from the fact that an investment in a pre-launch company is almost never rational when viewed by any traditional investment lens. Given the lottery-like odds that a pre-launch company will ever return money to its initial backers, dumb-money investments are more akin to a grant or donation than an “investment.”

But “dumb money” is often exactly what is needed at the idea stage of a business, and it usually means hitting up friends and family—people who know you well enough that they are willing to take a leap of faith on your ability to pull it off. In short, you are raising money from people who are willing to invest in you, as opposed to investing in the fundamentals of a deal.

I dislike this term, as it is both pejorative and a misnomer—anyone who can bankroll the $50k or $100k needed to get your startup off the ground has probably done quite well for themselves based on their own smarts and drive. They may not be savvy private equity investors, but they probably know a few things about business.

Further it neglects how important the friends-and-family funding economy is to a healthy startup ecosystem. Indeed, it is the invisible army of doctors, dentists, parents, grandparents, and great aunts who catalyze the dreams of wild-eyed entrepreneurs and who enable crazy ideas to come to fruition and change the world.

So this holiday season, let’s raise our glasses to the unheralded champions of entrepreneurship, the ones you don’t read about on TechCrunch but who in aggregate are more vitally important to the startup world than all the VCs combined.

And, as the liquid refreshments begin taking effect, and as you move in to seal the deal, let’s review a few tips to ensure the dumb money round does not become a disaster:

Understand The Risks: If you raise friends-and-family money and your startup fails—and odds are it will—you’ll still see your “investors” each Thanksgiving and at each wedding, baptism or bar mitzvah. Is this going to cause significant heartburn and family strife? Proactively visualize your father-in-law’s reaction to losing his money, and it’s effect on your relationship. Make sure you can stomach this before cashing his personal check.

Make Them Understand The Risks: Directly related to the above, you should temper your pitch by being painfully, explicitly candid about the risks of the venture. Talk through all the reasons the company might fail, and state that although you will do everything legally possible to make the business a success, the odds are that they will never see their money again. Is this something they are willing to accept? Perhaps more importantly, is this going to cause them financial hardship? If so, you’d do best to look elsewhere.

Structure It As A Loan: Selling a percent of your company at an early stage is exceedingly difficult, not only because you must issue shares, but because it generally implies you are setting a valuation. Further, a messy cap table—with many small investors who may or may not be “accredited”—can make it difficult to raise money later from professional angels or VCs. A better approach is to structure it either as a non-recourse loan, or as convertible debt (i.e., a loan that converts into equity once a valuation is negotiated later with VCs).

Paper It Up: Many friends-and-family rounds are done via lunch and handshake. In general, I think this is a mistake, and you are better served by drafting a written deal. It need not be overly complex, but it should state the amount being loaned or invested, repayment terms (if any), and an acknowledgement of the risks involved. The most valuable takeaway is that you’ll have something tangible that you can refer to later if things go awry or if perceptions diverge.

Go Like Hell: The best way to solve all of the issues above is to execute like hell and make the business a success. Granted, this should be a given, but building a startup is always a roller coaster ride with serious highs and lows, and many entrepreneurs want off when things get rocky. Taking other people’s money brings an additional level of obligation and pressure; it means you need to be more committed; it means you can’t easily walk away. In particular, this manifests itself in a sacrifice of personal life and freedom. But this is the deal with the devil you make when you take other people’s money. Further, for your investors, demonstrating that you gave it your all will lessen the pain of losing their money if the startup fails.

In sum, dumb money is what you need at the idea stage. But let’s come up with a better term for this critical bedrock of innovation. How about “concept capital”?

What Startups Can Learn From Sailors (Pt. I)

I’m a simple guy. I basically have just two passions in life: startups and sailing.

Last fall, after nearly a decade spent working with startups, my wife and I embarked on an extended ‘sailing sabbatical.’ On a pre-dawn October morning, we sailed under the Golden Gate Bridge, pointed the boat south and explored Mexico, then headed west across the Pacific to French Polynesia.

It was a fantastic trip, and a long one. Traveling 7,000 nautical miles—at an average speed of about 6 knots per hour—gives one plenty of free time to think. I spent an inordinate amount of this time reflecting on the similarities between sailing a small boat and running a startup.

A few startup / sailing parallels, cliches, and lessons learned from the journey:

The Value Of Charting A (Flexible) Course

Before leaving San Francisco, we spent a good amount of time figuring out exactly where we wanted to go, and then we laid out a plan for each leg of the journey. This process was daunting at first, but it helped us manage our timelines and budget. In addition, it helped keep us safe; as with startup navigation, many offshore hazards are “known” and can be anticipated or gleaned from people who have done it before.

For example, on our first major passage from San Francisco to Cabo San Lucas, we charted our route to avoid the major shipping lanes just outside the Golden Gate. We entered waypoints in our GPS to skirt around Southern California islands, and researched protective anchorages along the Baja peninsula for rest stops. We plotted our course in detail, but we also baked in enough cushion to allow for mid-course corrections or delays. In addition, every time we entered an unfamiliar port or narrow anchorage, we had a contingency or ‘escape’ plan if things suddenly went awry.

Startups can benefit from this approach. Mapping out markets, setting waypoints and milestones, and preparing for ‘what if’ situations helps keep a young company moving forward while avoiding hazards. Successful startups recognize the value of creating a strategic plan to help guide the way, and they develop one that is flexible and can be readily adapted to reflect new information and real-time situations. Finally, they learn from precursors—both by studying other firms, and by integrating “experience” into their company’s DNA through seasoned hires or a strong advisory board.

Build The Boat For The Task At Hand...

Prior to departure, we outfitted our boat in anticipation of all sorts of events—everything from minor mechanical issues to potential catastrophes. We upgraded key components like the rigging and sails, and had backups for most systems—if our nav equipment shorted out, we had a handheld GPS. If our steering went out, we had an emergency tiller. If our boat sank, we had a life raft. Limited by our budget, we kept things exceedingly simple, but in the end, we were (relatively) prepared to take on the high seas.

For startups preparing to venture forth, replace the words ‘right equipment’ with the words ‘right talent.’ Just as a boat requires good sails, rigging, and steering gear to be sea worthy, a startup needs, at a minimum, enough technical skills to develop the product and sufficient marketing skills to sell the product. Indeed, the most potent founding team is made up of a hardcore engineer and an energetic, passionate evangelist. The rest can be outsourced or added later, but without product skills, the startup will be swamped by the first set of customer demands, and without sales skills, it will drift invisibly through the market.

…But Be Quick To Untie The Dock Lines And Cast Off.

Even with the best planning and preparation, no sailor is ever fully ready for the challenges of the open ocean. This awareness can have a paralyzing effect, and if you walk the docks, you’ll meet a sizable number of sailors who wax poetic about future voyages, but who never actually leave the safety of their slip. There is always another piece of gear to save up for, or a myriad of ‘boat projects’ keeping them in the harbor.

At some point, inertia must be overcome, often suddenly and without restraint. We knew we couldn’t possibly anticipate every mechanical issue; no boat is ever fully shaken-down. We also knew we didn’t know it all; some things we’d have to learn on the fly. Yet when our departure date came, we sailed off anyway. The anxiety that had enveloped us for months dissipated within a few hours of our departure. We were off and running, and it was exhilarating.

Similarly, good startups prepare, but they also pull the trigger; they hoist the sails and go for it. There is always a balance between planning and action, but successful startups err on the action side. They know that “perfect” is the enemy of “good enough,” and that the benefits of launching a little bit too early far outweigh the costs of missing a market window. Thus, they get to market with the minimum set of viable features or services, and build from there. They learn and grow as they go. They embrace the challenge and scrutiny that comes with being out in the open, exposed. No startup success story was ever written by staying in the garage.

May The Wind Be Always At Your Back

A key characteristic of a good sailor is that she uses nature and the elements to her advantage, instead of fighting against them. An example is the daily effect of tides and currents. If you are entering San Francisco Bay against a 4 knot ebb, and your boat does 5 knots, you’ll essentially be treading water, whereas if you enter on a flood, the current will whisk you to your destination. A macro-example is in using predictable annual weather patterns to find the best wind to carry you across the ocean—or to avoid seasonal hurricanes.

The startup metaphor is that like the tides and seasonal winds, markets can be studied, and in many cases, predicted. Markets have repeating, cyclical trends and patterns that can be used to help make decisions. Are you trying to sell into a declining or contracting industry—i.e., sailing against a current? Could you take another tack, and point the boat in a more favorable direction? Another example—is VC funding for your space drying up? Can you adjust the shape of your sails, make do with less, and keep moving forward? In short, working with and not against the forces outside your control will make the journey a whole lot easier.

“You Take The Good, You Take The Bad…”

The popular image of sailing is of a spirited, beam-reach blast on a bright sunny day, or a pleasant sunset cocktail hour at anchorage. This is, in fact, reality—10% of the time. The remaining portion is comprised of either not enough wind or too much wind, weather that’s too cold or too hot, cramped quarters, seasickness, and conditions that are either extremely boring or way too ‘exciting.’ However, when the sailing is good it’s great, and it is these moments that keep you going the other 90% of the time.

Similarly, the popular image of a startup is of a fun, hip company that launches to great fanfare, quickly scales its customer base, and is acquired by Google at an astronomical valuation. The reality is much different; popular perception doesn’t reflect the hours of both chaos and tedium, of slaving away in cramped C-class office space on uncomfortable chairs, of fighting to stay afloat and meet payroll while running on Ramen and Red Bull.

Nonetheless, a few key moments—closing the first paying customer, raising a venture round at the 11th hour, or presenting to the accolades of peers at a conference—make it all worthwhile. Savor, celebrate, and then remember those moments during times of stress.

No Rest For The Wicked

While passage-making, both captain and crew must be constantly “on”—scanning the horizon for larger ships that that could present a collision hazard, listening for unusual boat noises, watching the barometer for any sudden weather changes, and repeatedly checking all the gear, gauges and equipment for signs of wear or distress. It’s pretty amazing, actually—you develop senses you didn’t know you had, and you tune in to the littlest sounds and rhythms. But there is no way to turn it off, no pause button, especially on long passages (our longest, the Mexico to Marquesas leg, was 22 days of open water). In short, you’re “all-in” and “always-on.”

Running a startup is much the same—all consuming. I’ve never known a successful founding team who ran their startup as a 9-5 job. They take it home, they take it on vacation (if they get one), they live and breathe it 24/7/365. As in sailing, this takes some serious adjustment, but you soon get used to it, or you head home.

The key for both sailors and startup founders is to find an optimal pace and rhythm, a measured trot that can be maintained without burnout or exhaustion. Further, it’s critical to conserve energy, and not waste effort on unnecessary or trivial concerns. To mix up a few metaphors here, both sailing and entrepreneurship are best viewed as a marathon, not a sprint. By accepting that you’re in it for the duration, your daily rhythm and attitude will adjust to meet the challenge.

The Only Constant Is Change

For sailors, the most dangerous moments generally occur not on the open ocean, but rather, when sailing along a coast or when entering a bay or atoll. Sailing near land means there are things you can hit-- rocks, shoals, reefs, and sometimes even whales. Sometimes you find yourself caught in a situation where wind and currents are working against you, and it takes all your effort to simply stay in place, with no forward progress. It's like running on a treadmill. But as frustrating as it can be, staying in place also means you are not sliding backward, and being pushed onto a lee shore (a common cause of shipwrecks).

It is during these moments that we take comfort in knowing that even the worst weather conditions will, eventually, change. Tidal flows reverse direction at least once per day, and storms always pass. The lesson here is that when things are bad, keep plowing ahead—survive to fight again another day—conditions will improve. Likewise, when things are good, enjoy it, because again, the only constant is change-- eventually, another storm will form. Hopefully the metaphor for both thriving and struggling startups is obvious.

…to be continued (as I mentioned it was a long journey!)

Setting And Shaping A Strong Startup Culture

Of all the determinants of a startup's success, company culture reigns supreme.

Over the past several years, I've had meaningful interactions-- meetings, calls, etc.-- with perhaps 700-800 early stage startups. From that broad pool, I have worked closely with about 100 firms, on a variety of business plan, business development, and fund-raising projects.

In short, I have been exposed to a 'statistically significant' number of companies, over a long-enough time-frame, to be able to discern certain patterns-- among them, which traits lead to failure, and which lead to success.

The short answer to what I've found?

A handful of factors-- all internal to the startup-- are the best predictors of whether a company will make it big, or crash and burn.

Not the amount of funding raised, and not the vertical in which the company operates. It almost always comes down to how the startup operates, day in and day out.  In other words, it all comes down to startup culture. In more detail: 

Culture of Speed
The first indicator of a company's success is the speed at which the founding team operates. The reason is simple: startups have the benefit of being fast and nimble; remove these traits and you remove a huge competitive advantage. Large firms have greater resources-e.g., more access to talent and capital-but are weighed down by sluggish decision-making and bureaucracy. Startups, by nature of their lean structure, can adjust rapidly and can often "win" by innovating and responding to customer needs faster.

Slow startups on the fail-track operate at a pace resembling their big-company peers (sometimes due to too much big-company DNA on the resumes of management). They take a long time to make decisions, are slow to respond to inquiries, and hold too many non-essential meetings. In short, slow startups lack a culture of urgency. A key fail-track warning sign: frequent excuses of why something hasn't been done yet or can't be done (and a cultural acceptance of such excuses).

In contrast, fast startups seize opportunities immediately as they arise-even if it means responding to an email at 10 PM or working through a long weekend to deliver on a customer request. They have a cadence of work that emphasizes frequent product releases, short meetings, shared accountability for hitting milestones, and rapid decision-making (even without all available information).

Further, they create their own opportunities by paddling out in anticipation of where the next wave will be, and by trying new things. They realize it's ok when experiments fail, because being nimble means they can bounce back and try again. Simply put, fast startups value time differently, and have a culture marked by rapid plan-test-refine cycles; this is at the core of any startup's advantage.

Culture of "Launch Early, Launch Often"
One of the most dispiriting experiences is when a company never actually gets to market; or, by the time the company finally does launch, the market has passed them by and their product is irrelevant. In such cases, a huge amount of money and talent is often wasted, unnecessarily.

Sometimes this is due to poor planning-e.g., underestimating the time required for product development. But in many cases, startup founders get obsessed with building the "perfect mousetrap," fearing the market or press will skewer them if the product is not up to their impossibly high standards. This becomes exacerbated in a competitive space, when other firms are making noise, and product release paralysis sets in.

In my experience, this is largely a psychological issue; wise founders "let go" and realize that Version 1.0 is just the beginning, not the finish line. Success-track founders get to market early with the minimum set of viable features, and then iterate like mad based on user feedback. If needed, they slap a "Beta" stamp on the product, which brings a greater level of acceptance of bugs or rough edges. In short, they are guided by the knowledge that the benefits of reaching perfection far outweigh the costs of missing a market window.

Culture of Promoters
Second only to the dismay felt when a startup idea becomes stillborn is when the company actually does get into the market, but after initial launch, the product languishes, collects dust, and is soon forgotten. Opportunity lost.

This is most common with startup founding teams that are heavy on the technical prowess but short on marketing skills. Technical teams sometimes underestimate the true level of effort required to not only get attention and mindshare, but also to convert such attention into actual, paying customers. It is the classic "build it and they will come" fallacy.

The good news is that even highly technical engineers can become skilled at marketing fairly quickly. Technical founders- the builders- have a pride and passion for the product that cannot be taught. Further they have more credibility with other techies, who are often the earliest adopters or beta users. The key is to first gain a basic grasp of marketing strategy- where do your customers spend their time? How do they make buying decisions?- and then to develop a simple, flexible marketing plan with discrete action steps, timelines, and milestones, as well as a way to measure effectiveness. 

And then, just do it. Get out there and pitch, honing your message as you go, and doubling down on the marketing activities that demonstrate a positive ROI. If you are able to simultaneously pitch and listen attentively, it's remarkable how short the learning curve can be. 

We're going to pick up the pace here and cover a few more in short order:

Culture of Focus
Fail-track startups try to "boil the ocean" and compete on the depth and breadth of their product feature set. This is a losing proposition from the start; startups are, by definition, resource-constrained. Most startups that go down this path run out of money. By comparison, success-track startups strip out all non-essential bells and whistles. They focus with a laser-like intensity on the most pressing needs of the most attainable customer base, while retaining the vision for broader markets and verticals as resources allows. They do just one or two things, but they do them exceedingly well.

Culture of Confidence
Fail-track startups are unnaturally cautious-- often bordering on paranoid. They are convinced that around every corner, someone is plotting to steal their idea. As a result, their ‘story' is kept close to the vest. An early fail-track indicator is when the CEO requires an NDA before he can give even a high level overview of what the company does. In every single instance in which I've seen this behavior, the companies never go anywhere.

While you should never give away true IP or trade secrets, a primary job duty of the CEO is to pitch and sell the vision of the company-all day, all the time, to (almost) anyone who will listen. Success-track startups realize that execution- not the idea- will win the game. They are judiciously open with their vision, and they have an evangelizing ability to get stakeholders such as customers, partners, investors, and potential hires to rally around that vision.

Culture of Action
Similar to the "culture of slow" is the "culture of theoretical." Fail-track startups tend to devote too much time to theorizing and hypothesizing, and not enough time doing. They defer decisions to wait for more information, and they spend a lot of time in meetings and at off-sites. Granted, brainstorming and forming a cohesive strategy is necessary, valuable, and important, but unless it leads to action and output, it is wasted time- something no startup has the luxury of. Success-track startups follow the "iceberg model": for every bit of ice visible above water (strategy), there is a huge amount of supporting ice floating underneath (action). Post Script: Fred Wilson of Union Square Ventures wrote a great blog post on this topic called "Action Oriented."

Connecting The Dots (aka, You Want to Be "Playing for the Yankees")
The factors described above have proven to be the most common determinants of success and failure at the several hundred companies I've interacted with over the years. To reiterate, they are all internal traits of an organization-- traits that can be embedded, infused, or hired into a firm.

Granted, external factors will always play a role in determining a company's outcome; markets shift and funding environments change. But teams with strong cultures are flexible and can adapt. As a result, strong teams will view tough markets as opportunities to pull ahead of the competition.  After all, the startup ecosystem-- especially in an emerging, crowded, and rapidly growing market-- is the purest business example of Darwin's 'survival of the fittest' theory in a business context. In short, strong startups operate with the confidence that they will come out ahead when the dust settles. 

Bringing It Home: Hiring Smart
Having identified that success is tied to stong cultures, the question then becomes, "how do you ingrain a winning culture into your startup?" The answer is disciplined hiring.

A generally accepted maxim is that a company's culture or DNA is set by the time it hires its fifth or sixth employee. Fail-track startups hire based on who's cheap or available. As a result, they hire B-players. Success-track startups maintain a greater level of hiring discipline, and "hire smart," holding out for A-players. The effects are magnified as the business scales, since A-players attract other A-players, while B-players (who are less capable or confident in their roles) tend to attract other B- or C-players. (For more on what constitutes an A-player, click here.)

Hiring smart has many other elements to it, such as the aforementioned culture of speed-i.e.., can each new hire keep up? If not, they should be weeded out before they slow down the overall average pace of the tribe. Success-track founders also know to hire people more intelligent than themselves and to give them free rein to run with the ball. Ultimately, this helps the founding CEO retain his or her job; shifting responsibility to an A-team means the CEO can spend more time on strategic issues and less time on micromanagement.

How strong is your startup's culture? What can you do to improve it?

Financial Modeling for Startups-- How Much Will It Really Cost?

I came across this blog entry from Christine Herron of First Round Capital detailing the costs of starting web wunderkind Mint.com (acquired by Intuit for a handsome $170M).

Christine does a great job of breaking out Mint's costs by "Garage Phase," "Seed Round" and "Series A," showing the cost structure of building the company at each step. 

We build about 10-15 startup financial models per year, and this post is right on the money (pun intended). The key element is in the thinking that goes into the model-- building out solid model logic and assumptions-- since everyone knows reality will be far different than the pro-forma.As Christine puts it:

"Know how the business model works. People do X behavior and it turns into $Y income, add up those $Ys and it's a $Z business. If you can walk people through these assumptions convincingly, you'll get that seed round. "

and she continues:

"What model do you build next in order to raise the Series A? Testing and learning from your seed model, show user growth, retention, COGS, revenue per sale/user, and profit. The accumulated loss is how much you need to raise, and a well-though funding strategy combined with an understanding of (hopefully good) business economics is what will speed the Series A process along."

An interesting side note from a post on WSJ blog Venture Capital Dispatch is that Mint raised about $32 million from investors but only used about $12 million of that capital.

Naturally, it makes me wonder if founder Aaron Patzer now wishes he had raised a series of smaller rounds and retained more of his equity. But of course, this type of Monday-morning quarterbacking is easy to do with post-acquisition hindsight, and in this market most startups are wise to raise as much as they can, when they can.

Either way, it's an impressive success story and a good archetype to follow.

Positioning for a Startup Market Turnaround

It was around this time last year-- Summer of 2008 to be precise-- that a rash of VC firms and angel investors such as Ron Conway and Benchmark Capital issued highly publicized decrees to their portfolio companies to bunker down, cut costs, and prepare for a deep fund-raising freeze.

Now there are signs that things may be (slowly) starting to turn around. I've had a couple lunches with attorneys this week which were illuminating. I would posit that startup lawyers are the 'canaries in the coal mine'-- they work on deals well before the deals are publicly announced. So these data points, while not statistically significant, were nonetheless encouraging.

During a meal of excellent Osha Thai food in SF, one boutique attorney stated that he has worked on something like 25 early stage financings this summer, mostly involving web startups and angels or 'super angels' (i.e., folks with small seed funds like the aforementioned Ron Conway).

Indeed, angels have picked up the slack in the early stage funding market, as evidenced by an Under The Radar Strategy Series conference I attended in September. This 'fireside chat' was led by Rob Hayes of First Round Capital, Jeff Clavier of Softtech VC, and Aydin Senkut of Felicis Ventures, all of whom have been very active investors as of late. To wit: Hayes had six investments in the last quarter, Senkut had five with three follow-ons, and Clavier stated he had put down two term sheets that very day.

The other attorney I brunched with this week works in Silicon Valley at a large law firm. He stated that he has recently worked on several deals where large VC firms were making seed investments. This is unusual-- large venture firms, who are investing from funds that often top $200M or greater, generally seek to put substantial amounts of capital to work in each deal-- typically a minimum of $4 or $5M and up-- due simply to the fact that any given partner can effectively serve on only so many boards at once.

The attorney's thesis is that the large VCs are making such small bets to secure an 'option' to invest later-- basically, using the $500k or $1M seed round to guarantee a seat at the table for a future larger round, when things pick up again. (Indeed, there is some corroborating buzz around this trend; see this post, "Seed is the new Series A for VCs.") The sentiment he picked up was that follow-on rounds would start happening in Q4 of this year or Q1 of 2010.

It's certainly encouraging, as things have been fairly tepid for all but the hottest web and social gaming startups. August was among the slowest months we've had here at VentureArchetypes since 2002, when the funding market hit bottom in the last recession.

But these things always go in cycles, and we have been taking advantage of the downtime between clients to lay the foundation for the next upswing. It's actually rather nice to have some time to take care of all that is neglected when we're going 100 MPH-- website updates, marketing materials, etc.-- as well as the network. It is a luxury to have the time to reach out and catch up with contacts-- after all, this is a relationship-driven business.

We have also been laying the groundwork for a new service line, which we will debut shortly. It is called StartupPartnerships, and the focus will be on offering outsourced business development consulting to technology startups. It is a service we have been doing semi-formally with clients for many years, so it is a natural spin-off of our business plan and venture strategy work.

You can get a sneak peak at this new direction here: www.StartupPartnerships.com -- please let me know what you think, and how we can make the service as valuable as it can be to startups.

And finally--to end on a positive note-- I leave you with two more links showing encouraging signs regarding the startup market: Mark Suster's post on "The Big VC Thaw" and Bob Ackerman's post on how "M&A and IPOs are Restarting the Innovation Flywheel."

This may, in fact, be the best time to pursue your vision and finally launch that startup idea -- carpe diem!

The Care and Feeding of Advisory Boards

A recent post on Vator.TV got me thinking about advisory boards. This is an often-overlooked, under-utilized, or completely neglected strategy for early stage startups.

But it needn’t be so; setting up an advisory board can bring benefits well beyond the cost (in terms of time and equity) required. A brief primer:

Why, When and Who

To begin with, let's start with a basic question: why bother? In short, because a good advisory board can help open doors, keep you on track, and avoid common company-killing mistakes. An advisor's role can take any form, but the most common duties are to provide guidance, introductions, and feedback. They help you think through difficult decisions, and act as a sounding board for company strategy and positioning. Ideally, they tap their network and provide leads for funding sources, early customers or partners, and key hires.

Advisory boards have the most relevance and bring the most 'bang for the buck' for startups that are very early stage—generally, when the company is just 2-3 founders, pre-launch or recently-launched, and trying to gain initial market share and/or raise money. They are particularly useful for first-time entrepreneurs or for founding teams lacking a substantial amount of domain experience in the market.

After the first round or two of funding, an advisory board can still be quite helpful, but by that point there are usually enough people around the table—new senior-level hires, investors, etc.—that talent gaps are mostly filled. Indeed, many startups find that the usefulness of their original advisory board is diminished once they have a complete team and a formal Board of Directors, and contract terms are structured to reflect this (more on this topic later).

In a typical situation, a startup will put together a group of 3-5 people to turn to for counsel. Ideally, this group has diverse yet relevant experience; they will be local (within driving distance for meetings); and, they will have all run or grown young companies before-- but each will bring a different, non-overlapping skill set.

Sample Scenario

As a hypothetical example, let's say your startup is developing a SaaS-based system for managing inventory at independently-owned pet shops. Your founding team is made up of two developers and one person acting as manager/marketer/visionary. The product is nearing beta release and has half a dozen potential customers in the pipeline.

To complement this founder group, an advisory "dream team" might include a former product manager from Netsuite or Salesforce or even SAP, maybe a marketing VP or CFO from Petco, and one or two folks who have started and exited software businesses. To throw an extra bit of flavor to the mix, it might also include a co-founder from Web 1.0 flameout Pets.com.

In this scenario, the product manager advises on development and feature sets for the initial release. The marketing VP advises on channel strategy, while the CFO helps introduce some structure and process around the billing and cash flow cycle. The ex-software entrepreneurs advise on all of the above, and also make introductions to potential investors. Finally, the Pets.com veteran brings domain expertise and helps the young firm navigate around pitfalls (learning from those who tried and failed can be just as valuable as learning from those who’ve succeeded).

Recruiting Advisors

There is no real trick to recruiting advisors-- you simply ask them. Most people are flattered by the request and by the lure of being associated with a new successful company. It's a soft sell, and taps the ego-drive for recognition as an expert. More challenging is finding and screening the right ones.

Finding them is a function of first identifying your needs--deep introspection required-- based on where your founding team is weak, or by what near-term goals you are aiming to accomplish. Next comes scouring your existing network and the open web to find the right folks. Social networks like LinkedIn can be invaluable here, but don’t neglect using Google. Searching on phrases like "former VP of Operations at Google" may turn up articles or interviews with a potential target candidate.

After working your network for an intro (or if necessary, searching online for their email address), a simple introductory note stating what you do and that you're seeking to build an advisory board is usually enough to get the conversation rolling. Include a link or two if you have a beta site or demo up.

Screening and Filtering

Screening the candidate pool, however, takes a bit more effort. I would advise you to filter based on their overall level of interest in your concept and their willingness to actively participate. You want people who are genuinely motivated to help your business—free riders need not apply.

A good way to evaluate this is by how quickly they respond to your emails or phone calls. Many times, an advisor's greatest value comes during a critical moment-- "should we accept this term sheet or keep hunting?" or, "we have a national chain interested in purchasing our software, but they want steep discounts--what do we do?" You don't want to be waiting a week for an advisor's input.

Another criteria, of course, is whether they are willing to get materially involved for the level of compensation you are proposing (more on this later). It makes no sense to overpay and incur unnecessary dilution to your company's equity—there are plenty of fish in the sea. Also avoid those who are well-known, but who are likely to be "advisors" in name only. These types seek to benefit from the startup’s success without actually contributing to it. While their implied endorsement may look good on your investor pitch deck, it's usually not worth the cost in equity to the company.

Care and Feeding of Advisors

Once you've built your rock-star advisory board, what do you do with them? The short answer is: use them as much as you can-- but not more than you agree to. Keep in mind that advisors are not employees; their role is generally to provide introductions and guidance on product and company strategy. They may endorse and/or evangelize your company-- but their role stops short of actively marketing your company. In other words, you should not expect them to do the 'heavy lifting' of building your business, nor be responsible for routine operating tasks.

The best way to manage advisors-- and get the most out of them-- is to invest upfront whatever time is required to accurately set expectations. A 'reasonable' scope for an advisor role might be something like the following: i) 6 month duration, with option for extension; ii) primary responsibility is to introduce the company to 8-10 relevant investors; iii) secondary responsibility is to participate in monthly strategy meetings with the rest of the advisory board; iv) tertiary responsibility is to advise on key decisions or product input via periodic conference calls or emails.

Work It Into Your Company DNA

Curiously, despite all the effort expended to build a great advisory team, one of the more common mistakes startups make is to under-utilize their advisory board. This is rarely intentional—running your business sucks up all your available time and capacity, and trying to "herd cats" (while respectfully wrangling in only their best feedback or ideas) can feel like a distraction.

To help keep this valuable resource from falling by the wayside, I suggest, at a minimum, having a standing quarterly or monthly meeting—say, the third Thursday of each month—for the duration of the advisors’ contracts. This helps keep your company in the forefront of their minds, and it also introduces an element of “communication discipline” for the founders—in other words, knowing you have a meeting coming up will force you to review your progress over the previous month, identify things you need help with, and set new goals going forward. This is also good training for the day when you’ll have a formal Board of Directors to report to.

Advisor Compensation

So, having built a great advisory team and having charted out a realistic gameplan with each, how do you compensate them? This is more art than science, and the real answer is "it depends"-- on their level of involvement, the reach and relevance of their network, and yes, on their name brand. But I dislike fuzzy answers, so let's try to pencil in some guidelines.

I posed this question recently to my good friend and colleague Diana Benedikt who runs Venture Insight Advisors. Diana and I have worked together on numerous startups over the last ten years, and I respect her opinion. Her take, based on many years of experience as both advisor and consultant, is that a reasonable range is 0.25% to 0.5% of the company’s total equity (though up to 1% is not unheard of) for approximately 4-8 hours of involvement a month.

This corroborates with others' views on the subject; most published ranges are between 0.25% and 1.5% per advisor, or 1% to 4% for the total advisory board. Amounts may vary—you don’t need to give everyone identical stakes—but you do need to codify each arrangement in a simple contract, detailing their roles and tasks, the duration of their involvement, and a vesting schedule (generally, monthly over the term of their contract).

Non-Equity Issues

Other items to include are an out-clause (where either party can terminate the contract with written notice, usually 30 days) and the type of currency to compensate their efforts (generally, restricted stock, which has tax benefits for the advisor). To note, not all advisors demand equity—sometimes a few nice lunches, repayment for any expenses incurred, and some heartfelt gratitude and recognition will suffice.

Diana also notes that from the advisor's perspective, the challenge is in holding down the amount of work he or she will end up putting in. Although ideally, if you have done the upfront work of carefully selecting and screening who you bring in, your advisors will be emotionally invested in the business, and will work beyond the contracted level—simply because of passion for the idea. (Indeed, many advisors even take it a step further and invest in the seed round.)

Hybrids and Other Animals

Alternative approaches to a standard 6- or 12-month advisory role are many, and include contracts that are structured around specific deliverables or results. For example, here at VentureArchetypes, we tend to initially engage with a startup around a finite task—developing a business plan, financial model, partnership proposal or pitch deck. Then, following this “dating period” where we get to know the company (and vice versa), the relationship evolves into either a traditional advisory role as described above, or into an interim operating role.

Structuring it in this manner helps avoid the ambiguity that can sometimes accompany the role of "advisor" since compensation is directly tied to specific actions/results. It also affords greater flexibility in terms of the currency used for remuneration. For example, while we typically require a cash retainer for document deliverables, deferred compensation is sometimes used for interim CFO or business development work, and equity can be in the form of options or warrants.

Interim Roles

This type of interim operating role is like a bridge between bringing on advisors (devoting 1-4 hours per week) and full time staff (devoting 40-60 hours per week). The advantage for startups is that it moves headcount expense to more of a variable cost that can be dialed up or down depending on need—for example, a company may need additional, temporary support around a deal or transaction. Conceptually, it is similar to using an outsourced IT development shop, and thus it is a structure that many startups are already familiar with.

Regardless of the specific structure, the aim with any deal should be to align the interests of all parties in the direction of a common goal, and remove any ambiguity about what constitutes reaching that goal. It should also pass the gut-test of being ‘fair and reasonable’—or, at a minimum, both parties should wince equally at the pain.

Remember the Fun

A final piece of advice-- one that echoes the Vator.tv article that originally inspired this post-- is to make the process of being an advisor fun. Be appreciative of their efforts. Make sure they have ample opportunity to socialize with the other advisors on the team. Hold your monthly or quarterly meetings at a restaurant or bar. Take them sailing or to a ball game. One of the companies we worked with sent us on a winery tour, and then sent us bottles of wine periodically-- it was a great gesture.

In short, most advisors are motivated more by being in the startup game than they are by the potential of financial gain. Recognizing their help, and keeping them involved and informed beyond the duration of their tenure will pay exponential returns over time.