RWI Group: Entrepreneurs FAQs #12

In writing a business plan and negotiating with venture capital firms, many first-time entrepreneurs have misconceptions which may prevent receipt of venture capital funding. Here are a few examples of such misconceptions.

Failure to "explain the pain"
Many new companies, especially in the business-to-business arena, provide meaningful solutions to business problems which may not be clear to those not in that specific market segment. For this reason, it is essential that business plans describe the pain felt by potential customers or users and how a company’s products or services reduce or eliminate that pain. Many business plans gloss over the actual need for their product or service and just assume that customers will line up for a company’s product simply because it exists. Having a referenceable customer who can attest to the value of a company’s product will help readers to "get it".

Failure to describe or acknowledge existing or potential competition
Many entrepreneurs cite that because they are offering a new product or service, no competition exists. Other entrepreneurs are worried about their ability to receive funding if they candidly describe competition. Nothing could be further from the truth. No quality venture capital firm will invest in a company without understanding and evaluating all competitive issues. Most venture firms will appreciate a detailed assessment of existing and potential competition because it demonstrates that the entrepreneurs truly understand their business. Venture capitalists are used to taking risks on upstart companies which face competition, provided the companies have advantages which distinguish them from competitors.

Excessive focus on price and dilution
Valuation by venture capitalists may differ somewhat from firm to firm (especially in first-round financings), but usually not by an order of magnitude. Relationships between entrepreneurs and their venture capital firms last many years, so good venture capital firms recognize the need to balance achieving returns on their investments with ensuring that founders have strong incentives to devote themselves to their companies’ success. Entrepreneurs behind leading companies view venture capitalists as offering far more than mere money. For these reasons, venture capitalists discourage entrepreneurs from "shopping" their deals at many different firms solely to gain small increases in valuation. One common way to prevent excess dilution is to limit the size of the first round of financing. Once certain milestones are met, another round of funding can be raised at a higher valuation (and thereby with less dilution to the founders).

Unreasonable financial assumptions
While forecasting financials is by definition uncertain, entrepreneurs should take care to ensure that projections are based on reasonable assumptions. These assumptions should be stated clearly. Where possible, independent confirmation of various assumptions should be provided. In defining market size, entrepreneurs should focus on the Total Available Market (TAM), rather than some overly broad market size definition. The TAM represents the total annual revenue available to the company were it able to execute its plan perfectly, become a de facto standard and not face competition. This may still be a fraction of the size of the industry or industries in which the company competes. The company’s revenue forecasts should use TAM as a sanity check in assessing their projections. Are the market share projections reasonable given the likelihood of competition? On the expense side, entrepreneurs should be familiar with costs and margins typical for companies in their industries. Look at the margins of the most successful technology companies in your business. Are you projecting better margins than leading players? Many projections show dramatic growth in revenues without a corresponding increase in costs.