The traditional way that we fund startups is broken.
I know what I’m talking about. My own startup failed in the early 2000s, though it was just a minor failure. I blew away “only” 1 million euros of investors’ money on a business model that never really worked. When the dot-com bubble burst, my startup’s demise was nothing more than a dog’s fart in an imploding galaxy.
With perfect hindsight, I know what we did wrong. Our business model was unsustainable, but we had no talent for switching to another. We could have benefitted from the Lean Startup method: iterate with small production cycles, validate with paying customers, and pivot when things don’t work. We might have changed direction faster. But I think the Lean Startup approach only addresses half of the challenges of entrepreneurs. The other half could be dealt with using Lean Funding.
When bootstrapping (self-funding) and crowdsourcing are not valid options, entrepreneurs usually turn to angel investors for seed capital. To obtain this capital, entrepreneurs engage in an elaborate courtship ritual with potential investors. In return for the investment, the angel investor gets equity ownership. The great challenge is: how much capital for how much equity?
Because there is often no inventory and there are hardly any sales, it is common to guess potential sales of the new company so that investors can calculate the current “value” of the business. Here, the entrepreneurs have reason the exaggerate the potential of their fledgling business to epic proportions, drawing hockey stick diagrams of fabulous “projected revenues” that are even larger than their egos.
I did that too, many years ago. I even won a business plan contest with it. With traditional seed investments, optimistically “predicting” the future is rewarded because if you’re not a naive optimist, you won’t get any money. Now I realize that my business plan and its impressive diagrams should have been classified as a work of fantasy, with lovingly crafted fantasy art.
As we have learned in the Agile community, there is little value in trying to predict the future. Startups should learn to embrace change instead of following a plan.
The mating ritual of entrepreneurs and investors is interesting to watch, but I consider it a complete waste of everyone’s time. Elevator pitches, business plans, six months of networking and negotiating… Yes, entrepreneurs should spend their time selling, but to customers not to investors. However, because a “seed round” is only done once or twice, there is a lot at stake. And both parties waste a significant amount of time finding the “right” balance of capital and equity.
I remember having endless discussions with my investors, trying to convince them that, no really, my ideas were thoughts of pure gold, and they just needed to sign on the dotted line.
The whole process is suspiciously similar to getting agreement over a requirements study with a large customer. Because both parties want to go through this ordeal only once, it only makes the process more complicated and more agonizing. After the signature on the deal, there is no way back!
The Agile Manifesto teaches us that customer collaboration is more important than contract negotiation. Every minute you spend talking with investors about imagined customers is one minute not spent collaborating with real clients.
I still have the legal documents of my failed startup, with all its impressive signatures. These papers not only cost me a lot of time and effort to obtain, but they were also expensive to produce. My God! The legal fees that financial and legal “experts” charged me were insane. And did they deliver any value? Not really. The papers went into a drawer, and they never came out. If I had used that money to get ourselves a room full of massage chairs, it wouldn’t have made any practical difference to our performance. Except, my startup would have collapsed more comfortably.
It would have been nice if we had a product that was being used, and paid for, by a customer. After all, as agilists, we have learned that working products are more important than comprehensive documentation. I’m not saying that you can simply run a business without any documents. But the effort and costs that went into producing legalese could have been better spent on finding customers first.
The more you have, the less it’s worth. When you only have a small amount of money to pay your bills, that money will be worth a lot to you. But when you have so much money that it doesn’t even fit on one bank account in one country, you’re probably not using it with care.
I remember spending a ridiculous amount of our startup capital on some overpriced professional bookkeeping software because I felt the need to plan ahead. My diagrams in the business plan said that we would be making a huge amount of money from customers in a few years, and I had just received several tons of capital from my investors. So, why not purchase the Ferrari of bookkeeping programs? At least nobody could say that I lacked the will to invest in the future.
You can find similar stories of well-funded startups about overpriced tools, outrageous perks for workers, lavishly decorated offices, and other non-value adding expenses. Startups with an abundance of cash often lack an abundance of restraint and foresight.
As agilists, we know that individuals and interactions beat processes and tools. If I had not received such a large amount of capital, I would not have been able to waste it on useless tools and perks. Instead, I might have invested more time in networking with friends and partners who could help keep the business afloat at a minimum of expenses.
Lean Startup + Lean Funding
A friend asked me recently to invest in his startup. I like his business idea, and I think he is someone who could make it a success, with a bit of help. However, now that I was suddenly asked to sit on the other side of the negotiation table, I wanted to think more deeply about my own (bad) experiences with funding and how the problems that I described above might be addressed with a more Agile and Lean mindset.
Less prediction, less negotiation, less documentation and less capital. That is what many entrepreneurs should strive for, in my opinion. The Lean Startup method, useful as it is, doesn’t deal with these issues. It offers an approach to creating products and services that work, with a clear focus on getting money from customers. But it offers no suggestions on funding the business, by receiving money from investors.
So, let’s solve that problem! Here’s what I have come up with.
There are several ways of assigning a value to a business. You can calculate assets minus liabilities, and add some goodwill on top, but this won’t get you very far with a startup which doesn’t have any of that. The only “assets” of startups are the founders themselves, which is exactly what many angel investors value most when they offer an entrepreneur seed capital: they believe in the person. I admit, I could be quite charming 17 years ago.
Another way of calculating a value is by taking the revenue of the business and multiplying it by an industry-dependent number. For example, an accountancy firm may be worth its annual income times 100% but a pharmacy may be worth its revenue times 25%. These are just rules of thumb, of course, but it’s better than nothing. The startup we want to invest in probably has little or no revenue, but that doesn’t matter. We know in which sector it operates, and there should be revenues soon enough. The entrepreneur will make sure of that. (Keep reading!)
The third way is to base a startup’s valuation on future earnings. The Discounted Cash Flow method is the most famous example of that. But, as a true agilist, I refuse to go there. What the company may or may not earn in the future is interesting for futurists and fantasists, not for a lean investor.
Conclusion: with a startup we can only base valuation on the worth of the entrepreneur and the sales he can generate. We can make a simple funding formula for this. For example, Value = 100K * Founder + 100% * Annual Revenue. In other words, the value of the startup is 100,000 euros for each founder, plus any revenue earned in the last twelve months.
With a traditional seed capital approach, the valuation and funding process easily takes months. But when something is hard to do, agile thinking suggests that we should do it as often as possible, in small iterations, which forces us to keep things simple. Well now, we have a formula, which means we can apply it anytime we want, for as long as it works!
For example, on January 1, the entrepreneur doesn’t have anything, except for his smart brains, and therefore his business is worth 100K. But if he works hard on validating his business model in the first three months, maybe he can send a couple of invoices worth 5K in Q1. This means that annual revenue (last 12 months) is 5K on April 1, and the value of his startup has grown from 100K to 105K.
Maybe by the end of the year, the entrepreneur will have earned 40K, and his startup will be worth 140K. Obviously, when he wants the value of the business to increase further, he will have to sell more in Q1 of next year than he did in Q1 of this year.
Now comes the interesting part: at any time during the year, the entrepreneur can ask for investment. The amount of capital that he asks for will (if the investor agrees) be traded against equity in the startup using the valuation at that moment.
For example, in January, the entrepreneur asks for a 10K investment, just to get started with the business, purchase some essentials, and pay the fees of one or two part-time workers. A 10K investment in a 100K startup means the investor gets a 10% stake in the company at that time. Three months later, the entrepreneur asks for another 10K. However, now the value of the business is 105K. Therefore, a 10K investment results in an additional stake of 9.52% in the company. The price of equity has climbed a little because the entrepreneur made a little bit of money.
By generating revenue, the entrepreneur will be able to trade away less of his business to the investor. A year later, at a valuation of 140K, an additional 10K will be traded against 7.14% of the company. With 200K in annual revenues (a valuation of 300K), a 10K investment would be worth just 3.33%.
With this investment approach, the incentives for the entrepreneur are in the right place: He should validate his business model as soon as he can, with paying customers, because actual revenue will drive the price of the shares up. He will be giving away less for more. He should also ask for as little money as possible, just enough to survive in the next few months. Because asking for too much means trading away equity at a price that is steadily climbing. As long as the business is growing, it is best to postpone each trade.
The reverse is also possible: the entrepreneur can give money back to the investor!
For example, suppose that the business is suddenly taking off in the second year. Annual revenue turns out to be 100K, which is more than double the amount of income in the first year. The entrepreneur now has a choice: keep investing in the business in the same way? Maybe ask a bank or a venture capitalist to scale things up? Or just grow the business naturally with cash from customers?
Either way, the entrepreneur can try to buy back his shares from the first investor. But the investment formula still applies, which means the entrepreneur has to pay a much higher price for the equity than the price at which he sold it. If the investor agrees to sell, he will have made a nice return on investment. It will all depend on the situation and plans of the investor and the entrepreneur in the future. Maybe they decide to choose the long road and aim for an IPO. Maybe some other opportunities come up, such as an acquisition by a larger firm. Right now, they don’t know, so it’s better to keep all options open, including divestment.
Investments and shares in the company can change hands at any time, but that doesn’t mean that you need to formalize everything with legal documents in those early stages. Nobody cares about legal documents, except the overpaid experts who make them. Between an early investor and an entrepreneur, a simple I.O.U. with a signature should suffice. If they don’t trust each other, they shouldn’t be collaborating anyway. Formalization of ownership status can be done later, or at longer intervals.
I am going to start experimenting with Lean Funding. Diversifying your investments is always a good idea, is what the experts say. Investing everything I have in my own business is therefore not a wise approach. It’s better to let some of my money work for friends and partners who have good ideas and a talent to realize their dreams.
But I will not be interested in plans and projections for the future. Entrepreneurs can share their fantasy stories with their spouses and children, but I will want to see actual achievements regarding sales. I want to invest in startups that generate revenues, not forecasts.
I will also not waste much time on negotiations. We will use a funding formula that will be more or less the same for different entrepreneurs. And once we’ve agreed on the formula, we use it for all further investments or divestments. No startup will waste its time on my negotiation table. I want to see them sell great stuff to clients, not to me.
We will waste none of the money I invest on legal experts and documents. Of course, we will sign a simple one-page I.O.U. that should even hold up in court. But capital should be used to create working products and services, not comprehensive documentation.
Last but not least, I will invest as little as I can get away with to keep the startup alive. Lean Funding should be like a life support system for newborn businesses when their caretaker(s) lack sufficient funds. But I’m not going to bathe the newborn in champagne and dress it in robes of silk and silver. One pair of shorts will be enough.
Lean Funding is a perfect companion for Lean Startups. It allows entrepreneurs to focus on individuals and interactions, customer collaboration, working products, and responding to change. While the Lean Startup approach guides the development of products and services, Lean Funding takes care of the capital needed to make them.
At least, that’s my hypothesis.
Let’s start the experiment!
Jurgen Appelo is a leading expert in Agile. Inc. rated him as one of the top 100 greatest leadership speakers and his blog has been consistently ranked in the top 50 Agile blogs in the world. He is the author of Managing for Happiness.