Every startup has its own natural level of startup costs. It’s built into the circumstances, like strategy, location, and resources. Call it the natural startup level; or maybe the sweet spot.

1. The Plan

For example, Mabel’s Thai restaurant in San Francisco is going to need about $950,000, while Ralph’s new catering business needs only about $50,000. The level is determined by factors like strategy, scope, founders’ objectives, location, and so forth. Let’s call it its natural level. That natural startup level is built into the nature of the business, something like DNA.

Startup cost estimates have three parts: a list of expenses, a list of assets needed, and an initial cash number calculated to cover the company through the early months when most startups are still too young to generate sufficient revenue to cover their monthly costs.

It’s not just a matter of industry type or best practices; strategy, resources, and location make huge differences. The fact that it’s a Vietnamese restaurant or a graphic arts business or a retail shoe store doesn’t determine the natural startup level, by itself. A lot depends on where, by whom, with what strategy, and what resources.

While we don’t know it for sure ever — because even after we count the actual costs, we can always second-guess our actual spending — I do believe we can understand something like natural levels, somehow related to the nature of the specific startup.

Marketing strategy, just as an example, might make a huge difference. The company planning to buy Web traffic will naturally spend much more in its early months than the company planning to depend on viral word of mouth. It’s in the plan.

So too with location, product development strategy, management team and compensation, lots of different factors. They’re all in the plan. They result in our natural startup level.

2. Funding or Not Funding

There’s an obvious relationship between the amount of money needed and whether or not there’s funding, and where and how you seek that funding. It’s not random, it’s related to the plan itself. Here again is the idea of a natural level, of a fit between the nature of the business startup, and its funding strategy.

It seems that you start with your own resources, and if that’s enough, you stop there too. You look at what you can borrow. And you deal with realities of friends and family (limited for most people), angel investment (for more money, but also limited by realities of investor needs, payoffs, etc.), and venture capital (available for only a few very high-end plans, with good teams, defensible markets, scalability, etc.).

3. Launch or Revise

Somewhere in this process is a sense of scale and reality. If the natural startup cost is $2 million but you don’t have a proven team and a strong plan, then you don’t just raise less money, and you don’t just make do with less. No — and this is important — at that point, you have to revise your plan. You don’t just go blindly on spending money (and probably dumping it down the drain) if the money raised, or the money raisable, doesn’t match the amount the plan requires.

Revise the plan. Lower your sites. Narrow your market. Slow your projected growth rate.

Bring in a stronger team. New partners? More experienced people? Maybe a different ownership structure will help.

What’s really important is you have to jump out of a flawed assumption set and revise the plan. I’ve seen this too often: you do the plan, set the amounts, fail the funding, and then just keep going, but without the needed funding.

And that’s just not likely to work. And, more important, it is likely to cause you to fail, and lose money while you’re doing it.

Repetition for emphasis: you revise the plan to give it a different natural need level. You don’t just make do with less. You also do less.

There was a nice piece in Small Biz Labs yesterday, in which Steve King notes that you should have a business plan whether or not you expect investors to read it. He offers this summary in that post:

In my opinion, the best way to prepare for the pitch process is to develop a business plan. Preparing a plan organizes the entrepreneur’s thinking, requires going through all aspects of the business and helps to identify important issues facing the company.

Agreed.

Imagine, if you will, this scene:

You are in a group of angel investors talking with entrepreneurs looking for funding. Or you are in a group of venture competition judges giving feedback to teams after the judging is over. The entrepreneurs listen intently, nod, they’re understanding, and then suddenly one or more of their faces change, crestfallen, disappointed, cheated. Something that was just said triggered an immediate reaction:

But we put that in, they say, because so-and-so (the last angel group they talked to, or the judges of the last contest they entered) recommended it.  We specifically changed our plan to accommodate feedback. And now your feedback is in exactly the opposite direction.

I see it a lot. I’ve seen it for years in the judging of the venture competitions. Lately I’ve seen it in reviewing potential angel investments.

For example, one that comes up a lot is whether you go for the broad sweeping expansive view of future market potential, which some groups like and other groups tag as lack of focus or realism.

I like focus myself. Keep it manageable. Narrow targets. Getting to $5, $10, $20 million in three or five years, but more in control. More realistic.

A lot of other judges want to see a bigger pot of gold at the far end of a more distant rainbow. “How do you get to hundreds of millions?”

So they go for big, because the judges say so. Then the next time, it’s “but you have too many targets; you’re doing too much.” And then there’s that look again, the disappointment. We’re supposed to do what the last judges suggested.

(I posted Organizing Angel Investors Monday on Up and Running about positive developments in angel funding. David Rose, CEO of angelsoft.net, added the following as a comment to that post. Although I haven’t had guest posts on this blog, David’s comment is worth it. And I’ve been using angelsoft.net for a while now, I know it’s good. So I’m posting David’s comment here as if it were a guest post.)

Tim, you are absolutely correct in your observations about what’s happening in the angel world. Historically, angel investing has tended to be a personal, haphazard thing, with entrepreneurs and angels finding each other almost by chance. During the dot-com boom, however, angels in various cities who repeatedly found themselves in the same deals began to organize into semi-formal groups, in order to share deal flow and expertise, and pool their funds to make larger investments.

After the crash, when venture capital firms effectively stopped funding during the ‘nuclear winter’, the Kauffman Foundation, dedicated to supporting entrepreneurship, figured that the best way to help entrepreneurs was to jump start angel investing (which, as you know, accounts for more startup investing annually than all VCs put together.)

So Kauffman convened a summit meeting of the major angel groups from around the country, and out of that arose the Angel Capital Association, the professional alliance of angel groups, and the Angel Capital Education Foundation, which trains angels and entrepreneurs in best practices. This past week we held the 2009 ACA Summit in Atlanta, at which over 300 leading angels and group managers from around the country got together to meet each other, share best practices, and work on syndicating deals.

At the same time the ACA was being formed, many of the angel groups were in need of a solution to help administer their organizations, encourage collaboration among angels, and enable cooperative investments both among groups, and between angel groups and VCs. Thus arose Angelsoft, which today provides the back-end infrastructure for virtually the entire global, organized angel investment community. Five years after its founding, Angelsoft supports 17,000 accredited investors in 450 angel investment groups in 45 countries.

While Angelsoft is not a ‘matching service’, nor does the company itself make investments, the platform functions much like the CommonApp for college admissions. The difference is that because the vast majority of angel groups use the system to manage their deal flow and collaboration internally, there aren’t parallel systems. So if an entrepreneur applies for funding to a group using Angelsoft, they’ll be working on an Angelsoft-powered application no matter how they got to the group in the first place.

This provides a number of advantages, among which is the need to only fill out an application once. After that, applying to any other Angelsoft-based group is a matter of a single mouse click. And entrepreneurs can find groups that invest in their type of company by using the Kayak-like sliders in Angelsoft’s investor search engine at http://angelsoft.net/startup-tools/investor-search.

Another by-product is that for the first time entrepreneurs have some visibility into the often-murky operations of angel groups. Because Angelsoft powers all the group’s processes, the system can provide entrepreneurs with statistics including how many other companies have applied for funding this month, how long it typically takes the group to review a submission, what percentage of applicants to a group actually get funded, and so forth. For example, check out the profile page for New York Angels, my home angel group here on the east coast, at http://angelsoft.net/angel-group/new-york-angels

Finally, one of the coolest things is that with all the angel groups on a single platform, Angelsoft is now also being used by other parts of the early stage industry, including, as you pointed out, VCs. Over 50 venture funds use Angelsoft to process their deal flow, and many of the leading venture law firms, such as DLA Piper and Cooley Godward, are beginning to use the platform to refer clients to angel groups and venture funds for consideration.

We are living in a fascinating time with fast moving changes in every area, and the expansion and growth of the Internet promises to bring some much needed order to the chaos of early stage funding!

-David S. Rose
CEO, Angelsoft
Chairman, New York Angels

Business plans everywhere. I’m reading, annotating, filling in score sheets, and getting cranky. I explained that on this blog last Monday.

So what’s with the unrealistically high profitability projections? This year it seems like I’ve discovered a new 50-50 rule of profitability in business plans, as in, 50% of the plans I’m looking at project 50% or higher profits on sales.

That reminds me of a song my youngest daughter used to play: “That Don’t Impress Me Much.”

Occasionally a very successful startup will come up with something so new that it can, for a while, chalk up very high profit margins. That’s extremely rare. Out here in the real world, though, nobody really makes much more than 5-8-10% or so profits on sales. The real startups might make 15% or even 20%.

Projecting 40%, 50%, and even 60% profitability on sales doesn’t tell me you have a great business; it tells me you haven’t done all of your homework. You’re underestimating cost of sales, expenses, or both.

I find this particularly galling in business plans with some social implications, related to health care, or education.

What would I like to see instead? First, find out average profitability for the industry you’re in. Put that number into your plan. Then explain why your company’s projected profitability is higher. Proprietary technology, specialty niche market, new processes? Okay, I can take that; just be aware of what the normal is, so you know what you’re up against. Please.

Standard financials are available from several vendors, for less than $100 per industry (and here I can’t resist adding that they’re bundled with Business Plan Pro, my company’s software product. Sorry. I’m an entrepreneur. I can’t help it.) You can also get those from Oxxford Information Technology, or the Risk Management Association (RMA).

Anyhow, that’s my opinion.

Isn’t this about as dumb as saying a screenplay doesn’t matter because the audience won’t read it:

Small businesses seeking financing from venture-capital firms need not worry about writing up a solid business plan, since it doesn’t sway funding decisions anyway, concludes a new study by researchers at the University of Maryland Robert H. Smith School of Business.

That, I’m afraid, is the lead of Business Plans Don’t Matter to Venture Capitalists, in the Wall Street Journal’s Independent Street blog, yesterday. And I like that blog. Raymund Flandez should know better.

Think about it: what the researchers mean to say, I would hope for their sake, is that the document itself — the formatting, the presentation, the painstaking worry about where to break the page, and all of that — isn’t as important as some people think.

What they say there, as quoted by Flandez, is as if they don’t even know what a business plan is. He makes it seem like they think it’s a piece of paper, or a collection of pieces of paper. Certainly, by the time they’re on the faculty of a major business school, well, that’s got to be journalistic exaggeration, right? Here’s what a business plan really is (and this is me, not them, from my The Plan-As-You-Go Business Plan book):

So the plan is a collection of concepts in the middle, [the strategy] surrounded by specifics that have to be done. Around the core you put a collection of metrics to be measured and tracked (lots of them are sales, expenses, and the like, but not all), task assignments and responsibilities for different people, dates and deadlines, budgets, and so on. That’s your plan.

Seriously, do you think for even a minute that venture capitalists don’t care about companies having strategy, and metrics, and tracking, and tasks and responsibilities, and forecasts, and budgets? Are you kidding me? They may or may not read the business plan, but the entrepreneurs they fund can’t possibly do a decent presentation without knowing their plan. What happens when they get to the first question about how much they need, and why, and what they’re going to spend it on?

I’ve consulted to venture capitalists in due diligence, for years, my company had venture capital investment in it and bought it back, and lately I’m also an angel investor. And I can tell you this: they may not read the plans, but that’s because the plan is for you, the startup wanna-be, to know what you’re trying to do, and how much money you need, and why, and what you’re going to spend it on. You may only show the VCs the presentation, but if you don’t have a plan behind it, with your numbers straight, then they’ll know it. Forgive me for quoting myself again, but:

From that core plan, you spin off various outputs. You take the highest highlights of the plan and 60 seconds or so to explain it in an elevator speech. That’s one output. Or you write it all out carefully, and add supporting information about the market and the industry and the backgrounds of the management team, and it’s a plan document. Or you create a 20-minute 10-slide summary with PowerPoint or Keynote slides, and that’s a pitch presentation for potential investors. Or you create a cover letter or cover e-mail, about a page or so, along with a 5- to 10-page written summary, and that’s a summary memo. Or you do none of these, you simply keep that plan as a collection of bullet points, of picture financial projections, and a list of things to be done by whom and when and for how much money, and share it with your team. In that last case you don’t ever edit or polish it, or sweat the page headers and page footers or font size. You just use it to manage your company.

Notice that none of these outputs stands as something you do instead of the plan. And none of these outputs is really the plan. The plan exists at the core, and you create the outputs as needed.

Doesn’t that make a lot more sense? And shouldn’t the professional researchers ask the right questions? The Independent Street continues:

“Our results are most supportive of the premise that planning documents play, at best, a minor ceremonial role and do not inform venture capitalists,” wrote researchers in next month’s issue of Strategic Management Journal. “Therefore, we conclude that planning documents do not play an important role in VC opportunity screening.”

Doesn’t the screenplay analogy apply here exactly? As if the fact that the investors don’t read the plans means the entrepreneurs don’t need them. The plan isn’t for the investors, anyhow, its for the people running the company. It’s not a sales brochure, it’s a business plan. And I hope this is just a quick reading of the real research.

Authors of the study are quoted as saying “A business plan may be useful in helping entrepreneurs organize their thoughts and details.” What’s the phase for that? “No duh?” I hope they play that out better in the full report.

When they get into the details, it sounds like this research was done in the wrong way, at the wrong time:

Researchers sampled 718 funding requests from April 1999 to February 2002, at the height of the dot-com bubble and its immediate aftermath.

I think by now everybody knows that the dot-com boom was not the brightest moment of the venture capital industry. I don’t think many of them look back with pride at how well they picked investments between April 1999 and February of 2002. I’m pretty sure the phrase “back to fundamentals” has come up a lot since.

So I’m tired of this silly myth that having a business plan doesn’t matter if the investors don’t read it. The entrepreneurs need it and want it, whether the investors read the details or not. They expect the entrepreneurs to know what they need to do.  I hope the actual research is better than the write-up it got in Independent Street.

Billionaire Mark Cuban announced his own stimulus plan earlier this week. It's sheer genius.

Here's how he describes it in his blog post, The Mark Cuban stimulus plan:

Rather than trying to be a Venture Capitalist, I was looking for an idea that hopefully could inspire people to create businesses that could quickly become self funding. Businesses that just needed a jump start to get the ball rolling and create jobs. I'm a big believer that entrepreneurs will lead us out of this mess. I just needed a way to help.

Then he lists the rules:

1. It can be an existing business or a start up.
2. It can not be a business that generates any revenue from advertising. Why ? Because I want this to be a business where you sell something and get paid for it. That's the only way to get and stay profitable in such a short period of time.

So far, so good. But now pay attention to these next four rules, as a group:

3. It MUST BE CASH FLOW BREAK EVEN within 60 days
4. It must be profitable within 90 days.
5. Funding will be on a monthly basis. If you don't make your numbers, the funding stops.
6. You must demonstrate as part of your plan that you sell your product or service for more than what it costs you to produce, fully encumbered.

Do you see it with those four rules? He's promising to fund companies only if they don't really need funding; only if they have real value; only if they're perfectly set up for bootstrapping. It's sheer genius. I don't think he's being cynical, or deceptive; I think he's making a point. But we go on…

7. Everyone must work. The organization is completely flat. There are no employees reporting to managers. There is the founder/owners and everyone else.
8. You must post your business plan here, or you can post it on slideshare.com, scribd.com or Google docs, all completely public for anyone to see and/or download.
9. I make no promises that if your business is profitable, that I will invest more money. Once you get the initial funding you are on your own.
10. I will make no promises that I will be available to offer help. If I want to, I will. If not, I won't.
11. If you do get money, it goes into a bank that I specify, and I have the ability to watch the funds flow and the opportunity to require that I cosign any outflows.
12. In your business plan, make sure to specify how much equity I will receive or how I will get a return on my money.
13. No multi-level marketing programs (added 2/10/09 1pm).

So there you have it. This is somebody who's made it, multi-billionaire, showing a whole lot of common sense. He calls it "open source funding," which is apparently a reference to making the business plan transparent.

Not, by the way, that the country doesn't need the full formal stimulus plan as well, for about 300-some million reasons … but let's hear it for old fashioned ideas like making something people need, selling it for more than it costs to make, and minding the cash flow.

I think valuation is fascinating. What is a company worth? With the larger publicly traded companies you can easily calculate a valuation using the wisdom of the crowd, the market itself, by multiplying shares outstanding times price per share. But in the real world of small business, gulp, this is much harder.

Concretely: how much is your business worth? How much could you sell it for? How would you decide? What formulas would you use? More importantly, what formulas would your hypothetical or theoretical buyers use?

Ultimately, like it or not, just about anything is worth what somebody else will pay for it. Your business is worth what you could sell it for.

And what would that be? Well, that's really hard to know, until you go to the market. Some people talk about 5 or 10 or more times profits, but then face it, in small business, in the real world, profits is a very vague number, an accounting conceit. Some people talk about 1 or 2 or more times sales, which eliminates a lot of the accounting fiction. Others talk about valuations based on book value, or assets.

I'm amused at how much of this stuff is loosey-goosey, even though it's in the realm of finance, which is supposed to be mathematical and exact. And isn't.

I posted here last Fall about BizEquity.com, Tom Taulli's really intriguing site that's attempting to create a database of first-cut estimated valuations of businesses all over the United States. I talked to Tom last month after the big meltdown, and found, happily, he's still optimistic about the long-term value of the BizEquity site. They're working on it. I suggested he take his September data and multiply it by about 0.5 or so; and I was only partially joking. Tom knows this area very well, but of course the whole volatility burst has been a challenge. Last summer might not have been the most opportune time for Tom and his backers to start.

So I was interested yesterday Monday morning as I soaked in coffee and I noted — thanks to Ann Handley in Twitter — Advertising Age's Simon Dumenco's angry analysis of the Huffington Post's recent venture capital infusion at a valuation of $100 million.

His title, unfortunately, is What's $200 Million Divided by 2009 Reality. That's too bad, because the $100 million (or less) estimated valuation was widely publicized when Oak Investment Partners announced the investment last November. Simon doesn't enhance his argument by referring to the twice-as-large-as-fact figure, $200 million, that actually appeared much earlier, last Spring. The phrase "straw man" comes to mind. 

That glaring error aside, he seems offended by the VC's reported valuation. He has references to the big Internet bubble of the late 1990s. It should be only $2 million, according to him.

I think he exaggerates his point, not just by doubling the figure, but also by lowballing his real estimate. The Huffington Post has made huge (and well reported) gains in traffic. Furthermore, unlike a lot of the Web 2.0 sites he wants to knock, this one has an actual revenue model. For better or worse, the Huffington Post is almost like old-fashioned media. It generates readers with news and opinion, and it sells advertising. So somewhere in the numbers — which are not public — is a number for revenues, and a valuation based on (among other things) revenues as well as traffic.

And it all goes to illustrate my point, today: valuation is hard to figure. It's also important. And, in the end, a company is worth what buyers will pay for it. In the case of Huffington Post, it's not a vague theoretical guess. The VCs who invested in Huffington set a price, and, with that, a valuation.

I highly recommend watching this video of a conversation between John Doerr (Kleiner Perkins Caufield & Byers) and John Heilemann (New York Magazine), at the Web 2.0 summit last week

John Doerr is a smart person who's been leading Kleiner Perkins — which leads the venture capital world — for a long time. I was a vice president at Creative Strategies in 1983, and at that time he was already a leading VC.

The interview starts with some second-hand questions from president-elect Barack Obama, and stays interesting throughout.

I can't summarize this 32-minute video. Watch it. The challenge of this generation, the reference in my title, is about energy. Towards the middle, he lists 11 points for high-end startups during a period of three to four years of hard times. Things like securing cash, communicating, selling …

"While you're cutting things, above all, do not cut hope."

Times are tough for venture capitalists too. You may have already seen the Sequoia Capital slide show that's been circulating for a few weeks now. It's pretty stark. You may also have seen the great Survival Matrix piece Fred Wilson posted the day before yesterday.

In a nutshell, there haven't been any IPOs for a while now. Liquidity events are rare. And we know that things don't look like they're getting better for a while.

And the VCs want the companies they're into to survive.

These days they're thinking a lot about burn rate, how much the companies spend every month. And runway, which is how long they'll be able to last, given their burn rates and the capital stowed away.

It's a simple calculation. Cash of a million and burn rate of 250K is a runway of four months. The longer, the better.