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Sunday, April 5, 2015

Reasons for New Venture Funding Rejections and How to Avoid It

Whenever you read a business publication today, it would most likely contain articles on venture capitalists, how they find great opportunities and the ventures they fund. It would also showcase success stories and how entrepreneurs landed themselves with venture capital and soared to wealth in a short period of time. And by doing so, it paints a picture that getting funding from venture capitalists is easy while in reality, only a few young companies would get it. 

Timmons & Spinelli (2009) explained that venture capitalists rejects 98% of the opportunities presented to them by young companies. Due to the high risk involved, venture capitalists are very picky. The reasons for the high rejection rate are due to a very stringent screening criteria these venture capitalists use in order to select opportunities with high propensity for commercial growth. 

The reality is that most ventures do not qualify and therefore rejected because of one or more of the following reasons: 

1. The business proposals are not in their preferred industries. 
2. The business proposals have not displayed the potential for growth. 
3. The entrepreneur are not referred by the right person and many other reasons. 
Most venture capitalists like to invest in ventures after the potential has been proven and the risk reduced. They do so by screening every proposal with specific criteria that was based on good business sense. 

Understanding the Mind of Venture Capitalists

Macmillan, Seigel & Narasimha (1985) administered a questionnaire to one hundred venture capitalists to determine the most crucial criteria that they use to decide on funding new ventures. The study shows that above all criteria, the quality of the entrepreneur ultimately determines funding decision. Five of the top ten most important criteria had to do with the entrepreneur’s experience or personality. And the business plan aids the venture capitalists to understand the product or service, the market and the competition and how the entrepreneur fits in the entire picture. 

The study also indicated that venture capitalists assess proposals systematically in terms of six categories of risk that needs to be managed. The six categories are: 

1. Risk of losing the entire investment – the prospect of 10 times return within 5-10 years are relatively insulated from the threat of total loss of the investment. 

2. Risk of unable to bail out if necessary – entrepreneurs who are familiar with the industry knows how to bail out and be able to do so if necessary. 

3. Risk of failure to implement the venture idea – Ventures in which the entrepreneurs have clear idea of what they are doing, who have developed a functional prototype, and which product has a demonstrated market acceptance are more cushioned from product and market development failures. 

4. Competitive risk – a venture with a proprietary product that has little threat of competition within 3 years and an existing market is clearly competitively insulated. 

5. Risk of management failure – The entrepreneur must be capable of intense sustained effort, knows the market thoroughly, and reacts well to risk.

6. Risk of leadership failure – aside from the other factors, the ability to lead is something every venture capitalists consider prior to funding. 

Reasons for Rejections 

Understanding the criteria at which venture capitalists disqualify opportunities is key in creating great business proposals. In order to do this, the study showed 10 essential criteria rated by the respondents.

Ten Criteria Most Frequently Rated Essential

According to the same study, the researchers have identified characteristics of “critically flawed” proposals, which a combination of any of the two would result to rejection.

Percentage of Venture Capitalists Who Would Reject Proposals Which Fail Two Criteria





To interpret, let’s take combination 1 in the list. 84% of the sampled venture capitalist would reject the proposal because it failed two criteria as shown above. And as you go down the list of combinations, you can see the rejection rate. And if we apply to this to the real world, most likely we will experience the same rejection ratings as described in the research literature and findings.

Having the Right Team Matters

Also, looking closely, it would seem that at least one criterion in each of the combination described above is about the entrepreneurs’ character or experience.. In order to mitigate the potential of refusal due to personality or lack of experience, the entrepreneur must ensure that he/she can assemble a team who can compensate for these flaws.

The succeeding graph below came from the same study showing the percent preference of the venture capitalists in terms of team composition. More than half said that each new venture should have a balance team essential. Regardless how the other factors are attractive, most venture capitalists would reject a proposal if this were not met.

Required Venture Team Composition


How Young Companies Can Overcome This


In order to increase the chances of success in securing funding, my research led me to a realization that all the roadblocks for acquiring financial resources points to the elements of Timmon’s model – Opportunity, Team, and Resources.

The case studies and research done by other people still points to the basic foundation of Timmon’s model and how venture capitalists screen all aplicants for funding. It talks about finding the right opportunity using a set of criteria such as growth potential, rate of return on investment and exit strategy.

It also talks about the element of a team and how venture capitalists puts a lot of weight in the character of the entrepreneur and his recruited team members whose skills, expertise and experience compliments that entire venture.

Lastly, this topic is all about securing financial resources which is the third element in Timmon’s model. I learnt that this component of the model if secured via venture capitalists is highly dependent on the two elements. If the entrepeneur deosn’t have the right opportunity and has a mediocre team, the chances of rejection is extremely high.

6:49 PM Posted by Nicco Joselito Lopez-Tan (陳里道) 0

Sunday, January 4, 2015

Top 10 Reasons Why Investors Reject Financing New Businesses



Ever wonder how start-ups find capital to fund their businesses?

A study was conducted by an American research firm to analyze a 10 year historical performance of new businesses opening and businesses closing down. The study reported  that an average of 46.4% of new businesses fails within the 2 to 5 years of operations. From an industry perspective, real estate being the lowest at 30% and technology having the highest at 55%. Some takes a bit longer but eventually closes down.


Also, start-up funding is not as easy at is seems. Based on the same study, roughly 98% of new businesses from young companies are rejected for venture financing. What I learnt is that the reason for such high rejection rate is not satisfying certain criteria.


So if you are in the lookout for investors to finance your up and coming businesses, let me share my top 10 reasons that you should avoid to ensure high probability of getting an investor - or at least spike their interest based on what I learnt from by studying and working in several start-up environment.



Top 10 Rejection Reasons for Financing New Ventures

1. Opportunities that are non-market centric tends to be unattractive opportunities. These are opportunities that are unfocused regarding customer needs. Some of the indicators are companies who have low customer loyalty, a payback to the user of more than 3 years and unable to expand beyond a one-product company.

2. Opportunities that competes in industries that are highly concentrated, perfectly competitive, or that are mature or declining are typically unattractive. Capital requirements and costs to achieve distribution and marketing presences can be prohibitive and price-cutting.

3. Opportunities that have unknown market size with growth rate of less than 10%.

4. Opportunities that forecasts less than 5% market share within 5 years as well as competing in markets with low demand yet high supply.

5. The time to breakeven or positive cash flow is more than 4 years and the ROI is less than 15% - 20%. 

6. There is low value-add strategic importance such as distribution, customer based, geographic coverage, proprietary technology, contractual rights, and the like. 

7. There is no exit mechanism and strategy. Giving some serious thoughts to the options and likelihood that the company can eventually be harvested is an important initial and ongoing aspect of the entrepreneurial process. 

8. Non-attractive opportunities don’t have existing teams that are strong and contain industry rock stars. A team with no proven profit and loss experience in the same technology, market, and service area would most likely result to a poor-performing business. 

9. Founders that are misaligned to the requirements of the business is a sign of poor fit which results to rejection. 

10. The core technology that runs the business has many substitutes or direct competitors.

9:28 PM Posted by Nicco Joselito Lopez-Tan (陳里道) 0

Monday, July 7, 2014

How Calculus Can Help You in Business

Ever wonder why we take calculus during college (with the exception of degrees heavily focusing in the arts)? I remember that most students do not really appreciate this subject due to the 'alien' concept and mind-boggling equations.

Being an engineering student myself, I was a bit confused as to how this subject can help me once I get a full time job. Like any other student, I also asked sarcastically the question - Why do I need calculus? It's not like I'll go to the market and ask for the differential price of a product. Nobody really uses it in real life.  

But as years gone by, and I matured in my chosen field of profession - I realised that Calculus was more than a math subject I need to pass in college. I remember my CEO calling me one time showing me a bell curve graph showing the fluctuation of our EBITDA numbers as we increase or decrease our OPEX. I know, I know... big words! Simply put, my CEO was asking me to find out what metric should we tweak in order to meet that sweet spot to optimise our production cost and at the same time hit our profitability target.

This experience is one of the countless events that forced me to go back to my old textbooks and find a way to answer these crucial questions. And it brought me back to Calculus and the concept of derivatives, limits and functions.

In order to appreciate Calculus and its many applications for business, let me hone this discussion in the topic of derivatives and differentiation. To make it simpler, let me provide a non-standard definition of these two concepts in the context of business administration and management.

A DERIVATIVE is something (a number, a metric, a KPI, etc) which is based  on another source. It is the number or the event that you would like to know given a certain set of information or facts to predict a certain outcome. It is determined only if another variable is present. And the process of finding this Derivative is called DIFFERENTIATION. 

To make sense of this topic, let me give you two cases that I've used  this concepts in reality

CASE 1: Budget Rooms for Rent

Situation: One of the business owners I've helped is an owner of a small apartment for rent for backpackers. He owns 250 rooms across the city and marketing it heavily via the internet and travel agencies. If they rent X apartments then his monthly profit, in dollars, is given by the following equation:

P(x) = 3200x - 80,000 - 8x

Where:
3,200x is the price per room per stay.
-80,000 is the fixed monthly cost to operate the business.
- 8x2 is the recorded rate of the variable cost during operations.

Case Problem: How many rooms should they rent in order to maximise profit?

Some people would think immediately that renting all rooms will be the best case scenario reaping maximum profits. But factoring in cost of operations (both fixed and variable cost), it would be interesting to know if renting out all rooms will definitely be the best possible course monthly for this business owner.

Solution:

We know that the maximum profit is between 0<x<250 range of rented rooms. What we need to do next is to find the derivative of the profit as declared above to get the Critical Points to which we will get the maximum profit. Again, as defined, derivative is something that you would like to know based on other facts (in this case the PROFIT). And we need to differentiate it to get the derivative.

(I assume you know basic differentiation)

P'(x) = 3200-16X
If P'(x) = 0
0 = 3200-16X
16X=3200
X = 200

200 is one of the critical points. Hence the range is between 0<200<250

Substituting these three numbers, we get the following profit per month:

P(0) = -80,000
P(200) = 240,000
P(250) = 220,000

As you can see, renting all 250 rooms produced less profits versus 200 rooms if we factor in operational cost. Hence, the business owner was advice to aim to rent out 200 rooms at regular price in any given month and utilise the remaining 50 for any promotions they would like to do to further increase their earnings.


CASE 2: Cupcakes for Sale!

Situation: Every December, one of my friends sells cupcakes to earn extra during the holiday season. One of her biggest challenge is that after the end of the month, she feels that her total effort in producing the cupcakes versus the money she earns from it is not generating her significant income. She doesn't know what price tiering she would do because her cost increases if she produces more cupcakes.

So, after observing and recording data, we found out that her production cost per day has this function:

C(x) = 2500 - 10x - 0.01x - 0.0002x3
Where:
2500 is her total cost
-10X is her savings since she can produce 10 more cupcakes using the same amount of ingredients
- 0.01xis her savings on electricity
- 0.0002xis her savings on delivery per batch to clients

Case Problem: She wanted to know what would be the rate of change of her cost if she produces 200, 300 and 400 cupcakes in a day in order for her to create an optimal pricing scheme.

Solution:

Same process in the first case, look for the derivative and apply the critical points 200, 300 and 400.

C'(x) = -10 - 0.02x + 0.0006x

C'(200) = $10
C'(300) = $38
C'(400) = $78

As you can see, producing the 201st cupcake will add $10 to her cost, 301st cupcake will cost $38 and the 401st cupcake will be $78.

From this information, she knows that her cost increases every time she increased her production. This made it possible for her to create tiering in her price schemes to cover the increasing cost associated with production.

So there you have it, simple ways you can use derivatives in your business. It has more applications which we can cover in other blog post. If used properly, you can definitely outwit your competition.



11:51 PM Posted by Nicco Joselito Lopez-Tan (陳里道) 4