Startup Q&A #24: Venture Capital - Who can invest and who can raise money?

Hey everybody, Matthew Paulson here. Today we are going to start a two part series on venture capital. We are going to talk about what type of businesses can raise money, who can invest in privately held companies, how to find angel investors in determining the value of your business. Let's do this. This is officially episode 24 of Startup QR, the online video show that helps small business owners, startup founders and entrepreneurs grow their businesses faster and achieve their dreams of financial freedom. So whether you're just getting started or if you have 100 employees, this is the show that will give you actionable ideas and advice that you can implement in your business. Now today we are going to start a two part series on raising money for your business. So we're going to talk about how to find investors, is your company investable, what steps are involved in doing due diligence, legal paperwork, pretty much soup to nuts, all the different stages of raising money through an angel investment, venture capital or something like that. So this episode and next episode, episode 24 and 25, these questions were inspired by a pretty long question from Lisa Grew. And so Lisa, I am going to do my best to answer your questions today and next Monday and hopefully we'll create a resource that is helpful to others in this process. Process as well. This episode will focus on some general information about raising money for your business. And next week's episode we'll really focus in on the pitch, the process of pitching investors and due diligence and making the deal happen. But before we dive into the questions and go any further, let's move into a segment that I call the Tip of the Week where I provide you a tip, trick or idea that will help you grow your business faster or or achieve your dream of financial freedom. So this tip is not directly related to venture capital, but it is a good tip for any business and that is to use session recording software to see how people are interacting with your website. So session recording software will track the mouse movements and clicks of people on your website. It will show where their mouse is going, what they are clicking on, what they are not clicking on. It will do a really good job of just helping figure out where people are getting stuck on your website or what user interface issues you might be having. So it's almost like you're standing over somebody's shoulder and watching how they use your website 100 times over and you can just see why people aren't doing the thing that you want them to do, what their eyes are focused on instead, instead of what you want their eyes to be focused on and then what they're clicking on versus what you want them to click on. This software, there's a bunch of different ones. Hotjar Mouse Flow Clicktail 1 We use Hotjar at MarketBeat, but it's been very valuable in identifying issues with landing pages and just our website in general. So if you want to see how actual people are using your website, seeing where they get stuck, seeing why they aren't doing what you want them to do, watching their user sessions and seeing what pages they're going on, how they navigate through your website, where their mouse is going, what they click on, definitely use a piece of session recording software like hotjar. So my employee Rebecca, who also edits this podcast, she set up Hotjar in this business in MarketBeat and we've discovered a few different interface issues with our landing pages just through the software and it's been very valuable to us. So that is the tip of the week. Let's dive into the questions. Every weekend we take four or five questions that are submitted to Facebook or through our website. And if you would like to have your question answered on part of this show, go to the domain startupqa Co that will take you to my website and under the Startup Q and A show menu item there is a link to submit a question I also periodically ask on Facebook. So if you ask if you see one of those posts on Facebook, feel free to post a comment there and have your question answered. The first question is what types of businesses can raise money? So some businesses are just more investable than others. Remember that anybody that gives you money for your business is going to want a return someday and a pretty good return. If you wanted a 10 or 12% return, you could invest in dividend stocks, real estate, lots of other types of income generating investments that are just much less risky than investing in small privately held, high growth companies. Angel investors recognize that most of the companies they invest in aren't going to work out. They're going to fail. That's just what the statistics are. Most angel Investors assume that seven out of 10 companies they invest in are going to fail. So that the two or three companies out of 10 they invest in that make it, they really have to provide a return that covers the losses from those other seven investments. So a company, a privately held company that does a 10 12% return per year is just not going to make enough money to cover all those losses. So as a whole, the angel investor will still lose money. So as an angel investor, you're really targeting 25, 30% annualized rate of return on your money, on the companies that work out. So if I own a company for 10 years, I probably want that times 10, my money back. For investing in a privately held company, you want really good returns to make up for those losses, so that overall, your portfolio has a 25 to 30% annualized rate of return. And of course, that's not a guarantee. You could easily lose that money as well. So angel investors typically were not going to invest in a restaurant, a local daycare center, a gas station, or any kind of local business that is specific to one geographic area, because they're just not going to get big enough to provide the types of returns necessary to cover the losses from the companies that never work out. So if you are going to raise money, your business model really needs to be something where you can have a bunch of different locations, or you can scale to like eight figures or maybe even nine figures in annual revenue so that your company can get really big. You can buy out the investors with your profit, or you can go public, or you can get bought out by an even bigger company. Really, those types of exit events are what angel investors are looking for. So you've got to set your business up in such a way so that it can get big enough to do that, to provide those future returns to attract the interest of angel investors. So really, yeah, I mean, you have to have a business that can go really big, or it's just not interesting enough for an angel investor to care about. There are some other criteria that angel investors look for other than can it get really big. The second thing that we look for is that we typically like to see teams over individuals, because if one team member happens to quit the business, the other team members can kind of pick up the pieces and keep it going. Angel investors, we also like to see traction. Typically, people don't want to invest in an idea on the back of a napkin. Nobody invests in ideas. It just very rarely ever happens. We want to see some type of business that already exists. Or maybe you have your first customer, you've got a little bit of revenue, and you want to see something other than just, here's my idea. People don't fund ideas. People find actual businesses. If you look at the companies that pitch on Shark tank, they all have some kind of revenue or some kind of existing business, at least the ones that get money due. So if you have an idea, do something to get it started. Get a first customer, and that will make your business look a lot more attractive to an investor. Of course, these criteria are going to vary from group to group to group. Like at Falls Angel Fund, we only focus on companies in South Dakota and surrounding states. We will look at high growth stuff and then we also look at the individual too. Can this person pull that off? So those kind of are criteria, but different funds will have different criteria. Some will only invest in specific industries, some will only take on referrals. And just it's going to vary a lot from investor to investor. And just be aware of that. And if you don't know what an investor's kind of criteria are for what they look for, it is totally okay to ask them, say, hey, what are your investment criteria? I'd love to see if this is a good fit because you are interviewing them as much as they are interviewing, interviewing you as a possible investment. Second, next question. Who can invest in a privately held business? So if you're going to go out and raise money, you can't just go on Craigslist or Facebook or Snapchat or whatever and say, hey, I'm raising money for my business. This is referred to as a public ask and it can get you into trouble with the securities and Exchange Commission, also known as the sec. You really don't want to publicly state you're raising money because even publicly saying that you're raising money could be considered a public ask and that could get you into trouble. So why does the SEC not like public requests for investment? You know, one, it's kind of to prevent securities fraud. You know, you really need to be registered with the SEC if you're going to be selling securities. There's a whole bunch of legal stuff that goes wrong with this. Some of that's over my head. You really do need a securities attorney if you're going to raise a serious amount of money. Second, they also want to protect small investors from making the high risk, high reward investments that are probably going to fail that angel investors make. So they just don't really want that out there. So you can really only pitch your business investment opportunity to individuals that are accredited investors or investment groups that are comprised of accredited investors or people that you. So you want accredited investors, you can pitch those people or people that you know personally. So like if I wanted to pitch my mother in law on an investment opportunity, I could do that because we have that relationship in place. I couldn't go pitch somebody I don't know that, I don't know that they're accredited investor can't do that. That's kind of a no, no. So you can pitch an angel Group, because they're all accredited investors. You can pitch an individual accredited investor, or you can pitch friends and family. You can totally do that too, even if they're not accredited investors. So you just don't really want to go out publicly and say, hey, we're trying to raise money. You do have to be kind of quiet about it and just be mindful of that. So to be considered an accredited investor, you need to have $1 million in assets, excluding your primary home, or you need to have $200,000 a year in income or $300,000 as a couple over the last couple years. And there are also various ways that investment funds and trusts and other more unique entities can be considered qualified accredited investors as well. So because you can only solicit accredited investors and people that you really know directly, you can't ask most people for money. This is entirely okay, though, because the people that you can ask are the people that actually have money to invest in your business. And the people that you can't ask are probably people that shouldn't be investing in your business anyway, like my parents. They're great people, but they probably shouldn't be investing in anybody's business. My dad's a police officer. My mom works at Walmart. Those are not the types of people that should be investing in angel deals. Their money should go in a retirement account and to pay off their mortgage, if they still have one. So angel investors need to be prepared to lose all of their money and not lose any sleep over it. That is how risky this type of investment is. Unless you've got that high income or the high net worth, you're really just not in a position to lose all your money. So you shouldn't be making that type of investment. If you've got a high net worth or high income and you meet the accredited investor status, then you can't afford to lose that money, and that's okay. Then you can make those types of deals if you want to play the startup lottery and see if you can get a good rate of return. So pretty much anybody that kind of labels themselves as an angel investor in every venture capital firm in the world, every angel fund in the world is considered an accredited investor. So if you see somebody that lists themselves as an angel investor, it's probably okay to pitch them privately, like on a one on one basis. That's pretty safe to do. And they can, of course, legally invest in your business if they're an accredited investor. I'm probably not explaining this all that well, but if you are serious about going on a fundraising round. You should probably consult somebody that specializes in raising money, maybe a securities attorney, maybe somebody like the Enterprise Institute that runs all the South Dakota angel funds. They do consulting for companies that want to raise money. They can kind of give you the lay of the land and say this is how it works and what you can do and what you can't do. That's definitely worth an hour or two of a securities attorney's time or a non profit that helps small businesses raise money. SBA might be a good resource. There's a bunch of other state level organizations. Like in South Dakota we have a bunch of them. It's true in other states. Like we have the Small Business Development foundation, several of those. Like we have those locally and I know other states have those as well. The next question is, how do I find angel investors? So let's say you're running a small but growing company and you want to take your business to the next level. You need to find that one right investor or a small group of investors that can be a partner in your business. You are going to need to go through a lot of names to find the right partner who can put the right amount of money in your business at the right valuation. Fortunately, it's gotten a lot easier to pitch angel investors over the last several years. There are two major platforms that serve as social networks for angel investors. These are Angellist and Gust.com. gus tends to be more for groups than individual investors and AngelList tends to be more for individual investors than groups. So Gust, for groups like Paul's Angel Fund were on Gust and then me as an angel Investor, I'm on AngelList. So you can go on these sites, you can make an account and then you can try to find investors that have funded companies in your space, your kind of industry that you're in. So if you're a SaaS company that sells products to digital marketers, you know, go find a company that has invested in, say Semrush. This is a free T shirt. I got a traffic and conversion. I'm not wearing it for any particular reason and I like it, but it's a good example here. So go find the Semrush investors and go pitch them. Because you say, hey, you did really well with Semrush. You can go do the same thing with me for your next company. So yeah, I mean, you'd want to look for companies like Marketo and leadpages and Drip and find, you know, their investors and say you've invested in a Previous company in this space. Maybe my company is interesting to you as well. You can also look for angel investors in your area. Maybe not. This isn't as good of a tip in Silicon Valley or la, but in smaller communities, definitely, you know, people tend to favor local investment opportunities over, you know, stuff across the country because it's closer to you, it's closer to home. You want to help somebody out in your community. I'm more likely to take a call from somebody in Sioux Falls than I am from somebody in Omaha. And even somebody from Omaha. I'm more likely to do that than California. We want to help out our home team, and the way that we do that is we take the phone calls from local companies. Definitely start at home. Don't be a South Dakotan that goes and tries to pitch somebody in New York or California, or don't be a Californian that starts by trying to raise money in South Dakota because we're going to assume you tried to raise money in California and you failed. Now you're coming to South Dakota because you couldn't raise money in California. That is the assumption that we will pretty much always make. So start at home. Look for people locally, at least for your first several pitches. That is a great place to start. So you should probably start out with a list of about a hundred different investors you want to pitch. Send them an introductory email telling you working on a space in an area they are interested in, many of them won't respond to you. Just be prepared for that. You can check back in once or twice if they don't respond. But don't assume that they didn't get your email. Just assume they're not interested because they got your email and they're just not interested. Be prepared for rejection. Most people are just going to say no right off the bat or simply not respond. This is why you're starting out with a list of 100, not a list of 10. Because really you're just looking for that one right individual or that one right group or small group of people to raise money for your business. You're really looking for that one single partner that can really be a partner in your business to help you grow. You're not looking for 100 people to invest in your business. You're only looking once. Or you start at a large number and you kind of filter that down to find that one right partner. The next question is, how do I determine a valuation of my business? There are a few pieces of homework you need to have in place before you pitch an investor or a venture capital firm. First, you need to identify what you're going to value your business at. So remember, the value of your business is only what somebody is willing to pay for you. It is not what a consultant tells you your business is worth. It's not an arbitrary number that somebody just decides. It's not just a number that you pick out of the thin air. We at Falva's Angel Funds, we had a company come in, no revenue, nothing to show for themselves. It was one guy in an office. He had a patent, hadn't really executed on that patent well, and he wanted a $10 million valuation for his business. Ask me if I think that's going to fly. We didn't even bother taking a meeting because we were just so far apart on valuation. So for comparison purposes, MarketBeat does just under $3 million in revenue, maybe two and a quarter million dollars in profit off that. And if I were to sell my business today, I'd get between like 9 and $10 million on my business. So there's no way that guy that's to going got himself in an office with no product, no revenue. There's no way that no matter how good his patent is, there's no way that's worth the same amount of money as this business that does almost $3 million a year in revenue. It's just unrealistic to expect a valuation that high. Given that he had no traction. It can be kind of tough to kind of firm out your valuation. Figure it out. You do just need to have a sober understanding of what your business is worth. And the way to kind of do that is to look at comparable companies and see what valuations they actually raised money at. Talk to people in the venture capital world and angel world and see what kind of valuation they might think is reasonable. In a company like yours, the value of your company is really what the market will bear. So talk to people that are in your market, talk to companies that are similar to yours that have raised money and see what kind of valuations they got, and then make adjustments for the size and traction of your business. Actually, I had one company come to me maybe a month or two ago. They probably had four or five hundred thousand dollars in revenue, and they were going to look at like a valuation of like 1 to 1.5 million. And I thought, frankly, you know, these guys are probably coming in on the low side. So I coached them a little bit and said, hey, you can probably get a better valuation from this based on these other companies that have raised money recently. And the valuations they got. So it is definitely not, you know, you can make the mistake of valuation on the other side too, and ask for too little money and not too much. So it might be worth having some conversations with individual angel investors and say, hey, what do you think a fair, you know, I'm not asking you for money, but what do you think a fair valuation for this business might be? That is a conversation certainly worth having. So those are the questions for today. We are going to continue this discussion next week. We are going to talk about deal structure. We're going to talk about PPM documents, talk about preparing to pitch, actually pitching, then doing due diligence afterward, and finally closing the deal. So make sure to join us next week for the 25th episode of Startup Q and A. So if you would like to get next Monday's show delivered to you automatically go to the domain Startup Q and A co and there are links to subscribe there via email, RSS, Facebook, iTunes, YouTube, and Stitcher. We really do try to be everywhere with this show. You can also follow me personally on facebook@facebook.com matthewpaulsenpage or you can add me as a friend on facebook@facebook.com MatthewPulsen and if you enjoy the show, please take a couple minutes to leave a review and a rating on itunes. Definitely you can just log in and click the five star button by searching for Startup Q and A on itunes. Find the podcast, click on it, click the five star button. That's really all you have to do and that will help more people hear the message of achieving financial freedom through the power of entrepreneurship on this podcast. I think that's it for today. Make sure to join us next week. I'll see you guys next next time. I guess.