Who needs risk capital anyway?

The Pittsburgh Business Times ran an interview this past Friday featuring Kit Needham (subscription required), a former colleague at the Allegheny Conference who is now: running her own consulting firm; working as a senior advisor at CMU’s Project Olympus (described as “bridging the gap between cutting-edge university research/innovation and economy-promoting commercialization for the benefit of our communities”); and serving as educational coordinator for Blue Tree Allied Angels, a network of local angel investors. There is no doubt that she has dedicated countless hours to the entrepreneurial community over the years.

In the article, she discusses her own investment strategy, which seems to be directly at odds with her advocacy for early-stage businesses. To quote Ms. Needham:

“It’s so hard to pick the winners and what I’ve learned is, I can’t pick winners,” said Needham, who also runs her own firm, Needham Consulting, and has worked for the Allegheny Conference on Community Development and what is now BNY Mellon.

“I learned I just didn’t have the time or, really, the commitment to spend the time to do a good job of this,” she said. “I am not keen on relatively illiquid investments.” (Emphasis mine.)

The article goes on to explain how she came to her investment strategy, which she described as a “proven sets of rules to build and preserve client’s wealth.” She broadly outlines her methods and the success she’s had (roughly 4% five-year return vs. S&P’s 0.99%).

For the record, I don’t fault anyone for a low-risk investment strategy that relies on mutual funds and stocks. Everyone has a different risk tolerance, which should be taken into account when pulling together a wealth-building strategy. Diversification is great. We should all aspire to structure our investments in a way that minimizes losses.

BUT, isn’t it concerning that someone so deeply entrenched in the entrepreneurial community can’t find space in her portfolio to directly invest in a local start-up? Sure, I could see where she might be reluctant to invest because of a potential conflict of interest, e.g. there’s an opportunity for personal profit if she provides advice relating to a company in which she’s invested. However, it seems counter-intuitive that someone who’s so directly involved in commercializing technology and guiding the funding of risky ventures admits that she can’t pick winners and isn’t keen on illiquid investments.

The oft-heard complaint in Pittsburgh is that we don’t have enough risk capital. I’ve heard great arguments from the various sides — some believe that VCs and angel investors are too risk-averse and let good companies flounder, others think there aren’t enough good deals worth funding, still others think that there’s plenty of risk capital in the region. Regardless of where you stand on the issue, can entrepreneurs get a fair hearing when someone who can’t handle the risk of a start-up is advising critical early-stage-oriented organizations? Finally, why would she publicly admit that she’s uninterested in risky ventures given her role?

I perceive that getting funded in Pittsburgh can be a challenge. While I’ve had the chance to help successfully pitch to an angel investor, our funding came from a close contact of one of the company’s founders who isn’t involved in the local angel community. As a result, we were fortunate to bypass the standard pitch-your-ass-off process that most start-up companies have to endure. Perhaps I’m over-reacting to a one-off PBT article, but if the folks influencing investment into our regional start-up companies can’t bring themselves to invest in these companies, then I can’t see how the money tree is going to be shake loose new money any time soon.

As someone who has worked on a project that got an Angel round (and some subsequent cash infusions), I can understand the difficulty in finding that money and, as a result, I’m a bit biased. Looking at the landscape, I believe that there are some very intriguing companies/technologies coming out of our colleges, universities and innovative entrepreneurs, and that should be supported. Obviously, I’m not alone — the Pennsylvania government and local foundations infuse local organizations with capital that is then extended to these companies. However, when those companies have grown out of the alpha stage and to a point where they’re ready to start beta testing in real-world environments, are they the quality deals that attract VC investment? Is Pittsburgh’s risk tolerance unusually low?

My guess is that our VC community isn’t much unlike others around the country. I’d also guess that Pittsburgh has similar state-level resources to other areas and, perhaps a little more. What I don’t think we have is an ecosystem — a critical mass of successful entrepreneurs that have cashed out for several million and immediately feel the responsibility to return the favor to other hungry entrepreneurs.  The cities most often cited as models for the ecosystem — Silicon Valley, Boston, etc. — have earned that reputation honestly, but have taken decades to build that ecosystem. As one local VC said to me, “they weren’t built overnight, and we won’t be either.”

But, I think we’re getting there. There is a lot of energy in this community and, I suspect, additional resources will be devoted to not only supporting these companies, but helping to create that ecosystem that is critically important. I also believe that we need to do a little marketing to the outside world, showing off some of the companies that are making a difference. Would engaging other cities’ communities help facilitate some cash inflow by introducing their financiers to our companies? Would connecting with the diaspora help us to bring some of that money back to Pittsburgh? I think it would.

In the end, almost any money is good money, no matter where it comes from. Would I like to see more low-level risk capital? Of course. But, until we have a critical mass that can support some of these good-to-very-good deals (as opposed to great deals), we’re going to struggle to fund these companies. Should the state take a more active role? How do we get this done in a down economy? And, what are the best way to keep these companies fed in the meantime?

However, this is only part of the story. If you look at the PricewaterhouseCoopers (my spell check believes this word should be ‘slaughterhouses’, by the way) MoneyTree report (the source of the VC funding data point), you’ll find that a lot of critical investment money isn’t included in their research, including angel investment (see the criteria summary here). Obviously, the report is invaluable in allowing us to track what kind of investment activity is happening across the country, but I feel like there are some gaping holes in really being able to assess how much entrepreneurial funding activity is happening in a given area.

I suppose this is because it is very difficult to track this type of investment. For instance, a business plan project on which I worked will likely be funded within the next three weeks at about $50,000 (obviously a very early-stage investment). The individuals involved aren’t what I would consider part of the “entrepreneurial community” in the region, so no one will know about it. This also goes for another project on which I worked, which secured $500,000 in its first round; there were no trumpets sounded or press releases written, yet the company opened the offices in the heart of Pittsburgh with six new jobs within city limits.

Is the nature of angel investment such that tracking it just doesn’t work? Are angels usually uncomfortable having their investments publicly discussed? Or do many people in the realm simply not care about having this type of investment counted? While there are good arguments to be made that Pittsburgh needs more risk capital than it has available, I believe the picture has to be better than even what the PWC report says.

So, how do we keep better track of this information? How do we make it easier to brag about Pittsburgh’s entrepreneurial community?

I’m not a finance wizard, but I’ve pulled several pro forma financials together for various businesses. The long and short of it is, every investor/bank wants to see the same stuff — sales, cost of goods sold, expenses, net profit, etc. It’s not altogether difficult, but the process can be very intimidating.

I have some things that I’ve followed along the way below the fold . However, to get you started, I’ve developed a starter template that I’ve used on several projects (albeit with some significant edits) that you’re free to download (FinancialsTemplate.xls – 118kb). This should help get you started, but realize that it’s only a template and I don’t take responsibility for your final version.

Thoughts and tips are below the fold…

First, pulling together a beginning pro forma is absolutely essential. From a business standpoint, it helps you to figure out whether or not your product idea is viable in the first place. From an investor standpoint, it helps to get a general idea of what the business opportunity is. I’ve seen many entrepreneurs go years before doing rudimentary calculations like this (needless to say, it wasn’t until they took this step that any Angel/VC took them seriously). This is not to say that these projections can take the place of something a CPA can pull together (In Pittsburgh, my personal favorite is Wilke & Associates in Carnegie, who I’ve used several times), but it makes sense to hold off on spending the money until you have a better idea of where your business stands or when a serious investment prospect asks to take this step.

Second, your pro forma projections will constantly change as you get a better idea of costs and revenue potential. It’s not unusual to game out several scenarios with multiple changes given certain factors. The best way to save time is to create an assumptions page where you place most of your data. That way, if you’re changing your numbers, you can adjust them in one cell on one sheet, and the rest of the sheets will automatically update with your new information.

Third, I suggest linear cost structuring (i.e. pick one number and stick with it). In one business plan I saw, an entrepreneur created a rather complicated cost of sale function that curved downward. When I saw this, I asked the entrepreneur if she had perfect foresight to determine what the beginning marketing costs would be, on which the curve was based. She responded that she did not and, in fact, the number was pretty much out of thin air. She changed her projections to something far simpler, which in turn led to fewer questions from her potential financiers.

Finally, do some serious market research before you create a pricing model. While this is good advice in general, a bad  pricing model (Chris Dixon speaks very well to cost/pricing here) can make your top-line revenue unnecessarily low, which will make your business less attractive.

Good luck with your projections and feel free to ask questions or let me know if there are errors in the sheet.

Storytelling is, at the most fundamental level, the way we humans have communicated for as long as we’ve been able to speak. It is absolutely critical to our ability to exchange information, establish social norms, build rapport and make an impression. As social creatures with limited time and attention, a story can easily summarize information in an understandable, digestible way.

This particularly hit home with me when attending the recent Three Rivers Venture Fair Boot Camp, a tune-up of sorts for entrepreneurs that will be making nine-minute pitches to venture capitalists and angel investors. I was fortunate to be able to watch four different presenters go through their slide decks, and, as a panelist, help to provide feedback. Each company targeted completely different markets (i.e. social media, security, manufacturing and space exploration) but presented in very different ways.

The first three presenters were able to articulate, more or less, the value proposition of their product or service. They could describe features and functionality, identify their key team members, explain their marketing and sales plan and demonstrate the depth of knowledge needed to lead a start-up company. However, while each company had an interesting product, the presenters had challenges being able to spark the “aha!” moment that investors need to take the next step.

I found myself suggesting adding a story to each presentation. I kept saying, “if you can put someone in the shoes of a purchaser, they will more easily see the value proposition of the product.” My fellow panelists seemed to agree.

The final presenter nailed it. He as able to articulate in about 45 seconds how his security product would be used in the marketplace. He very quickly was able to speak to the challenges faced in this market niche and how his product would make people safer. It was storytelling at its finest.

When pulling together a presentation to potential investors, educate them by telling a story of the average user. Put a human face on the product or service you offer and use that story to demonstrate that there’s a large enough market for you to earn the type of returns necessary for an investor to be interested. While a particular technology might be interesting, cutting-edge, innovative or game-changing, it won’t matter if you can’t make someone feel the pain that will compel a prospect to become a customer.