A successful software company is more than software

A few weeks ago a software entrepreneur made an appointment to visit with me at the Idaho Small Business Development Center.  She brought a mock up of the web pages that encompassed her idea.  She wanted my opinion as to whether or not the idea was worth pursuing.

This is a common occurrence. Someone gets an idea for a very cool new piece of software and the next step is to mock up a design.  For some, the next step is to hire programmers and begin the process of development. But, I think the correct next step is to determine the business potential.

Here are the questions I asked my client to her determine the business potential of her idea:

1.  What is the problem being solved?  In order to have a successful business, her product or service must address a problem in the market place.  Unless there is a real problem for which people will be willing to pay money to solve, the company will fail, no matter how unique or beautiful the software expression. 

For example, in the case of Group-on, the problem addressed is:  businesses would like a cost effective and measurable way to reach new customers.

2.  How big is the problem?  How many people or businesses have this problem.  Unless there is a sufficiently large number of potential clients, the problem while real, may not be worth solving.

For example, Pinterest has discovered there is a very large number of people who are interested in posting pictures to the Internet, and for whom Facebook does not present a satisfactory solution.

3.  How will the company acquire its customers?  Sometimes referred to as the “go to market strategy,” this crucial question is often trivialized.  I often hear answers such as “social media” or “it will go viral.”

The fact of the matter is it is difficult to identify, target and communicate with the market, especially when you are new, have no brand presence and little money to spend on marketing.

Many successful businesses will identify a channel already talking to the target customers and then tap into that channel.  For example,  dealsaver.com, a Group-on competitor has partnered with the Idaho Statesman to bring its service to local advertisers.  The Statesman’s sales force is already calling on businesses so it is relatively easy and inexpensive for that sales force to also pitch Dealsaver to the Statesman’s customers.

4.  What will it cost to acquire a new customer?  Software companies can be very profitable once the software is developed, as the cost of selling another copy is virtually zero. However the business has to find the customer and convince them to use the product. This typically takes money--sometimes lots and lots of money. In order to have a profitable business, the cost of acquiring a customer must be less than the revenue the customer will bring to your company. 

For example, the rumor is that Amazon initially sold its popular Kindle devices for less than its cost.  But, so long as the loss Amazon took selling a Kindle, along with the other costs of acquiring and serving the customer is less than the revenue the customer will spend on e-books, the completed transactions will be profitable.

I recommend all software entrepreneurs think deeply about the above questions and the possible answers before they begin to spend money developing their dream product.  If the answers to the above are not favorable, developing the software is likely to be an exercise in disappointment, and quite possible a financial disaster.

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Dr. Kevin Learned is a counselor at the Idaho Small Business Development Center (www.idahosbdc.org) at Boise State University where he specializes in counseling with entrepreneurs seeking equity capital. He is a member of the Boise Angel Fund, and is a principal in Loon Creek Capital (www.looncreekcapital.com), which assists angels in forming angel funds. He can be reached by email to kevinlearned@boisestate.edu or by phone at 208-426-3875. 

Why the Entrepreneurial Community Should Support the School Levies

I wrote earlier about the fact that new businesses account for most of the new jobs in our economy (“Where do jobs come from? June 20, 2011).  In that piece I argued that to create new jobs in the Treasure Valley, we needed to create an ecosystem that supported entrepreneurs.  Every since then I have been writing about one component of a healthy entrepreneurial ecosystem-early stage capital provided by angel investors.

Today I want to talk about another component of this ecosystem—intellectual capital.  We now live in the knowledge economy where much of the goods and services created by our  businesses, especially our new businesses, are dependent upon a well-educated workforce that can supply the necessary skills and knowledge.

All eleven of the businesses supported by the Boise Angel Fund depend upon access to an educated workforce to provide the brainpower they need to produce and market their cutting edge products and services.  They need, for example, engineers and marketeers; accountants, financiers and intellectual property attorneys; computer software writers and food chemists. None of them need unskilled or semi-skilled workers. 

We obtain these knowledge workers from two sources.  Some are produced by our education system locally.  Others are recruited to move here.  First lets address our own production.

We are not producing enough knowledge workers for our economy. For example, KTVB reported in November that Treasure Valley employers had openings for hundreds of computer programmers that they could not fill (“Demand for software engineers in the Treasure Valley outweighs workforce,” KTVB, November 15, 2011).

There is no quick or easy fix for this problem.  We will solve it only by providing a high quality, challenging education system, from kindergarten through Ph.D programs.

Our state, like most, has had to reduce the resources it can provide to the entire educational system.  Our educators have done a terrific job at holding the system together in the face of declining resources, but the system is fraying. 

Our colleges and universities have made up part of the shortfall through tuition increases, contributions and research grants.  But the K-12 schools have no such options.

They must either reduce services or ask the taxpayers to pay more.  Both the Meridian and Boise School Districts will ask the voters to raise their taxes to provide additional resources on March 13. 

It’s clear to me that the consequences of our failing to provide additional resources to the schools will be a lower quality education for these young people which will result ultimately result in fewer workers with the skills needed to match the demands of our employers.  And without the skilled employee base, our entrepreneurs will not be successful in creating new businesses.

 A note about importing workers.  Yes, we know many people move here for our quality of life.  But they bring families with them and high on their list of requirements in determining to move is the quality of the public education system.

So, my argument to the entrepreneurs who create our exciting new businesses and the angels who finance them, as well as to those who believe a healthy entrepreneurial ecosystem is important to our valley, is to support our local school districts by voting to increase their resources. 

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Dr. Kevin Learned is a counselor at the Idaho Small Business Development Center (www.idahosbdc.org) at Boise State University where he specializes in counseling with entrepreneurs seeking equity capital. He is a member of the Boise Angel Fund, and is a principal in Loon Creek Capital (www.looncreekcapital.com), which assists angels in forming angel funds.  He can be reached by email to kevinlearned@boisestate.edu or by phone at 208-426-3875. 

New Angel Fund Under Development

I am delighted to report that a new angel fund, to be known as the Treasure Valley Angel Fund is in formation and seeking investors.  The purpose of the Fund is to support economic development efforts by providing capital and advice to local entrepreneurs while providing an opportunity for the investors to make a return on their investment.

The CORE, an economic development group based in Meridian and focused on creating a CORE competency in the state in Health and Research sponsored the initiation of the fund. Leadership of the Core worked extensively with the Department of Finance to develop offering parameters that ensure that sales of interests in the Fund are properly qualified under the Idaho Uniform Securities Act.

Over the past few years both the Boise Angel Fund and Highway 12 have been potential sources of early stage capital for local entrepreneurs.   However, Highway 12 is no longer accepting applications for new investments and the Boise Angel Fund is nearly out of capital.  So a new source of capital interested in supporting valley entrepreneurs will be a welcome addition to the entrepreneurial ecosystem.

The Fund will be a “member-managed” LLC.  That means the investors (called “members”) in the fund will make the investment decisions. Once capitalized, the Fund members will appoint a screening committee to consider initial applications from entrepreneurs.  When the screening committee recommends an investment, a due diligence committee will be formed to thoroughly investigate the entrepreneur and his or her business plan, and if warranted, to negotiate the terms of a possible investment.  The recommended investment will then be brought to all the members for a vote.

Whether or not the Fund members agree to make an investment, members will be encouraged to help the entrepreneur by providing advice, access to their contacts, and such other assistance as may be appropriate.  Individual Fund members will be  free to make an investment in the company whether or not the Fund members decide to make an investment of Fund capital.

Before the Fund can make any investments, it must first raise capital to invest.  The Treasure Valley Fund is raising between $750,000 and $2 million.  Units of $50,000 each are being offered to qualified Idaho residents.

The offering to form the new fund is subject to a number of restrictions, the most important of which are:

1.  Only accredited investors (who generally must have a net worth greater than $1 million, excluding the equity in the investor’s primary resident or income greater than $200,000 per year) can participate in the Fund.

2.  Investors must be residents of the State of Idaho

3.  Any investment must not exceed 10% of the net worth of the investor excluding the value of the equity in the investor’s principle residence, furnishings and automobiles. 

Of course, such an investment is very risky and no one should invest in the Fund unless they can afford to lose their entire investment.

If you meet the above criteria and would like to know more, additional information and a copy of the Fund’s Confidential Placement Memorandum can be requested through the Fund’s web site at www.treasurevalleyangelfund.com.

I hope to chronicle the formation of the Treasure Valley Angel Fund over the coming months so that others interested in forming such capital pools might learn from the experience of the Fund.

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Dr. Kevin Learned is a counselor at the Idaho Small Business Development Center (www.idahosbdc.org) at Boise State University where he specializes in counseling with entrepreneurs seeking equity capital. He is a member of the Boise Angel Fund, and is a principal in Loon Creek Capital (www.looncreekcapital.com), which assists angels in forming angel funds. Loon Creek Capital provides consulting services to the Treasure Valley Angel Fund. He can be reached by email to kevinlearned@boisestate.edu or by phone at 208-426-3875. 

Improve your Chances of Receiving Angel Funding

I recently attended a seminar on Trends in Raising Capital in Palo Alto sponsored by the Angel Capital Association (ACA).  The ACA is an association of about 300 angel groups throughout the US and Canada.  Those 300 groups collectively represent about 10,000 active angel investors.

The seminar provided information to leaders of angel groups on the current state of the angel capital market.  One section I found particularly interesting was titled “Meeting Investor Expectations.”  The information, which I summarize below, was based upon a membership survey by the ACA.  58 groups participated representing more than 3,400 individual angels.  Those angels participated in more than 200 deals in 2010, and invested more than $45 million.  

Generally only one out of ten or twenty applications receives funding. According to this survey, there are things the entrepreneur can do to improve the chances of favorable action. While the survey was of member groups of the Angel Capital Association, I believe the findings can inform entrepreneurs approaching individual angels as well.

Get a Referral.  The typical group receives 15-30 applications a month, which is more than they can thoughtfully respond to. A referral to a group by a trusted party (e.g. another angel group, a respected individual angel or VC, an entrepreneur in which the group has invested) may help move the application to the top of the pile.  Referrals from economic development organizations and websites are viewed as having little value.  The perception is that the interests of these organizations are not aligned with those of the angels and therefore their referrals cannot be trusted. 

The Importance of the Executive Summary. The executive summary is like a resume.  The purpose is to get a interview.  Likewise, the purpose of the executive summary is to get a meeting with the angels. In the case of the Boise Angel Fund, over four years we received 214 applications.  Only 66 were invited to a meeting. So two thirds of the executive summaries did not capture sufficient interest to result in a meeting.

Good executive summaries are hard to write. In my experience entrepreneurs often spend weeks on their business plans and minutes on their executive summary, when in fact they should devote a great deal of effort to the executive summary.  In the ACA survey, only 38% of the executive summaries were rated as good.

Writing the Executive Summary. Compelling executive summaries are not more than two pages in length.  They are well written and without grammatical and typographical errors. They are delivered in PDF format so there are no accidental changes or formatting problems.

They cover the following both “POST” and “STORM.”

P-the Problem

O-the Opportunity or market size

S-your Solution (your product or service)

T-your Technology

S-your go to market Strategy

T-your Team

O-Others in the market (the competition)

R-Resources needed by your business

M-Milestones you intend to reach with the resources

Obtaining a referral to a group or an individual angel and preparing a thoughtful executive summary will improve your odds that you will be invited to a meeting with angels, which is the first step in the funding process. 

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Dr. Kevin Learned is a counselor at the Idaho Small Business Development Center (www.idahosbdc.org) at Boise State University where he specializes in counseling with entrepreneurs seeking equity capital. He is a member of the Boise Angel Fund, and is a principal in Loon Creek Capital (www.looncreekcapital.com), which assists angels in forming angel funds. Loon Creek Capital is working with The Core to help create the new Treasure Valley Angel Fund (www.treasurevalleyangelfund.com). He can be reached by email to kevinlearned@boisestate.edu or by phone at 208-426-3875. 

State Small Corporation Offering Registration (SCOR)

Federal securities law requires that securities issued by companies to their investors must be registered with the Securities and Exchange Commission unless the offering qualifies for an exemption from registration. Registration is a complicated and expensive process, generally prohibitive for smaller companies.

One exemption from registration is available if the company offers securities only to accredited investors in a private offering.   An accredited investor must meet certain criteria, the most important of which is that he or she, including the spouse if one, has a net worth of more than $1 million, excluding the value of the person’s primary residence.  A private transaction means that there can be no advertising or publicity about the offering, including no mention of the offering on the company’s web pages.

This type of offering is problematic for many entrepreneurs.  If they don’t have deep networks of accredited investors, it may be virtually impossible for them to raise capital, given that they can’t talk publically about their offering.

There is an alternative.  An entrepreneur can chose to register its company’s offering with its state securities regulator.  This offering is known as a Small Corporation Offering Registration or SCOR.  A SCOR offering allows a company to raise up to $1 million from an unlimited number of investors resident in the state using public advertising. The investors do not have to be accredited.

A SCOR offering is not simple, but it is doable. Boise entrepreneur Doug Joseph is currently conducting a SCOR offering for his company Locate Express as a means of raising capital to expand his business.  Doug reports that he was able to do most of the work of registering his offering himself.

In Idaho our regulator is the Securities Bureau of the Idaho Department of Finance.  The Bureau has published a SCOR manual and other useful documents on its web site. Click on “SCOR/U-7 Filings” under “Forms Available Online” in the upper right of their home page.

I’ve summarized the basics of a SCOR offering below.  But there are technical details that are important and anyone contemplating such an offering must engage legal counsel to advise the company and to give an opinion regarding the securities.

According to the SCOR manual the company must be a corporation or limited liability company.  This offering cannot be used for companies engaged in petroleum exploration and production, mining or other extractive industries.  And the company must not be a development-stage company with no specific business plan or purpose other than a merger.

The stock price must be $1 per share or more.  Financial statements must be provided.  If the company is raising less than $500,000 the statements must be reviewed by a CPA; for offerings between $500,000 and $1 million, the statements are generally required to be audited.

To register your offering with the State, you file a disclosure document known as a U-7 and other documents along with a filing fee of $300.  The purpose of the filing is to disclose all material information about the Company that a typical investor would want to know before making an investment in the company. 

The Idaho Securities Bureau is willing to talk on the phone or meet with an entrepreneur considering making a SCOR offering to review the requirements before the entrepreneur submits the documents.  You can reach the Bureau at 888-346-3378. 

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Dr. Kevin Learned is a counselor at the Idaho Small Business Development Center at Boise State University where he specializes in counseling with entrepreneurs seeking equity capital. He is a member of the Boise Angel Fund, and is a principal in Loon Creek Capital which assists angels in forming angel funds. He can be reached by email to kevinlearned@boisestate.edu.

New Data on Pre-Money Valuations

I thought my previous article was going to be my last for a while on the topic of valuation. But some germane new research has just been published.

In previous articles I discussed the concept of pre- and post-money valuation. Pre-money valuation is the value the entrepreneur and the angels negotiate before the angels invest. Post-money valuation is the pre-money value plus the amount of the investment, and it used for computing the percentage of stock the founders will retain after the investment by the angels.

In the second article on valuation I noted that one of the factors in setting pre-money valuations is the average regional deal value; that is at what value have other similar deals in the area been done? Since angels tend to invest close to home, the entrepreneur will have to compete for funding locally. Angels will look at the value of other similar deals in the area in deciding what value to offer or accept from the entrepreneur.

Bill Payne is a well-regarded angel investor in Montana. He is a member of the Frontier Angel Fund. The Boise Angel Fund and the Frontier Angel Fund have a close working relationship, from time to time investing in each other’s deals. Bill teaches classes on angel investing for the Angel Capital Association and has made more than 50 angel investments himself.

He just completed a survey of 35 angel groups in 26 states and two provinces. The complete results are available on his blog at http://www.billpayne.com/. His survey asks the question “What was the average pre-money value for investments made by your group in pre-revenue companies?” The average answer was $2.1 million, an increase of $400,000 from the previous year.

However, averages hide a lot of data. Valuations ranged from a low of $800,000 to a high of $3.4 million. Interesting for local entrepreneurs is that the Boise Angel Fund was one of two with the lowest valuation of $800,000. The other was Fargo/Morehead Angels, another group with which the Boise Fund has a relationship. In fairness, the Boise Angel Fund only did one pre-money deal in the past year, so that value was very specific to the deal that was done.

There are several implications for Idaho entrepreneurs.

1. Many Idaho angels have generally avoided pre-revenue deals due to their inherent riskiness. In order to entice investors to accept that risk, you have to offer a terrific deal, which means a low valuation.

2. While it is even more difficult to secure money outside of Idaho than inside, an entrepreneur with a truly exceptional opportunity may want to try to get the attention of non-Idaho groups.

3. Some valuations are skewed by the fact that bioscience and medical device deals typically receive higher valuations at the pre-revenue stage. Most Idaho angels will not do such deals.

4. Your pre-revenue deal will likely receive a lower valuation in Idaho than it might receive in a money center. The cure for this is to not seek funding until your company has secured its first revenue, thereby lowering the risk to investors. With a lower risk profile comes a higher valuation.

In our consulting practice at the Idaho Small Business Development Center at Boise State we frequently work with entrepreneurs to help them set a value on their businesses before they go to the market to raise capital. Our services are free and confidential. Call the SBDC at 426-3875 for an appointment if you would like to discuss your company’s value with one of our counselors.
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Dr. Kevin Learned is a counselor at the Idaho Small Business Development Center at Boise State University where he specializes in counseling with entrepreneurs seeking equity capital. He is a member of the Boise Angel Fund, and is a principal in Loon Creek Capital which assists angels in forming angel funds. He can be reached by email to kevinlearned@boisestate.edu.

Valuing Early Stage Businesses, Part III, Understanding Angel Math

This is the final article in a series on valuing early-stage businesses from the standpoint of the angel investor.  You can find the earlier articles at my blog, http://kevinlearned.blogspot.com.  Thanks to Mark Woychick, a participant in the MBA Honors Program for his assistance in preparing this series.

In the earlier articles we talked about the riskiness of an investment in your company and how lowering that risk will result in a higher valuation. We also talked about the importance of comparable such as the average regional deal value and similar businesses and about the value of the team.

In this article we want to present the math that most investors go through in order to validate a valuation.  It’s pretty simple.  Take these variables:

1.      How much money does the company need in this round?

2.     How much can the company be sold for and in how many years?

3.     What multiple of my investment do I believe I need to have the potential to earn to justify my taking the risk?

Given the answers to these questions, we can compute a preliminary valuation of the company.  For example:

1.     The company needs $500,000.

2.     The entrepreneur and our own due diligence suggest the company can be sold for $20 million in five years. 

3.     Given the risk profile, we believe we need to have the potential to receive ten times our investment. Therefore we need to have the potential to receive ten times the investment of $500,000 or $5 million when the company is sold.

4.     If the company will sell for $20 million and we need $5 million of the sales proceeds, then we need to own 25% of the company at exit ($5 million/$20 million).

If we need 25% of the company at exit in order to meet our return objective, and IF the company does not need to raise any more funds between now and exit (admitted a tenuous assumption in that most companies will need to raise additional capital which will dilute our ownership), then we can compute the value of the company today as follows:

1.      Money raised, $500,000

2.     Percent of company needed for this investment, 25%

3.     Value of the company after investment (the “post-money” value) must be $2 million.  That is, with a value of $2 million, our $500,000 investment will purchase 25% of the company.

4.     This means the value of the company before the investment (the “pre-money” value) must be $1.5 million (post-money value of $2 million less investment of $500,000).

Most investors will triangulate on a number of different approaches to valuing the company to substantiate the value.  In the above example, they will compare the computed value of $1.5 million to what they believe similar companies in the region are worth.  They may adjust the value up or down depending upon the quality of the management team or the strength of the intellectual property.  They may run a discounted cash flow analysis on the pro forma projections to see how it compares. 

Valuation of early-stage businesses is difficult and as much art as science.  In the end analysis, the value is what the investors and the entrepreneurs can agree upon.  But the well prepared entrepreneur will understand the different approaches and be prepared to negotiate with the investors based upon them.

In our consulting practice at the Idaho Small Business Development Center at Boise State we frequently work with entrepreneurs to help them set a value on their business before they go to the market to raise capital.  Our services are free and confidential.  Call the SBDC at 426-3875 for an appointment if you would like to discuss your company’s value with one of our counselors.

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Dr. Kevin Learned is a counselor at the Idaho Small Business Development Center (www.idahosbdc.org) at Boise State University where he specializes in counseling with entrepreneurs seeking equity capital. He is a member of the Boise Angel Fund, and is a principal in Loon Creek Capital (www.looncreekcapital.com), which assists angels in forming angel funds. He can be reached by email to kevinlearned@boisestate.edu.