Thinking Like Your Investor with Dr. David Croson

Source: GeniusDen archive transcript checked against the recording. Administrative opening and closing material is omitted; the presentation wording is otherwise preserved with light readability edits.

Hi, I'm David Croson, and tonight I'm going to talk to you about thinking like your investor. The idea is, you're an entrepreneur, you need to raise money for your business in some way. You have a clear idea of what it is that your money is going to be spent for. You're going to have a meeting with your investor, and you're prepared.

As you're trying to think about what you need to be ready to answer and how you can put yourself in the thought process of your investor in that situation. So today I'm going to be talking about four key pieces. One is I'm going to be talking about how your investor actually thinks about making an investment decision. If you're knowledgeable in psychology, you might remember this as the theory of mind. The whole idea is you're able to take your own consciousness and model how other people are doing things, right? Thinking like them is a very important way to actually...

Embed yourself in their social network and understand how they work. You do this all the time when you're playing games. You try to think about what kind of move your opponent is going to make, what kinds of things they're doing, whether you're playing chess or poker, and how to actually work with them. You want to think about how to actually prepare yourself for this presentation, which is a pretty stressful and high-stakes kind of venture. You want to think about how you're going to negotiate with your investor, what you can go and put on the table.

which can be either win-win, which expands the potential pie, or potentially distributive, win-lose, where you have to push back on them. And I want to close with just a few words about what to do when you actually really, really need the money. This is not something that you can do your first time with an investor. You can't very well go up to people you've never worked with before and say, "My business desperately needs $50,000. Will you work with me?" It doesn't work out so well that way. When you've established a relationship

I need $50,000 more than I originally thought. This is how you go and generate some kind of creative deal so that you can get the capital you need. So let's go on to the next slide. The trick here is that you want to be able to communicate information to your investors so that they can do their job, generating terms for you that you can live with. This relationship is commonly...

It has been adversarial, but it really isn't. You and your investor are both on the same side. You both want your businesses to succeed. Your investor wants you to get the capital that you need when you need it, and they want to participate in your success and help you get there. And so this is a very cooperative kind of relationship. However, people look at the investor across the table and they say, I need to squeeze every drop of juice that I can out of this investor, and investors look at entrepreneurs and they say...

How do I bend this entrepreneur to my will? I'd rather make this more of a dialogue and a cooperative relationship that you're going to be continuing forever, okay? So let's go on to the next slide. I just want to kind of introduce you to a very simple kind of numerical example of how your investor is thinking. Your investor has a portfolio of capital. They're investing in all sorts of things, including your venture, but you're not the only thing that they're investing in. So, you know, angel investors...

They start off investing $25,000 at a time in a fund. They may put individual investments of $10,000 to $100,000 in an individual company, but it's rare that they're working with just one startup at a time. They're thinking of you as part, one brick in the wall of their portfolio rather than the whole thing. But for you, it really is the whole thing. You're all in on your one venture, you're only running one thing at a time, particularly if you're going out in order to get money, and so, again, you see why it's important to think like them in understanding how you

So think about an investor who's going to be putting in a given amount of money. I'm just picking a million dollars as a nice round number that divides nicely. This could be a single investor investing $100,000 in 10 items. It could be a fund which is making 10 investments at the seed stage, and then it makes some follow-on investments going forward.

But the statistics that everybody uses in the venture capital industry is basically seven, two, and one. Out of these ten ventures, you have seven companies that are basically going to fail, and they're going to very creatively absorb all of your money. You're going to lose $100,000 100% of the time, basically, on those lemon ventures. They happen. There are a lot more ventures out there which are not going to succeed than which are going to succeed, but of course the ones that do succeed pay off so well.

There are going to be two, which are not lemons and neither are they cherries, they're basically going to go sideways. The investor puts in $100,000. You as the entrepreneur put in $100,000 worth of effort over the course of a couple of years, and at the end it's worth $100,000. Those are not actually winning propositions. You've lost some value there.

And you've put in time and energy, and yet the whole venture is not worth $200,000, it's only worth $100,000, but from the investor's point of view, they look at that and they say, "I broke even," because, of course, they invested, they have the first claim on that value that's there, and you as an entrepreneur said, "rats, I wasted my time." So from an investor's point of view, those go sideways. They're not good because they tie up capital that could be used in order to go and make a return.

But you don't really worry about the risk part of those; the capital is safe. And then finally you have the winner, which I'm going to call a cherry to contrast it with a lemon. And the whole idea is that the winner, you know, there's only one of them in any given portfolio, but one winner is really all you need. This winner is going to go and return some large multiple of the original investment. So here I'm going to say you're going to make nine times as much profit.

It's going to return a total of a million dollars, the original $100,000 plus 9x return on it. Okay? Let's think about what happens. You have a group of ten, seven of which are lemons. Those lemons soak up $100,000 apiece, but they return zero. That's the definition of a lemon. That makes the math easy. And we say, the ones that go sideways, you're going to get $100,000 back. I say, you being the investor, because we're thinking like the investor. And for the cherry, a million dollars is going to get returned. So how much is that?

It's $1 million plus two times $100,000 is $1.2 million, and the investor says I've turned $1 million into $1.2 million through this complicated lemons and cherries mixture for an overall return of 20%. So, that's just a basic overview of how the math works. Now, that's what happens if you have seven lemons and two normals, right, two sideways ventures and one cherry. You might be tempted to say, well, what happens...

There's more than one cherry. And I don't want you to think that way. As we'll see, investors are a lot more concerned about reducing or eliminating lemons or converting lemons into businesses that go sideways than they are about trying to cram more cherries into their portfolio. The whole idea is that a given portfolio is going to have one winner. If you have another winner, we're going to go and put it into another portfolio, is the idea. We're going to think about how many of these other types of ventures surround these one winners. You could double this and invest $2 million.

dollars and have 14 lemons and 4 sideways and 2 cherries if you wanted to, right? There's nothing magic about the exact number of dollars which are going to the portfolio, but I want to think about it as saying, for every cherry, how many lemons and how many sideways can we actually put with them? Okay, so I want to think about the cherry as the new analysis. So, think about what happens if you're able to, instead of funding 10 ventures, fund only 9, okay? So if you can eliminate one lemon, what happens? Now instead of investing a million dollars,

10 $100,000 chunks, you're now investing $900,000. You're investing nine $100,000 chunks because you successfully took several meetings with the entrepreneurs who were going to bring you this lemon, and after talking to them for a while, you said, this is not going to work, and you correctly decided not to give them $100,000. This is your finest hour as an investor because you have successfully saved $100,000 by going to lunch, right? It's a tremendous, tremendous payoff of not investing in a business which was going to lose your money. And so, in addition to the fact that you avoid this loss, you also improve your return.

That lemon was not going to return any money for you anyway. You still get the $1 million from the cherry, you still get the $200,000 back from the ones that go sideways, so your total amount returned is still $1.2 million, but now your original investment is not $1 million, it's only $900,000, and so instead of making 20% on your money, you're making 33 and a third percent on your money. So you've improved your expected return by eliminating one of these losers.

That's pretty substantial. Proportionally, you've increased your profitability by 62.5%, right? That's a big improvement just by targeting one lemon and saying, hey, I'm just not going to fund this. Now, you might do another calculation saying, what happens if we can take a lemon and turn it into something that's going sideways? Right, you're still going to invest a million dollars, but instead of losing seven times, you're only going to lose six times, you're going to make an extra $100,000, and your return's going to be 30%. So--

What happens if you can eliminate two lemons? If you can get rid of two lemons, it's even better than that. Because now, all of a sudden, you're only investing $800,000, you're still going to get $1.2 million back, but you're only going to lose $500,000 before, and so your return is going to be 50%. It turns out the math works out very nicely if you can convert three.

three lemons into going sideways. Now you have, you know, you still have some lemons here. You've got four lemons, you have five that are going sideways now, you have one cherry. Those three lemons going sideways will also return that same 50%. So if you think about being an investor, you're constantly thinking about how to identify these lemons and either not investing in the first place, which is certainly better when you think about it.

Your money is not tied up, right? So you're reducing the denominator of the amount of investment you're making, so your ROI is going to go up. And second is, it's almost no work to not invest in a company. You talk to them a couple of times, you say, "Sorry, don't call me ever again," you're done with them. It's not like they get to hang around and keep pitching you over and over again. You don't have to devote several hours a week to tell them no; they go away and you get a chance to talk to another investor.

However, it does take up a lot of time. It is a lot of work. And at the end, all you earned was $100,000. You successfully avoided losing $100,000 because you converted this lemon into an okay business, but you're not actually going to make a profit out of this. Before, you saved $100,000 just by going to lunch a couple of times. This is work. It's going to take you years in order to save that $100,000.

And so it's far easier just to not fund them in the first place. Certainly a smart investor is going to be interested in not only not funding lemons, but also converting the ones into normal investments. But it's a heck of a lot of work to do a lot of conversions. And so, lots of investors say, I don't even want to do that at all, I'd rather just kind of take my chances and not fund a lot of lemons, and they're really, really tough and selective about what's going on. Of course, if they're too selective, they may find that they've eliminated some of the cherries too, and they're kind of back to ground zero.

So let's go on to the next slide. So we're going to be thinking about, you know, this in terms of a fund. Now, as I said, if you invest a million dollars and you come up with a return of plus $200,000, that gives you a 20% return. That looks like it's a lot. You came out $100,000 ahead, but that's really not that much when you're thinking about being an investor. These investors are looking for returns of 25-plus percent per year. A standard kind of portfolio goal for a fund.

The fund is to try to turn $1 into $5 over 10 years. You'll often see a lot of funds that have aimed their portfolio at this. If you take a course in venture capital, this is often a common fund structure where they say, we try to invest in different tranches to be able to cash out at plus 400%. That turns out to be a compound annual growth rate of between 25% and 26% — it's about 25.8%. So it gives you an idea of what they're aiming for.

but they might find lots of lemons and not have any cherries in there at all. So this is the high risk, high return kind of venture. So if your goal is to turn a dollar into $5 over 10 years, let's kind of forget about the normal ones and just think about lemons and cherries, and think about how accurate you have to be in making your choices. So if your cherries return $10 for every dollar that you put in.

How does this math work? If you fund one cherry and one lemon, that's $200,000, right? They're $100,000 apiece, and you have one cherry; each cherry is going to give you 10 times your original investment — that's 10 times $100K, so a million, and so it's going to turn $200,000 into $1 million. That achieves your goal, right? 5x return, plus 400% over 10 years. However, that's hard to do. You have to be able to pick winners 50% of the time. That's hard enough to do in the NFL, it's especially hard to do

When you're talking about, you know, trying to pick ventures, and there are a lot more lemons out there than there are cherries. You think about all the ventures that are out there, how many of them return ten times their money, not nearly half of them, right? You have to be super selective when that happens. And so even though this cherry returns ten times your investment, if you're a professional investor and your goal is to return 5x on your money, you need to pick winners about 50% of the time if your cherries return only 10 times your investment.

This is why, in venture investing, most investors will only consider things which give them the potential for a really, really large multiple going forward. 10x just isn't enough. And it's not that they can't come out ahead, they can't come out enough ahead to justify taking the risk over a long period of time. Certainly if they're professional fund managers, their limited partners are going to be upset with them because they're not going to produce the kind of returns that they promised, and so this is a very difficult hurdle to come about. So now the question is, how much more attractive does it have to be?

If cherries return 20 times the original investment, something interesting happens. You can now achieve your goal by picking one cherry and three lemons. So you'll notice that one cherry is going to return $2 million all by itself, and so you want to make 5x since you have $400k to work with, and so you already spent $100k on the cherry, and so you have room for three lemons to be able to make three mistakes and turn $400,000

Notice how when the return gets bigger, you also have to invest more in your fund, right? You're investing in four things here rather than two, and you're investing $400,000 rather than $200,000. You need more money in order to chase after higher return items and still make that same return. Isn't that kind of interesting? It's not too surprising that you have funds that are too small.

to chase after the kind of returns that they're after, to be able to diversify their portfolio enough in order to be able to take advantage of the fact that indeed there are cherries out there, but they have to weather the lemons in order to do this. So here you only have to pick 25% winners, but notice the number of firms that get funded has doubled as well. Previously, two firms got funding, now four firms are getting funded. The number of bad firms, the number of lemons that are getting funded, has tripled. That's more than 100.

See it more than double again and again. So if cherries return 40 times, that is, your $100,000 returns $4 million, you can afford to fund seven lemons, and you only have to be 12.5% accurate. And, you know, if we move this up and cherries return something like 99 or 100x, right, you could, you know, return something, you could invest something close to, I don't know, like 20 lemons, right, something like that. So notice the pattern. The returns from 10 to 40 have gone up by a factor of four.

And the total number of companies that have gotten funded have gone up by a factor of four. But the number of companies which are not doing well have gone up by a factor of more than that. They've gone up by a factor of seven. You have these investors who are willing to be more aggressive, and they're willing to take more chances at funding lemons when the return on the cherries are higher. And so this is basically the story of high-tech venture capital.

You have investors who are willing to throw a little bit of money at just about anything because the potential return for the ones that work out is so, so high, and it's possible to end up funding seven lemons and one cherry and still actually make your goal. It's a lot easier to be able to pick winners one time out of eight than it is to pick winners one time out of two. On the other hand, if the upside from the investment is less than 10%, you have to get it right almost all the time.

In order to achieve your goal. This is much more like private equity investing than it is like venture investing. When you're buying a railroad or you're buying an oil company, you're buying an existing staffing company which is pouring out cash and you're just trying to figure out how to make it more profitable, you say, yeah, 70 or 80% of the time this is going to end up returning the kind of money that I have, that I need. You don't have to have it return 10 times that amount in order to actually make your goal on your fund. And so...

There is this hazy separation between private equity and venture capital, but really the difference is private equity firms don't invest small amounts of money in things that could return 40x, they invest large amounts of money which could return 3 or 4x over a long period of time. So what does this have to do with you as an entrepreneur getting funded? In addition to the idea that, you know, the investor is trying not to fund lemons, and that if they do fund a lemon, they're going to go and try to convert it. And believe me.

You spend a lot of time with these seven struggling lemons, trying to turn them into something which is going to become a cherry or at least break even. Lesson number three is don't be a lemon. I had this as lesson number one, and I went and put in two lessons before that. But I would say, renumber that lesson number three and say, your lesson as an entrepreneur is do not be a lemon.

A lot of businesses out there, which when I talk to entrepreneurs about them, I say, this sounds really interesting. Would you invest $100,000 yourself into this business? And they say, no way, that would be crazy. That's a pretty good indication that you have a lemon, that it's something that's very, very unlikely to actually succeed and to produce 10 or 20 times the original amount. And so if you have a bad business idea...

If you have one that you would not actually put money into, don't bother bringing it to your investors at all. They're just going to completely wipe you out and say, I'm not interested in talking to you. I don't want to fund you. You're not even worth taking a chance on to try to work with to see whether we can get our money back. They're willing to take the risk that you're not going to actually return any money because you don't have your ducks in a row. A lot of people look at the venture funding process, and here I'm talking about really angels and angel groups, somebody who's going to put in between $25,000 and a couple hundred thousand dollars, not multiple millions yet.

They think of this as totally a crapshoot, it's entirely random, and then if you bring these VCs a hundred venture plans, some of them are going to get funded and you're going to be able to get money and you're off to the races. It doesn't work like that. It's not random at all. These VCs are trying to filter out these lemons. Lesson number four is try not to obviously look like a lemon. If you...

...which has some kind of potential to it and it has some promise. You want to be in a market where the upside from successful ventures is really high, and now all of a sudden, they're willing to fund seven lemons for every cherry that they get, and they say, it's a lot easier to persuade these investors to fund you if they look at you and say, yeah, well, I think this has a one in eight...

You say, it's not so obvious that this is going to be a bad investment, even though seven out of eight of them are going to lose. In the previous example, seven out of ten of them were going to lose, and the VC would still be able to make a positive return. Here, their goal is to make a five-times return over ten years. If you are a lemon, you're going to have to go and hide pretty well, and the place to hide is in places where there are huge upsides for successful ventures.

It's hard to hide lemons in the private equity world where nearly every deal has to work. This is also a reason why you don't see a whole lot of debt financing for these kinds of high-risk ventures. People who are going to loan you money, as opposed to people who are going to go and buy stock or invest in options or warrants in these things, are trying to get their money back almost all the time. They say lemons are really terrible. Think about mortgage defaults.

They want things that pay back in a nice, predictable, normal way. They have to be right nearly 100% of the time just to break even. And so, going to VCs with something that is going to steadily produce a return but has a very, very low chance of actually hitting the ball out of the park is not going to be able to achieve their objective, even if you can demonstrate you can make 15 or 20% per year all the time.

They'll never fund you because they need to make 25 or 26 percent on average to hit their goal. Whereas a private equity company would say, "Hey, you can make 22 percent, let's talk. We can go and borrow money at a lot less than that. We can go and leverage your company up. Your cash flow is gonna be valuable. We'll be able to make a deal." So lesson number five, given that you're not a lemon, I'm not interested in showing you how to actually pitch VCs given your idea.

I'm assuming you have a good idea and that you're trying to cut through the noise and get them to pay attention to you. If you're not a lemon, be prepared to prove it. The whole idea is you need to go and separate yourself out from the large numbers of people who are sending in bad business plans, who are talking about investing somebody else's money in a bad idea. You need to go and show them beyond a shadow of a doubt that you are not the lemon type, that you're at least a good risk. You may not be able to prove to them you're going to be successful, but you say, I'm above the line. You're not

I'm going to fail seven times out of eight, right? And therefore, you should actually... so this leads me to something that I've come to realize is a key misconception. Everybody thinks that investors, and I'm talking about, I'm calling them VCs here, but really this is talking about angel investing, right, at the smaller levels, right, as I said, $25,000 to $300,000.

Everybody thinks that these investors are obsessed with trying to find winners. It's not really true. It's the fund which needs to have a winner. What investors are obsessed with doing is looking at the deal flow that comes over their desk, over the transom, and squeezing out the lemons, saying, I want to go and assassinate those lemon opportunities as quickly as I can, as efficiently as I can. They say, the cherries will take care of themselves. When something comes along, you say, I don't know whether this is going to work or not.

Clearly worth the risk. Let's put money into it and push it and let it go, and que sera, sera. Cherries will mature out of those. But they say, you know, I'm looking at this and I think this is just going to be a trap, right? I'm going to lose $100,000. Let me see if I can not fund that and improve my overall investment efficiency. You might think of this kind of due diligence procedure as doing like a back...

I cannot think of any situation where there’s an employee who has actually been hired because of what came out in their background check. Unless you're trying to hire somebody in order to rob a bank or something, you say, I would not hire you unless you have a previous conviction for bank robbery. Most of the time, the information that comes out in a background check is only bad news. It can only cause something to fall through that you previously were going to invest in. But the reason why employers do this in the first place is because bad news...

That in the beginning is really good news. They say, "Great, I'm not going to hire you because of what I found. I paid $29.95 for that background check, and I'm going to avoid maybe $100,000 of liability." Due diligence for angel investors is the same way. They say, "I'm going to try to figure out a reason why I should not invest in this lemon, and potentially save $100,000." I recently gave a talk about how to conduct this kind of due diligence. If you're going to spend somewhere between a few hundred and a few thousand dollars checking on an investment opportunity, what would you want to check?

The return on this due diligence investment is really, really large, because you can easily, for a cost of one or two thousand dollars, talk yourself out of a hundred thousand dollar risk, right? That's an amazing kind of return. I wish I could just make that kind of investment for a living and not have to worry about the companies actually succeeding. So every investor ever, you know, is thinking that they want to find cherries, and every business plan ever is written in a way of saying, "Look, you know, I'm cherry-flavored."

I know I'm the one who's going to win. I'm a perfect investment for you. I'm going to return 10 times on your money. I'm going to return 25%. Every single business plan always writes itself this way, saying I want to look like a cherry. However, every business plan reader is like, yeah, sure, you're a cherry, just like all 499 other business plans that I received this week.

They can't all be cherries. We know that most of them are going to be lemons. That's just the way of life. It's like these lemons are dressing up in Halloween costumes, you know, with little stems and they're painting themselves maraschino-colored. But, you know, at the end of the day, they're a lemon. And so every lemon business plan ever is saying, "Hmm, how can I find an unsophisticated investor who's not going to actually do their homework, who's not..."

They're not going to go and check me out, who's not going to go and kick the tires and ask me tough questions, and maybe they'll give me money even though they really shouldn't. There are opportunistic entrepreneurs out there who would not invest in their own ventures, but they're happy to invest other people's money, and they really, really, really want to have their startup, and if they don't have their startup, they have to go and work at Sears or something, and they'd be willing to do anything in order to actually have a real job. And so they will go out and pitch incredibly crazy, speculative ideas to other people.

That will only work if your investor is not able to actually do this due diligence; they're not able to actually push you on these things. And the key to getting funded, and this is the only thing I'm going to say about getting funded when you're a lemon, is you basically have to say nothing. Because anything that you say can and will be used against you, and when you provide true information to these investors, they figure out that they shouldn't invest in you, and you have to go and work at a retail counter somewhere. And if you provide false information to these investors...

And you're setting yourself up for, you know, extreme difficulties in the future, not only on the financial side but also on the criminal side, to say nothing of the business ethics involved in this. But this basic idea of saying I'm simply going to show you something, I'm going to go and present to you what I want you to hear and not tell you the whole truth, basically is creatively keeping your mouth shut about information that these investors should know, and it leads to something called pooling. And so pooling is pretending that you're just

Every good business idea is constantly saying, "Gee, it's really hard to raise money in this environment." The reason why it's hard to raise money is because of all these darn lemons. There are so many bad business plans out there.

Investors are gun-shy. They don't want to put money into things which are not practically guaranteed of success, and they say, I don't know, I've been burned on a lot of lemons before. Every good business plan wishes that these bad business plans would just give up and go home. So the trouble is, of course, these bad business plans are out there in the market, they're trying to raise money, you're competing with them, and you say, how can I persuade my investor that I am not a lemon? That's what separation is. You cannot do this by keeping your mouth shut, because the lemons are keeping...

Their mouth shut too, and they're relying on you not being able to talk with your investor so that they can stay in the pool and potentially get funded. So what you have to do, if you want to go and separate from the lemons, is to open up your mouth and say something intelligent. You must provide your investors with extra information that lemons cannot possibly afford to tell them, right? This is going to be the trick. So now we're going to transition.

So you've thought like your investor for a little bit, we're going to transition to saying what can you do as an entrepreneur in order to have a better experience working with your investor. So, the first way is to be very specific on your use of funds. A standard business plan, and this makes me cringe every time that I see it, a standard business plan concludes with a slide that says, hey, you know, we've got a deal for you. You give us $400,000 and you can have 10% of our business.

It basically is an offer. And it's an offer as if you, the entrepreneur, are in the driver's seat, and you're the one who is making all of the offers and making the plans. And you're, like, going out and trying to put together some kind of partnership offering and raise money for a real estate venture, right? That's a very standard way. I think it's the wrong way to do it for small amounts of money for high-risk ventures. And the reason is, anybody can do that. You can put together a very slick

deck. You know, as we can see from business accelerators, you can learn to put together an amazingly slick and professional-looking deck in, you know, a few weeks or a few months, which doesn't necessarily have a lot of business substance behind it. There are a lot of lemons doing this. You have to do more than that. However, the right way to do that is to take advantage of what you know. You know your business very well. Your business needs capital to grow.

Founder, know exactly what you're going to use this money for, and you need to convey to your investors that you're going to invest in the business and make it grow and not simply take half the money and put it in your pocket. Because you are going to go and invest the money in the business and make it grow rather than putting the money in your pocket. If you put the money in your pocket, you're a lemon, okay? So the whole idea is, this is you as a good idea. So, you know, I know this is going to be a revelation, but perhaps given that you have a lot of expertise about your business and you've worked out...

Exactly what you're going to spend the money on and you're going to invest in growth rather than basically filching it from the cash register, maybe you should say that in your pitch. You should say, here's what the money is going to be spent on. Here's exactly what the money is going to be spent on, when it's going to be spent, and what will be achieved by spending it. And so, I joke about this, I say you should treat your investors like your personal ATM.

And your ATM is a mnemonic device standing for the amount, the time frame, and the milestone that it's attached to. So you want to end with a statement that says, as you see from this table, this breakdown of where the money is going, we need $250,000 to get us to this milestone, right, bring us to market, which is going to be spent on--

Design and prototyping, so what is it you're going to spend on and when over the next twelve months? And then the investor says, oh, I get it, you need $250,000. You've given them the same ask, you can make it $400K if you want, whatever number you're asking for. You've given them the ask, but you've explained what you need in order to succeed, and you're entreating them to become your capital partner in this venture, and then they say, oh, I get it, we're supposed to come back with some kind of an offer.

We have $250,000 for the company and they know exactly what it's going to be spent on. And if they go into this, say, "we expect you to actually spend it on what you claim," say, "that's great." There's a reason why I put that table up there. It's what I plan to spend it on because I am not a lemon, right? I'm a cherry. I'm going to spend money on this. And if they then say, "well, we have $250,000 for you, but you said you're going to spend $40,000 on rent. Can we pay your landlord directly?"

say, "Great. Perfect. No problem. It's exactly what I would have done with my money." Your goal with this investor meeting, at the end, you want to have investors saying, "I love you," and then you can say, "I know." You want to have investors saying, "This is the entrepreneur that I want to be working with. I want to get my money into this venture. I want to get my money into this venture early." And if your investors are thinking this way when you leave the meeting with them, you don't have to say, "I'll give you 10% of my company for this amount of money." You should—

They'll come back with a term sheet. They say, "We've decided we want to work with you, we have $250,000, here is what we propose that we do." That's your goal. You have done everything that you can as an entrepreneur. As I said, I just cringe when I see a lot of business plans that have this as their final slide, when the entrepreneur proposes how much of their company they're planning to give up for this amount of money.

...a way to actually work with an investor. If the investor comes back and says, sure, we can invest $250,000, but you have to give us 75% of your company, you can always say no. You can say, no, I think I can find a better deal somewhere else. But you want every investor to come back and say, I want to work with you. You obviously belong in my portfolio. Let's see if we can actually make a deal. That's as much as you can do. Let's go on to the next slide.

So, how can you actually talk the investor into funding you? In addition to putting out how awesome your business is and how big the potential is and all the standard things that show up in a business plan, what else can you say that will make the investor want to actually work with you and say, this is more likely to be a cherry than a lemon? So, number one, you can show them how much of their capital is actually at risk and how much of it isn't.

If you're talking about creating something from scratch, you have this basic prototype and you have to go and turn it into a product, and then you have to go and buy Super Bowl ads and the money is going to be spent on advertising and it's all going to burn up in one day, you say 100% of it is at risk. If, on the other hand, you're talking about creating a rental business, you're going to buy a lot of lawnmowers and portable air conditioners, and then at the end of the summer you're still going to have a lot of lawnmowers and portable air conditioners, not all of that money is at risk. It's very important to say how much of it is likely to go away if this business fails.

how much can actually be salvaged. If there is something which is not at risk, it is possible to use some form of money other than venture capital to actually fund that business. Now, if you can get a bank, with the support of your investor, to loan you money in order to go and buy those lawnmowers and portable air conditioners, that's great. Your investor will support that.

However, the investor would rather put that money in rather than having your business fail. They just don't have to have the same kind of return expectations for that money, because after all, it's not at risk for being a lemon the same way that the other equity is. And so, if you go and show your investor that even if the business folds after a couple of years, they can get 50% of their money back, it makes it a lot more attractive for them to actually put money in in the first place. A lot of...

Some business plan books actually tell you not to do this. They say tell your investor that all of the money is at risk because who knows, you know, if you lose the money they might sue you or something. But they say don't tell people that you're thinking about failure because only losers think about failure. I couldn't disagree with this more. Tell your investor and show your investor what you know about this business and what's going to happen. Show them.

Thought about how this works, show them what it would take in order to cause you to cash out of this business after a year or two with a 50% loss. Meet that problem head on. It will impress your investor and make them a lot more likely to actually fund you. You can only benefit from this if you can find some naive and irresponsible investor who's going to invest somebody else's money, throw money at you even though you have no plan, and then you can put half of it in your pocket and lose all their money.

For you to come out ahead by having your business fail, right? But by being very clear about what happens when your business does fail, you show them that your interests are aligned with theirs, and you're going to do your darndest to make the business succeed. So along with that goes the risk-reward tradeoff. You say, for the number of dollars which are potentially at risk, for the amount that you're potentially going to lose if the business turns out not to work out, you're getting a much higher return if we succeed.

You say, sure, you're getting a 10 times return on the total amount of money that you're putting in, but you're getting a 40 times return on the amount which is actually conspicuously at risk. The other 75% is going sideways. You're going to get that back no matter what. So we're kind of like a quarter, like a cherry, and 75% like a sideways investor. That ratio is what they're after. An investor who is able to put lots of little investments in, all of which

Twenty times on their money is going to be just as rich as somebody who makes one big investment that returns 40% of their money. What they want to be sure of is that for every dollar that's potentially at risk of loss, they get a decent return. That's the important part. And so the relevant measure is the return on the at-risk capital, not the return on the total capital invested in the venture. Again, if you could find an external provider of debt to actually put the money in, there are banks which thrive on that.

If your equity capital provider is putting in $100,000, you can often find a bank to loan you $50,000 or $100,000 or $200,000 as well, right? Those two go hand in hand. Your equity provider will be more than happy not to have to put up the money. But if their choices are putting up the money versus not having the venture go, they'll figure out a way to actually make that investment work. Explain to your investor how getting in early gives them extra potential for getting in

Right? So, for example, it's very often the case that when you have a lead investor who comes in, who's going to put in the first money into your venture, you give them better terms or you give them the opportunity to invest more later at the same terms. The idea is they put in $25,000 or $50,000 now, and then you give them a warrant. You say, I'm also going to let you put in $25,000 or $50,000 more next year under the same terms if it turns out that we work together for a year.

You think we're good managers, you know, we haven't necessarily hit the jackpot yet, but you're pretty confident that this is going to work out, and you're happy with having $100K in rather than $50K in. That can be a very, very powerful incentive for the investor to put money in. It doesn't cost you all that much, because you're getting money now when you really need it. If it turns out your business fails, that money does not get invested, because they're not going to go and invest the extra money in a failed business. Next year, it's going to turn out that you have given them the deal of the century.

Because you've allowed them to invest at the initial valuation twice as much money, having gotten a chance to see you in operation the first year. So this is important because lemons can't make that promise. Bad businesses do not come out ahead by doing that kind of promise. And the reason is, after working with them for a year, you say, I'm sorry I put in the first $50,000, I'm certainly never going to put in the second $50,000, right? And so this is a way to separate yourself and distinguish yourself from the bad business plan.

You want to set some milestones where you say, look, if this business isn't really operating very well, if it doesn't meet these milestones, we're going to shut it down, sell off the lawnmowers or whatever we can salvage, and go on to the next business idea. So there's a famous article from the Harvard Business Review called Discovery-Driven Planning. It's by Rita Gunther McGrath and Ian MacMillan. It's one of the authors.

You can get it for free in a number of areas, just Google on discovery and planning, you can easily download it. And it basically provides a step-by-step method of figuring out what has to go right for your business to succeed. And so it's like thinking about doing a business plan for a business you haven't started yet, what do you need to assume is going to work to make this business plan actually reach your objectives? And then you look at these and you say, gee, I'd have to sell 200 tomatoes to every restaurant in Dallas, I don't think that's going to work out. It allows you to put business plans away before you

But the whole point of discovery-driven planning is that you set milestones where you say, if we have not achieved this level of success, we're going to quit. We're going to cut our losses and just go forward with another idea. You want to show your investor that you, the entrepreneur, not only have faith in your idea, but your time is valuable. And if this isn't working out, you're not going to go and try to hang on for another four years to try to draw a meager salary out of this venture. Instead, you want to get out of this, shake hands with your investor, take a modest loss, and go on to the next idea.

Lemons cannot say this. Lemons do not want to let investors out. Lemons don't want to give up their jobs at this bad idea. You, however, say, as an entrepreneur, I'm eager to go on to the next thing. If you do the math, for small investments, your opportunity cost of time working at a failed or failing business is much higher than your investor's opportunity cost of capital. If they're investing $100,000 in that venture, maybe it costs them six or...

$10 or $25,000 a year to have that money tied up, it costs you a lot more than $6 or $10 or $25,000 to go in and punch the clock at that business rather than starting up something else. So you want to show your investor that your incentives are aligned with them. And finally, just kind of a little throw-in section. I teach a whole class on competitive analysis for startups in my entrepreneurial strategy course. Show your investor that you have thought about what's going to happen.

Who else is going to go and try to put you out of business and how you're going to deal with them. I, you know, moderate a lot of investment panels for business plan competitions, and I always poll the judges about what they wish these presenters had spent more time on, and they all say I wish they had spent more time on the competition. They also say I wish they had told me more about how they're going to use the money, but I've already said that. They say I wish they had done more competitive analysis and explained what could possibly go wrong, who's going to try to get in their way, and what...

So, that's talking the investor into funding you at all. Now, given that you've talked them into funding you, now we get down to the part which is actually distributive rather than integrated. Previously we've been talking about working with them as a partner to create win-win solutions, but now, you know, you actually have to get down to brass tacks here. You have to negotiate how much of your business, what kind of equity or what kind of participation they're going to get in exchange for their capital investment. So as I said, you want to get a good pre. That pre stands for the pre-money valuation.

The amount of value that your investor is giving you credit for having already created before their money goes in. And so the idea is they say, "Hey, I think that your idea or your prototype or whatever it is, is worth half a million dollars. How about I put in half a million dollars and I'll have half of the company that follows, right?" They're giving you credit for having created 500K. They're putting in 500K. The pre-money valuation is 500,000. The post-money valuation is a million.

50% of your company for $500K. It's just a mathematical example, okay? But you need to talk your investor into a pre-money valuation, not only which will generate enough cash for you to achieve your business goals, right, we already explained what you're going to use the money for, but which will make you happy that you actually worked with that investor. So you want to emphasize the risk-reward tradeoff we talked about before. You say you're not putting in that much money, but it could turn into something which is 50x your capital. That allows you to talk them up in the pre-money valuation. You say, you know, this thing is now...

We think it can turn into $10 million; going from $1 million to $10 million gives you a ten times return on your capital, but only $250,000 of the original $1 million is at risk — that's a 40 times return on the capital which is there. That allows you to turn your business plan, or your very small business, into something which your investor will treat as if it's worth $300,000, $500,000, $1 million, $2 million, whatever. Your pre-money valuation as an entrepreneur is where you make money in these negotiations, because, since your investor is giving you credit for this, it's not quite the same as selling your business to the investor, but you are equivalently getting the investor's cash.

...of your company by having a better pre-money valuation. You can offer them sweeter options later on. You say, "Well, rather than putting in money at a one million dollar pre-money valuation, how about you buy stock at a two million dollar pre-money valuation, but I'll give you the option to buy more stock at the two million dollar pre-money valuation later on." Right? They can agree to that and get the same kind of risk-reward tradeoff, and instantly you've doubled the value of your company. Right? All you have to do is just...

And so instantly, that initial investor has made 5 to 10 times on their money.

The business is still growing. So if they think they can get you to that critical level of $5 million by achieving your milestone with you spending their money using exactly the plan that you have laid out to them, they'll look at that and say, okay, that's good. I'll give you credit for having created half a million or a million dollars just with your business plan and six months' worth of due diligence, six months' worth of work. That's a huge...

Huge implied wage for you as an entrepreneur. The goal is to think about what you're getting in return for taking investor money. You can stress to them that you need both at-risk and not-at-risk capital, but that you're asking them for the at-risk part. You say, we can go and borrow money somewhere else, we can go to hard money lenders, we can go to banks, there are a number of banks who do venture lending in conjunction with equity capital. And you say, but we're gonna have to pay them a lot of interest. So, you know, Texas State.

18% APR on business loans. There are a lot of money lenders out there who charge 18%, sometimes plus a little bit of extra, in order to provide loans to businesses. And you say, we could do that, but wouldn't you like to actually capture that return instead? If we pay out all our money on interest, you're paying for part of that because you own part of the company. Wouldn't you rather actually be the lender? And the investor might say, sure. Or they might say, no, I really need to focus on equity investments.

But I'll help you go out and get a better rate because I have a relationship with them. Either way, you win. You can offer them dilution protection and tag-along options. And so dilution protection simply says, well, you're putting in $100,000 for 10% of the company now, and you say, you will still have 10% of the company even after we go and raise more money later. And that's how dilution protection works.

Otherwise, when you raise more money, they go from 10% to 7.5% to 5%. You can still make a lot of money owning just a few percent of something which is worth an enormous amount, but that dilution protection is very valuable to your early investors and it doesn't cost you all that much. Similarly, you can offer them tag-along options, which says when we raise money later on, I guarantee that you will be able to also put more money in later on at the same terms that the other investors will do. You say you're getting better terms now, right, give me money now because we need it right now, but you'll be able to participate later on, whereas a typical investor doesn't know whether they're...

You're going to be able to put more money in later, it's up to you as the entrepreneur to decide whose money you're going to take. I personally think that you should explain to your investor, or at least signal to your investor, that incentives are important, that you want this business to succeed, that you're willing to put in 100%, if not more, of your effort, and that you are completely committed to the success of this entrepreneurial venture. But, you know, it never hurts to ask.

A little bit more incentive. It's entirely possible to motivate people who are coming on in the business, other than you, that is, to do extraordinary things, to put in a huge amount of effort in exchange for a very relatively small percentage of the company in terms of stock options. They come in and they take a tenth of a percent or a quarter of a percent or half a percent, and they work nonstop for you for a year and a half.

for only three or four thousand dollars a month. You're able to pay them relatively small amounts of cash, but you pay them in options which are valuable on the upside. And, you know, you explain to your investors that you're going to be going and building your team and compensating them with options and not with cash. That gives them extra leverage on their original investment. If you show that you know what you're talking about there, investors are willing to give you credit for creating value in the future in your business, and that will then reflect what kind of value you can get from them.

So I mentioned $3,000 or $4,000 a month. So this is something that, you know, I say a lot to investors, and I work with my MBA students in order to explain to them how it's possible to actually keep body and soul together on $3,000 to $4,000 a month. Lots of people do. That's like the median household income in the United States. It is really, really hard.

to be a startup founder and not have any cash coming in. I mean, you have to have saved up an awful lot of money in order to make that possible. It's simply not sustainable for you to live a high-stress founder's life and be whittling down your savings and constantly be worrying about when you're going to go and run out of money, and especially if your spouse is constantly, you know, carping at you about, you know, burning through this money and not getting any response. It's really hard to do that.

If you know that you have $3,000 or $4,000 a month coming in from the business, if you clear this with your investor and you say, yes, I'm going to take a salary, but my goal is not to get rich off of this salary, I'm not trying to drain the money of the company, this $3,000 or $4,000 a month is just to keep me in good shape so that I can put all of my effort into it, the investor will say, oh, that sounds pretty reasonable. I have never seen an investor who says, gee, this is a ploy in order to get a $36,000 a year job, particularly if you're coming with an advanced degree or some experience or a patent or...

No investor is going to think you're trying to pull the wool over their eyes when you pencil yourself in for three or four thousand dollars a month. And so I would advise you, don't take a founder's salary of higher than that with your first round of investment. Later on when you raise multiple millions, then you can deal yourself in for a real executive salary. Nobody will care at that point. But you go and you say, I need this much money in order to kind of keep things together. I've kept it at the minimal level. I'm keeping most of my founder's equity. I don't want to raise extra money just so that I can then pay myself, right? That's not your...

This is also something that a lemon cannot afford to do. You know, people will not be interested in working on ventures which are not going to succeed just for being able to draw $3,000 a month of salary, whereas if you start drawing $10,000 a month of salary, there are a lot of people out there who will work in any business, no matter how terrible it is, for $10,000 a month. This is a way to prove that you're serious. And finally, you want to charge a lot more for

You want controlling interest in the firm rather than a minority interest in the firm. You want to be selling off 10, 20, 25% of your business at most for this initial round of funding. You want to make sure that you still have solidly more than 50% of the shares, not only so that you can manage it effectively, but so that you have room in order to sell some more shares later at a much higher valuation. So you may find an investor who comes in and says, yes, I'd like to buy more than half of the firm.

And they'll offer you what seems like a lot of money, and you look at that and say, hmm, they're paying me a million dollars for 51% of the firm. That sounds like there's a pretty serious pre-money valuation in there, right? Two million dollars right off the bat. You're tempted to say yes. The trouble is, when you do that, you cut yourself off from a lot of future appreciation. That's the mark of a lemon, right? Lemons want to go and get all the money up front for a large share.

And sell lots and lots of stock up front. Whereas cherries want to say, no, no, no, I just need $122,500. I've worked that out. I think that's going to be enough. I want to sell as little as I possibly can. And I want to raise money at five times the valuation in a year or two. I don't want extra money now. All of these things are very important to getting your investor to say yes, because you're holding up a sign saying a lemon could not do it this way, right? I belong in your portfolio. I am not a lemon. Okay? Let's go on.

Next slide. So just a few thoughts about doing a second round. And so, you, you, you know, might have figured out, I not only teach this stuff, but I also do it. I've invested in dozens of startups in amounts ranging from $10,000 up to $100,000. I don't think I've put $100,000 of capital into any given startup yet, but there will always be this opportunity. And believe me, I've had plenty of lemons, right? I cannot pick winners.

100% of the time, however, I'm doing better than 1 in 8, right? So, you know, I guess we have to be grateful for those kinds of things. Very frequently what happens is that no plan survives initial contact with the enemy. The business plan that the investor put together, and they found out that they needed $150,000, and I went and put in $50,000 and two other people put in $50,000; they find out six months into it that they need another $50,000 that they didn't plan for. That kind of thing happens. You don't assume that they're a bad manager just because they weren't able to predict

It was actually the physicist Niels Bohr who said predictions of any kind are hard, but especially those about the future. It sounds like it's Yogi Berra, but it's not actually. And so there's no problem if they need this. However, it's extremely difficult to go to a stranger, to a brand new investor, and say, I need $50,000 right away, or either my business is going to fail, or I'm going to miss out on this amazing opportunity which is going to cause my business to grow. The typical investor.

This has conveniently come up at a time when I have to make my decision very quickly. And so it's very difficult to actually get a new investor to put money in there. However, an existing investor who has already gone through your stuff, who's vetted you, who's vetted your business, who knows that you're real, who's watched what you've been doing for six months.

who you've been keeping up on what's going on, who's seen this opportunity develop or seen the difficulty develop, will say, okay, I could see my way towards putting in some more money at this point, but it's going to cost you, right? You're going to have to give substantially better terms because you need this money quickly. It's either because your business is kind of potentially floundering, or it's because there's this great opportunity out there which, if you don't have the money, you won't be able to see it, you won't be able to seize. So, you know, as an investor, I love these.

Because the entrepreneur comes to me and says, I need $50,000. Here's what it's for. And rather than specifying what it is that they'll take, they say, can we come up with a creative way so that we can grab this opportunity together? And very often there's a way to be able to say yes. A lot of entrepreneurs miss this opportunity because they either try to raise too much up front or they say, well, I could never give an investor a good deal now because that would betray my existing investors. I don't want to

Raise $50,000 saying my business is only worth a million bucks. I mean, I'd have to give up 5% of my company, and they miss out on the idea that they could make their business worth several million dollars if they manage to make it happen, and the opportunity just passes them by. So, what's the solution? When you need money urgently, number one, be very happy that six months or a year.

You have persuaded your investors that you are the entrepreneur that they want to work with, that your business is the one that they want to invest in, that they wanted to get in their initial capital beforehand. So have existing investors who have already done their due diligence on you and on the opportunity. Come to your investors and say, guess what? We didn't think we were going to need money, but we do. Here is what we need the money for. How much money we need, $50,000. The amount.

Right, we need it quickly and we're going to go and spend it almost immediately over the next three months. And the milestone, you say, here's why we actually need to have it and what's going to happen if we get this money. Same method you used before, saying you have this one-time need right now for this specific amount of capital, and you say, I'm open to a creative offer, right? Can you see some method by which you could put more capital in?

And you point out to them, not only will they be able to profit by providing you capital when you need it, but their existing shares will be worth more because of that, because your business is going to be worth more because you actually have an idea of what you're going to go and put the money in. So after you put this idea to them and while they're trying to think about some kind of creative idea, you can do a little bit of calculation on your own. You ask yourself, how would I solve this problem in a perfect dream world? How would I say, well, I'd love for an investor to show up and say, oh, you've made a lot of progress in the last six months. I'm willing to give you twice the valuation.

In your previous round, and you say, hmm, well, previously I did the valuation at $2 million. I'd love to be able to sell stock at $4 million. Wouldn't that be great? That's a bad number. I'd love to be able to sell stock at $5 million. Wouldn't that be great? I'd only have to give up 1%, right? You need $50K, 1% of $5 million. And you say, OK, that's the dream world. And then the little dream bubble pops on top of your head, and you say, OK, in my dream world, I'd be giving up 1%.

Right, to get this money. And then the investor comes back to you and says, well, okay, I'll put some money in, but instead of you giving up 1% of your company, you're going to have to give up 2.5% of your company. Right? You say, this is not my dream world. They come back and say, or, you know, I want to get my $50,000 repaid with interest in three months, and I want to have a warrant for a half percent of your company.

You can then calculate out what the difference is between what your investor is proposing and what you would have had happen in your dream world. And then you look at that and you say, well, okay, I come out $10,000 worse this way. You convert this to a dollar amount. Rather than focusing on your valuation or focusing on dilution or anything like that, you say, it's going to cost me $10,000.

...as an investor, to seize this opportunity. And then you look at that and say, boy, that's great. For a cost of only $10,000, I'll be able to actually either avoid this huge problem, or I'll be able to go off in a different direction, which is tremendously promising. I look at you and say, great, it's a done deal. Once you reduce it to that amount, you can spend endless days arguing about what the valuation is going to be or what the terms are going to be...

But once you, as the entrepreneur, reduce this thing to the cost of getting out of the jam, or the cost of exploiting this one-time opportunity, you've basically solved the problem. Your investor will come back with something where you say, 'Okay, that's palatable. Maybe you'll only get 70% of the benefit, and you're going to let your investor get 30% of it.' It's okay. That benefit is not going to happen at all if your investor and you don't actually get together in order to make that happen. And so, as I said, these are just kind of my final thoughts about raising much-needed money without giving away.

Previously, you were thinking this through, you had a long period of time, you had all the time you needed to plan, you could think about exactly what it is that you needed to get, you could describe to your investors exactly what you need to spend it on, and you can prepare a presentation which shows that you've thought about them as an investor, shows that you have this theory of mind going on inside your own head, and that you've thought about what they need, I promise they will be receptive to this.

I promise that they will not think worse of you because you are thinking like them and trying to make this attractive to them. I gave you some tips about how to actually negotiate these deals at the negotiating table, what kind of things you can throw in to make it more attractive to them, to get them to say yes and to bring you an offer. And then finally, I hope that I've given you my perspective on how to deal with things that you have to get done in a hurry. This is not going to work with people who have not worked with you before, because you really don't have enough time to show.

Show them that you're high quality and they want to make this investment, but your existing investors will not only look at you and say, "this is great," but they will respect you more for thinking about them and bringing them the opportunity in order to make their existing investments more profitable while also showing them the opportunity to work with you in a creative fashion. And so with that, I think we have some time for some Q&A, and I'd love to hear your questions or suggestions of what you've heard of that works, or I'd be happy to answer questions about, you know, how you would go about doing any of this in practice in a business that you happen to be offering. So you didn't bring it up, but

So the question is, how do you go about finding an investor? The basic answer is, go to places where investors are and meet them, or talk to people.

People who know investors and get introduced. And so, you know, investors go and have breakfast and lunch with a lot of people, and coffee, right? You know, I have $500 on my Starbucks gift card. And, you know, I meet people for coffee all the time. The great thing about meeting people, meeting entrepreneurs for coffee, is that for $1.70 I get to meet them whenever I want. And so I say, hey, how about we meet at the Starbucks at Preston Center? For $1.70, I can get you to show up to that meeting. I'll buy you a cup of coffee. We can talk for half an hour.

Just about any investor is interested in doing some initial discussion with you, provided they have some reason to believe that you have some promise. And so if somebody introduces you or recommends you, or if you meet them at an event which is designed to bring together promising entrepreneurs and promising investors, they're willing to do this very initial kind of casual meeting.

Because most of the time they have to just eliminate people from their consideration. And as I said before, they have to eliminate six or seven or eight for every one that they're going to fund. There are plenty of investors out there, but basically, meet them or get introduced to them, ask them for a meeting, and say, I'd love to be able to just show you a few things about what's going on with the business. Do not let them get out of there without the ATM. Without saying, I need $50,000. I'm going to spend it over six months. I'm going to spend it on this. Even if they don't actually fund you personally, they may refer you to somebody who is interested in that.

Something completely random happens a few weeks after that, just because you took the meeting with that investor. Right. I'm really interested in forecasting. I feel like a lot of founders, they just throw out 12, 24, 36-month forecasts. They really don't know how they're going to get there. So what principles would you maybe offer to an entrepreneur that is looking to put together something that's realistic?

Well, I would say, you know, be prepared to answer questions about how those forecasts were created. If you basically say, well, so I picked a number and then I increased it 8% a quarter for every quarter, I just sort of copied right with Excel and I got some really big number, you've found a limit at that point. So I would say all good forecasts are bottom-up forecasts. If you can't tell me how you're going to get your first half dozen customers...

Tell me how you're going to get your first hundred customers. And so spend a lot of time in the first couple of quarters saying, "Okay, here's how we get customers. I have this list. I'm going to call them. I have people who are going to come and talk to them. We're going to convert 12% of them. I've talked to a dozen of them already, and two or three of them are interested." Build that forecast from the ground up.

I mean, that's not very original. It's discussed in the discovery-driven planning procedure. But it basically says, figure out how you're actually going to accomplish it. And then, at that point, you can wave your hand a little bit and say, so I've worked out what's going to happen in the first four months and exactly who we're going to talk to and who's going to be doing it. Now let me see. That says we're going to go and grow it 22% a quarter. If we extend that out for an additional eight quarters, and then you're explicitly telling them you have moved away from something which is bottom-up and now you're thinking about this kind of extrapolating. You say, if we extend that for the next eight quarters,

You've been very open with them about where your forecast came from. I would say anything that doesn't do it that way is doomed to fail. It's just kind of an indicative number to say, if this works, this would be what you were looking at. And you're just inviting your investor to say, okay, I'll take a look at that, but they're going to come back and press you on the specific data. Were a lot of your early statistics based on angel investing or venture capital, which are starting to [unclear] now?

But I mean, there's like the Halo Report and some things like that that have these statistics to prove this out pretty well. Well, I mean, I think it varies a lot depending on what type of industry is being invested in, how many deals are being presented. There's a complex process of saying, not only are you, these are statistics for ones that you've actually invested in, right? So not only are you investing in a subset of the ones that you've looked at, but you've considered investing in many hundreds of other ones. And so, you know, the 7-to-1 number is just set up.

to create a nice mathematical example in order to say, here's what happens when most of your original investments fail, but you can still come out ahead. Clearly, that statistic varies a lot depending on how much filtering you're doing up front, depending on what the base rate of success is in businesses, and it's quite different for manufacturing versus services versus transportation businesses, for example, than it is for high-tech innovation. So don't place too much emphasis on the 70% failing number. What I wanted to do with that example is to say, for every one that succeeds, here's how many failures it can bring along with it.

Right, think of it as the, you know, the offensive line dragging the football down the field and two or three defenders behind him. You say, how many failures can be put up with, given this kind of risk-reward trade-off? But as you mentioned, you can take a look at the actual returns of some pretty well-documented funds and angel groups in order to get an idea of how that works. But the trouble is, I don't...

I don't think you can necessarily learn a lot from that because you don't know how many other investments they've passed up, right? And you don't know how the investments they passed up did. And so, when you try to look at their performance and how many succeeded, you don't know what the correct counterfactual is to evaluate that against. You can't, for example, compare it to an index of all of the startups that they looked at, right, the same way that you can compare a hedge fund's performance against the S&P 500, because you literally don't know what the alternative was going to be. And so you can get that data, but it's kind of dicey to try to make any significant inferences from it and to be able to replicate their performance because you don't really know what else they didn't do. Now, the other flip side to this a little bit, from an investor's mindset, you wonder sometimes if...

They invest in eight deals. They have one cherry and seven lemons. They don't tell anybody about the seven lemons. All they ever really publicize is the cherry, and some of that is about their ego, that they brag, you know, it's all the cherry gets the publicity and the seven lemons get zero, so they kind of just wither away. So I sometimes wonder,

The investor mindset of trying to get the big thing is because they want to be a part of the big thing. Because I own one percent of Facebook or whatever. Well, I think this leads to a lot of, I would say, inefficient behavior by investors. They want to make sure that they are not shut out of the next big thing. They want to make sure that they have some Uber in their portfolio, for example. Fear of missing out. Exactly, right? And they're willing to pay out more.

...for tiny little slivers of these companies, like window dressing, just to show that they have something like that in their portfolio. I mean, I don't quite understand that, but I can understand how there could be both psychological reasons, as you described, and objectively financial reasons, if there are potential limited partners who are going to be investing in their future funds, who are going to notice that they invested in Uber and not spend...

They spend a lot of time doing due diligence about figuring out how early or late to the party they were and how much they paid for their sliver; that might actually work. And so I would say, you know, you ask yourself who benefits from this kind of thing. I suspect that the reason why investors are doing this is not because they believe that they're going to make a huge profit by investing in Uber at a $50 or $60 billion valuation, but they want to be seen as being a different kind of investor because they're willing to do this. And I mean, that's a game which is a couple of orders of magnitude above what I'm talking about here. I'm talking about people who are actually trying to get in early

You know, on a $1 or $2 million valuation at most, and try to turn these companies into $5 or $10 million valuations and flip them, right? Get bought out, right? Get converted, get cleaned up in later rounds so you can turn around and recycle your money and, you know, make another 500% or 1,000%. So talk to us about investing in the team, investing in the market opportunity, maybe the technology applied to market.

How has that turned out in the real world of investing? Well, I think there are a lot of investors who are

was not willing to put time and energy into companies that are not doing well, right? That are not meeting their objectives, they're not outperforming. So this is the so-called tilted runt strategy. And especially in very... tilted runt strategy. My understanding is that this comes from the practice of pig farming, where you have literally four pigs that are going to grow to maturity and one that's the runt, and you say, it's not worth actually feeding the runt because it's never going to produce enough bacon to make it worthwhile. And so you have to say, well, five were born, but really there are only four viable.

I think there are a lot of investors who have enough deals going forward and have enough companies that they're dealing with that they say, "I just can't put any time or money in trying to salvage my $100,000," right? Trying to convert the lemons into something that goes sideways. I may just shrug and say, "I'd rather just cut my losses, you know, get out, get back whatever I can, sell off my ownership in this to somebody who specializes in distressed companies, maybe get $30,000 back, and then go

and search for another chair. On the other hand, there are plenty of investors, and for that matter, consultants and business services that specialize in that kind of thing, where they say, I'd like to be able to come in and for a very small amount of money, get a noticeable ownership proposition in a turnaround situation. I don't think that just because a startup won't necessarily produce 25.9% compounded for 10 years,

But they can't be successful as a business. They're just not going to have that kind of explosive growth trajectory that the investors are looking for. And so, you know, often you speak of pivot. People talk about pivoting to say they're trying to get out of a mistaken strategy and into something that's just going to work. I would also say there's a pivot to being able to say, all right, we're going to go into damage control mode. We're going to try to figure out how to turn this into a business, which is going to produce some kind of return on capital.

There are all kinds of pivots that are available. I think the trick is when you're talking to an investor, you need to find out whether they are tolerant of the idea that it's possible that there's some middle ground between losing their $100k and making a million or two million or four million. Some investors will say I'm completely uninterested.

Some investors will say, yes, I'm a little bit more risk-averse, I want to go and preserve that capital. I've had businesses like this that turn $100,000 into $200,000. We don't look at those as being cherries, but it's still a lot better than losing your entire capital base, right? Some investors are willing to actually pitch in more. I can understand both sides of that argument. It really depends on their opportunity cost of attention and how many other deals they have clamoring at their table. If they have many, many more investment opportunities, they're just gonna want to kill the runts and get out and not spend any time doing it.

On the other hand, I can imagine that it might be possible to put together a little miniature private equity fund which goes and buys up stakes at big discounts in businesses which are not actually failing. They're just not producing the kind of returns that these venture investors want. And that could build up to a substantial value creation opportunity over time. Sorry, any other questions? As we wrap up, maybe two more questions, but as we wrap up, what I'd like to do is ask if there's some takeaways there that you'd like to share back for what we got tonight. Go ahead with the question. My question is regarding valuation. Okay. False valuation of the company. Can you talk about how that can be kind of detrimental as far as the company moving forward?

... Well, so I think I can kind of dodge your question in the way that I'm encouraging you to dodge that valuation problem in talking to your investors. It's my fervent...

It's investors who set valuations, not entrepreneurs. And so the whole idea is you say, look, I've got this great idea, right? We have a team which is capable of doing it, right? Joe, you know, asked about the team versus the market opportunity. There's this nice, another article by William Solomon called How to Write a Great Business Plan, and he describes how a typical investor, a typical VC investor, reads a business plan. They read the executive summary, which is a page or less.

to try to find out what the business is about. They skip through about forty pages of the actual business plan, and they go right to the bios of the team members. And if they don't see something where they say, obviously this is the right team for this, they throw the whole thing in the trash. And they say, you know, if you haven't passed that, right, they literally go right from the executive summary to the bios. You must pass that screen before they're actually going to go and take a look at your financials and think about what the opportunity is. That seems like it's a little black and white to me, but I don't think it's a

But, you know, I would say it's the investor who sets the valuation. You want to go in and say, I have a solid team. You want to believe that we can do this. You want to believe that we know what we're talking about. When we say we need $200,000, that means we need $200,000. And at that point, the investor comes back and says, okay, I feel like I can give you $200,000.

They’re making an offer to you rather than you trying to set an offer and worrying about scaring them off. So hopefully, you haven't put all of your eggs in one basket. You've talked to multiple potential investors because you've gone to a lot of, you know, ideas or you've gone to a lot of places. You have four or five investors who all say, "I'd like to get some of my money into this idea early," and then you can work together with several of them in order to come out with a nice blended valuation that will give you the money that you need at a valuation that you can deal with. I think it's that, you know...

and try to set valuations for their own companies are only putting themselves in jeopardy. And at the end of the day, you know, your company, especially a company in a very early stage with a business plan and a few months' worth of sweat equity into it, is worth what investors are willing to give you credit for, as opposed to having any true intrinsic value as a long-term cash-generating business. On the other hand, I can think of very few ways that one can generate true

For your $500,000 worth of value in a six-month period except by creating a strong business plan and putting together a strong team and then going out and raising money based on a $500,000 or $1 million or $2 million pre-money valuation. The amount of return that one can get from one's speculative investment in sweat equity there can be really, really high compared to the amount of time which is put in. But again, you can't

You need to value your company based on your own opportunity cost and say, "I could have earned this much as an attorney or this much as a manager." You need to let the business idea speak for itself and let the investors figure out how much they're willing to—how much they're going to ask you to give up for the given amount of money that you've shown them that you need. And so that's a long-winded way of saying I want to dodge that question entirely by asking them to set the valuation rather than you.

There's a particular form of valuation, a particular form of investment technique, which allows them to kick that problem down the road a little bit, and that's the convertible note. A lot of initial investments are made via a convertible note because then that way the investor doesn't actually have to set the valuation; they pass the buck to the next investor, and they say that next investor is going to set the valuation six months or a year from now. And at that point you say, hey, that's great, I got the $75,000 that I need in order to go and get started. It allows us to get going with a minimum of transaction costs; the note can be very simple, the investor understands exactly what's going on, and then later on you'll figure out exactly what percentage of the company or how many shares they're going to have after you actually raise more money later on. And if it turns out that you lose their $75,000 and whatever money you've put in before another investor puts in, it really doesn't matter how many shares they have in the company — the company is going to be worth nothing, and so it's kind of irrelevant. So it allows you to put off the valuation of the cherries while still not worrying too much about how you're going to go and manage your business.

Another question or reflection? A takeaway? What are our takeaways?

Due diligence is to figure out if you're a lemon, more so than figuring out if you're a cherry, is a really good way to look at this that I like in my brain. And there's actually, I like it too, because there's something you can do about that. There's a limited amount of what you can do to persuade people that you're great and awesome. I mean, your presentation and your experience and your resume will do some of that. But there are all sorts of things that you can do to make it easy for people to check you out and to say,

I actually for real, I do know what I'm talking about, you know, I encourage you to probe here and ask me these questions because the average person couldn't answer these questions. I met with a lawyer today and he was telling me in a private placement to really show a lot of risks, you know, come right out front with as many risks as there are to show that you're not an idiot and a pie-in-the-sky kind of guy, and then you'll actually get more respect.

From your investor, would you actually semi-do due diligence for him right up front? I would do that and say, I'm not afraid of showing you that this is true. You'd find it out anyway. Let's grapple with it. If you have questions about it, I'm prepared to answer your questions. I think that's the side of it. Yeah, we had a team here that graduated from GeniusDen. And you made a kind of funny comment that had been made to you.

They'd gotten their funding. Part of the deal was that they were going to move into this space with one of their lead investors, who's also going to help distribute their technology. And it made sense for them to be together. So here we are, off to the new location, great, good for y'all. And we were kind of talking about the win, both the money and the move to a nicer office, et cetera. And he said, it reminds me of my high school football coach. He said, when you score the touchdown, act like you've been here before.

And that's sort of the piece of it. These guys had an air about them that said, we've been here before, we know what we're doing, we're going to go on with it. So acting like, not only when you're number five you're not going to prove it; don't be in the first place, that's my big takeaway. And understand what kind of attitude your investor expects you to bring. You shouldn't be high-fiving your team in the hallway saying, I can't believe they went for it. They should be saying, they asked really good questions.

I can see working with these people going forward, right? You know, we got good advice, right? I respect what they know, etc. That kind of stuff gets back to investors when they know how you're thinking about things. You know, we've seen some disrespect for people who have bought mortgage-backed securities and things like that, right, in the financial crisis. I think that, you know, angel investors and particularly professional VCs...

You know that you're gonna be back for a second or third round later on, maybe for this venture, maybe for another one. You know, you want this to be the beginning of a beautiful friendship. And so you say, even if they say no, you want them to say, this is not a deal for us, but we thought you really showed that you knew what was going on. The reason why we're passing you is this, right, it doesn't meet our return or it's the wrong industry for us. But then they'll provide you with some benefit and potentially introductions to another investor saying, you should really talk to the guys over at Fund X. They make investments like this. I'd be glad to set up a pitch for you. And at that point, all you've done is gotten more practice for the people who are eventually going to fund you. You will still have to pitch an awful lot before you actually land the investment you want. But, you know, the goal is at the end of the day...

to come away with investment at a reasonable valuation from people who are actually going to help you succeed rather than just being passive investors. Does the goal — it just seems to me, from the things I read and stuff — but is it more common that it's really turn one dollar into three dollars over five years? They're both 3X returns. They're both about 25% compounded ROI. That's about right.

They're kind of the same thing, but it's not as big sounding, and yet they're the same return. They're a little quicker than 10 years, is what I'm getting at. Well, so it's challenging to do that, though. I mean, most venture funds that I'm familiar with want to reserve some kind of capital and do some follow-on investments in the people that they've originally seeded. Because if your fund doesn't have the capability of doing those follow-on investments,

Investments, you're really at the mercy of the people who do. You have the opportunity to get crammed down and you get diluted, and that's just a bad thing. And so I think funds that really have a very short horizon for that need to have very particular targets and know how to actually get liquid within that three-year period, and I think that's hard. I mean, you know, I think of three years as being the normal amount of time that an advisor would spend with a startup, for example, right, in their, you know, initial engagement period, or the length of time before you say, okay, is this working, or are we going to go on to another venture? It's hard for me to imagine that even these cherries would be ripe after three years.

Well, okay, well, five years, right, sorry. Yeah, but, you know, right, the question is, do you have a pretty well-defined path to be able to get your money out after five years? Or are you simply going to transfer this asset to another fund at some well-defined transfer price and, you know, right, just, you know, make an accounting transaction that makes it look like there's a five-year return? I mean, right, a three-x return over five years.

I just don't think that, you know, there are some types of businesses which have that kind of revenue cycle, but certainly the, you know, typical business that has the potential to return 40 or 100 times the money takes longer than that to actually have some kind of liquidity event, an acquisition or an IPO.