If you have viewed the Oscar Best Picture nominated film, The Social Network, you may remember the powerful scene when Facebook founder, Mark Zuckerberg’s friend, Eduardo learned he was practically ‘diluted’ out of any substantial ownership of the new company. This was after a number of rounds of venture capital start up financing. The scene is powerful because Eduardo knew that with every stage of new investment, the founders’ equity in the company got smaller and smaller. Ultimately, his ownership share was diluted to less than 1%.

What is dilution and how can you avoid getting ‘diluted’ out of your proper share of a start-up company? Consider a cup of water with a few drops of food coloring. You can easily see the coloring in the water. However, after adding three more gallons of water, the color of the water is diluted so much that you can hardly discern it at all.

The same thing happens when more and more money is invested in a start-up company. The more a venture capital invests start up financing in a business, the more equity they will claim in the company and dilute the founders to a less substantial position.

What can you do to assure that you and your co-founders of a start-up company are not completely diluted? Here are a few tips.

Ask How Much Dilution is Likely to Occur

When working with venture capital firm for your start up financing, be completely upfront and ask how much dilution may occur. This is especially important if you expect at least three rounds of start up financing.

The more successful your start up company is, and the more value it gains with each stage of start up financing, the better off you’ll be. However, do realize that if your business value remains about the same or even decreases, your amount of dilution will increase at a dramatic rate.

Obtain a Dilution Schedule

It is perfectly within your right to obtain a dilution schedule. A dilution schedule is simply a matrix listing each current ownership interest, including yours, your co-founders, mangers, and the venture capital group(s).

The matrix should also list all the series of start up financing A, B, C, etc, plus any convertible notes, warrants, common stock, and any convertible preferred stock. The total amount of equity interest for each party should add up to 100%. Double check the math and be sure to discuss any dilution that seems out of the ordinary.

Your start up business may not grow at the rate that Facebook did when it first hit the market. However, even so, you need to protect your equity interest and avoid over dilution.

If you are looking to obtain money from a venture capital firm, you may be asked the question, “so what is your expected burn rate?”

The burn rate is simply a calculation of the amount of cash that a start up business spends each month. Usually, the burn rate is based on the assumption that a new business will spend start up capital at a loss for some time before profitability and positive cash flow occur.

The burn rate is a critical measurement of the potential financial health of a start up, as well as how much start up capital may be required before profitability begins.

Calculating the Burn Rate

A new business owner may simply want to say that the burn rate is an average of typical monthly costs. However, one needs to consider what other sources of cash (not necessarily revenue), are available as well.

Consider a burn rate to be in terms of negative cash flow. For instance, the following simple formula helps provide the monthly cash flow:

All sources of current and expected income or revenue (not current cash on hand) LESS: Monthly operating costs, including interest and taxes (but not including depreciation or amortization

= BURN RATE (NOTE: Cash flow will probably be negative for start ups)

If the start up does have some cash available, such as loans from family and friends or other angel investors, the “Cash Zero Date” is the date in the future when the cash runs out. For instance, if the burn rate is $50,000 per month, and there is $150,000 in the bank, the Cash Zero Date would be three months in the future ($150,000 / $50,000)

Managing Your Burn Rate

It is important to have the burn rate calculation ready to present to venture capital firms. Some firms will want to know all future burn rate expectations. For instance, when the product is ready to be promoted “live” to the public, you may be in a position to hire more people, causing an increase in the burn rate before actual revenue is expected.

Of course, it is best to learn how to control expenses and keep the burn rate as low as possible. Constantly monitor expenses month-by-month, and continually compare actual expenses to the predicted ones. If a venture capital firm knows that you are in control of your burn rate and have predictions in the future that protect their investment and lower their risk, you’ll have a much better chance of approval.

Most people in America are familiar with reality TV game shows. Survivor is probably the oldest and most common reality game show that still retains popularity today. In Survivor, the contestants are put to the test in a remote part of the world.  To eliminate the competition and get further in the contest, alliances are formed usually between two or more people.

Using this kind of comparison, you can see how an alliance with a key business may be useful to obtaining venture capital funding. While your alliances will probably not be as cut-throat as a contestant game show with $1 million on the line, a key alliance or two may be the element you need to attract venture capital as an investment opportunity.

Advantages of Alliances

What are some of the advantages to alliances? Imagine finding greater success and building more revenue to attract venture capital through:

• Additional sales channels – Utilize your alliances to penetrate additional markets and reach more sales channels you could not do on your own.

• Shared technology – Through strategic alliances, you can get access to technology you wouldn’t otherwise have. Instead of investing heavily in new expensive equipment, an alliance may be the way to utilize that technology without burning through all your seed money.

• Credibility – A strategic alliance with a very prominent or visible partner could mean added credibility to your business idea. Imagine presenting venture capital firms with your idea that includes Disney characters, McDonalds logos, or 3M technology.

Tips on Forming Alliances

You can never dream too big when it comes to finding the right alliances.  As an example, Mello Smello, a small mom and pop sticker company, partnered with 3M and Disney to create scratch-and-sniff stickers that propelled the small company into national status. 

There are different strategies you can take to form alliances, including:

·         Joint Ventures – Talk to the top management in a business with whom you want to align yourself. Sell them on your business idea, and show them the benefits they will receive by joining you in a business venture. If you can get a few good alliances on your side, it may win over venture capital firms. 

·         Go National – Don’t just think locally for your potential alliances. Think national. As mentioned, the more high-profile your alliances are, the more credibility you get with venture capital firms. 

Don’t be shy or reticent about forming an alliance or two before you approach venture capital firms. Get these types of key strategic business relationships on your side and face the unique challenge of impressing venture capital with your partnership abilities.

Obtaining start up financing from venture capital firms is never a breeze. In fact, many new entrepreneurs and inventors face rejection after rejection when they approach venture capital firms with their new business ideas.  

Getting a “yes” from a VC firm may be a question of approaching them at the right time of your product development.

How do you know when your product is “ripe” for showing a venture capital firm? Here are a few tips:

Innovative New Business Ideas

Venture capital firms like to see innovation in the startups they finance. Brilliant new business ideas that have innovative solutions are a step ahead of someone who is simply reinventing the proverbial mousetrap.

Product Development

How long will it take for your product to get to the market?  For venture capital firms, the faster your product can launch, the better. 

Of course, this doesn’t mean you should race through research and development. However, if you still need many more years of research to turn a new idea into a marketable product, a venture capital firm may give you the “pass” instead of “fund” stamp.

By the same token, don’t be afraid to show your product-in-development to a venture capital firm in order to obtain start up financing. Your product doesn’t have to be perfect. Simply prepare your product to the point where it represents a good prototype that will give venture capital firms a reasonable idea of its use and purpose.

Proprietary Status

Does your product have potential intellectual property rights? Have you filed patents? Or registered copyrights?

The proprietary status of your product or idea can have a large impact on a venture capital firm’s decision. New business ideas that obviously require patent filing, such as unique inventions or improvements on an existing product, should have a patent filed or pending before you approach a venture capital firm. Let them know you have done your due diligence in keeping innovative ideas proprietary and safe from competitors “leapfrogging” your idea.

Don’t let the details of product development be a reason to avoid venture capital consideration, nor let it be the reason for rejection. Get your product ready for presentation, and you’ll have a distinct advantage with your venture capital presentations.

Before you go in front of a venture capital firm, are you ready to explain your exit strategy with them? Venture capital firms are particularly interested in this portion of your long term plan. The exit strategy is simply the way that the venture capital firm will “cash out” its investment at the end of the investment term.

Venture capital firms know that start up financing is not a short-term investment. It is a high-risk, long-term venture, but the rewards are also high if the venture is a success. Indeed, venture capital companies know that they could lose their capital investment in a company as many as seven out of ten times.  However, the few start ups who make it are worth the payoff.

How will your start up’s exist strategy pay off for the venture capital firm?  They already expect to wait between five and 10 years to get their money out, but after that time, the venture capital firm will want to receive money or marketable securities for their trouble.

Subsequently, if you do not have a viable exit strategy, a venture capital firm is not likely interested in making the investment.

What are possible exit strategies? Here are the most common:

• IPO – An Initial Public Offering, or IPO, is the point where a new start up company takes their business public on the stock market. They offer marketable securities in the form of preferred and common stock. The venture capital firm will usually be a major part of an IPO, with a preferred stock holding in your company.

• Merger or Acquisition – An IPO is not always an option. Instead, a small start up may look to be acquired or merged with an existing larger corporation. The buyout will supply the funds to pay back the venture capital firm.

• Reorganization and Recapitalization – Sometimes a small business start up may take longer to achieve success, but the VC still wants its money back.  Therefore, in some cases, it may be necessary to reorganize and recapitalize through other investments in order to pay back the VC and continue with the product research or market saturation process.

• Liquidation – In actuality, the majority of new businesses that receive venture capital start up funding will fail. Your exit strategy, though hopeful for the best, should also plan for the worst with a liquidation plan if the venture does not succeed.

Venture capitalists are not interested in slow-growing businesses. Take heed of their advice and be ready to present a viable exit strategy when you approach a venture capital firm for funding.

New business ideas may sound great on paper, especially to an enthusiastic entrepreneur. However, venture capital firms are more concerned about the risk the product faces in a targeted market.

Venture capital firms will ask many questions about your product or service, particularly regarding the acceptance in the market.  If you’re an entrepreneur, what are some of the questions you should ask yourself about your product or service before facing a venture capital inquisition? Here are a few key things to think about and prepare to answer.

1. What is the Trend You’re Riding?

Trendy technology faces a big risk. Will the trend be a short-term fascination with the market and fail to sustain regular sales and profits?  In order to avoid being a ‘trendy’ flash in the pan, be sure your product or service offers an integrated total solution, rather than something that falls by the wayside when the next best thing comes along.

2. How is your Product/Service Different from the Competition?

Can you quantify how your new business idea will differentiate itself from what’s on the current market? It’s important to brainstorm a short sentence about your market differential.  At the same time, you should also create a full matrix designed to spell out point by point how your product stacks up to its competition. This will give you the ammunition needed to show why your idea can take the market by storm. 

3. Is the Industry Aware of Your Product/Service?

Some new business ideas are unique and have yet to fall into a defined industry category, while others are ones that have been recycled.  Be sure you are fully aware whether your new business idea is a breakthrough “revolutionary” idea or whether the product/service already exists in the market. Keep in mind that a “revolutionary” product will have a much more difficult time carving out a new market.

4. How Safe is Your Technology?

If you do have a unique technology, you need to ask yourself how safe it is from potential competitor theft. Do you have all the patents and other intellectual property protection that keeps your technology away from curious eyes that can potentially take it to market first?

Remember, venture capital firms are in the business of taking risks. Just be sure that you also know the risks involved with your new business idea.  Be prepared to show a venture capital firm that you understand and are aware of the potential acceptance factors of your product.

What is your new business idea?  Every good entrepreneur worth his or her salt is confident in their idea, which is usually accompanied by high hopes and lofty dreams of tremendous success.  

However, what is the reality of the market opportunity for the business idea? If a start up business will take a new idea to a venture capital firm to present it as an investment opportunity, the market opportunity must be significant.

Even if a new business idea is worth its weight in gold, if it doesn’t serve a sizable market, then a venture capital firm will not consider it a qualified investment opportunity. VCs know that in order to get their investment back, a business idea will need to attract a wide market, and that market must be open to the idea.

Is your idea’s market big enough for a venture capital firm?  Here are a few factors to analyze before approaching a VC:

Identifiable Market

Does your market exist, and is it easily identifiable? Don’t ever think that your new product idea will “open a whole new market.” VCs aren’t interested in a possible market opportunity – only existing ones. And remember, a small regional market is not good enough. It must be at least on a multi-regional, national, or international level market.

Commercial Viability

If the market exists and it is sizeable as a VC investment opportunity, the next step is determining whether the product or service idea is commercially viable. Will it service a current need in the market? Will it fill an existing niche?

Other factors to consider about commercial viability are whether the product will be reproduced and manufactured repeatedly, efficiently, and in a cost-effective manner? Will it sell at a price that will generate a profit?  

The same questions hold true with a service idea. Will the service sell at a price that can generate enough revenue to pay back the VC – plus profits?

Competitive Advantage

Finding an existing market and knowing the product can fill a niche is not sufficient. The new business must have an identifiable competitive advantage over existing products or services in the market. VCs will want to know that new business ideas are worth the investment opportunity. Be sure to show them why the customer will buy your product over the competition.

If you are looking to find venture capital, be sure you get your research done. Find the market, and get the proof that people will buy your product. Finally, prove that the competition doesn’t stand a chance. Then you’ll have a much better chance at getting that VC deal!

Many new entrepreneurs have a skewed view about venture capital funding. Some believe that a great idea and lots of passion and enthusiasm are all one needs to convince a VC firm to become partners in a new business venture. However, VCs particularly scrutinize fresh entrepreneurs – especially if you don’t have funding and a track record already.  

To separate fact from fiction, a VC firm will not lend any money to a new company that does not already have some form of small business funding.

If you read that correctly, then yes, you need money before you can get money. VCs want to know that you are taking a financial risk yourself.  Of course, all entrepreneurs start by bootstrapping, but you still need more business capital before you approach a VC to ask for more money. 

Self-Funded Capital

Where can you get it? There are many forms of startup business capital. The top three self-funding capital types are:

• 401(k) – Either through your 401(k) or other types of retirement fund, you can take loans against the funds to invest in your start up.  Though it’s not recommended, you could even withdraw a portion or all of your fund to get startup capital.

• Savings – If you have substantial savings, this is a good way to show investors you believe in your business idea.

• Friendly Loans – Also known as “Friends and Family,” or F&F loans, these are also a common way for start ups to get their seed money.  If you can encourage the people close to you to get onboard, VCs might take a second look at your idea.

Third Party Funding

Other forms of small business funding may come from other outside sources before you approach a VC firm. Here are the top three you might consider:

·      Corporations – Though the last few years have been modest, corporations are known for investing money into startups. They know that VCs can make a substantial return on their projects – and so can corporations if they invest wisely. Approach corporations in the industry of your new startup. For instance, if you have a technology idea, you might talk to Dell, Cisco, or Microsoft for a stake in your new business.

·     Angel Investors  - “Angels” are similar to VC firms, except they are typically wealthy individuals who make it a point at helping startups. Angel funding can certainly be a good step toward obtaining venture capital funding, especially since angel investors are well suited for funding smaller amounts of capital. 

·     Incubators – This type of initial investor is one who may not invest cash, per se.  However, you could get valuable technical or business consulting, bookkeeping or accounting services, donations of office or research space, and even networking help.

To get to the next step of business capitalization, you need to have investors and/or your own money on board. Get to these types of initial business funding and then take your new venture to the VC firm.

Most entrepreneurs who pitch their great ideas to venture capital firms miss an important step along the way – they do not hire a top management team. No matter how good an idea may be, no entrepreneur can handle all the business functions alone.

A good management team is necessary not only to get specialists in certain areas, such as accounting and finance, research, and marketing, but also to show a venture capital firm that the company is worth start up funding.

How do you go about finding, evaluating, hiring, and retaining the right people for your top management team?

Recruiting Your Management Team         

·  Start with people you know – Many entrepreneurs who start a new business venture and want to find investors ask their current friends and contacts to join them. Even a casual business acquaintance who you know to be an expert is a good start. Present your contacts with your idea, share your enthusiasm, and get them on board with your venture.

·  Ask your contacts for references – Finding the right people may be easier than you think. The best place to look is with your current contacts. Ask around about people who might be interested in joining a new business venture at the ground level. Despite an ailing economy, many executives and higher management may be itching to get out of their current jobs and do something that has “meaning,” rather than just a nice paycheck every two weeks.

·     Get experts to recruit for you – There is everything to gain if you approach a professional recruiting firm to find the right people to join your team. Using their help will get you in contact with some of the best people in the industry you are seeking. The money spent may well be worth it.

Retaining Your Management Team

It’s not just the idea that keeps a management team at your start up’s side.  Considering that you can’t offer the highest salaries and 401(k) plans, how do you keep you team in your company?

• Bonuses – A bonus may be a promised amount at a future date (deferred compensation), or money awarded based on performance.

• Stock Options – Don’t forget to offer generous stock options to your management team if you plan to go public.

• Greater Job Authority – As your new company grows, so will the responsibilities. Be sure your management team is aware that they are expected to take on the greater authority, as well as the rewards and challenges that go along with it.

Your start up venture is only as strong as your management team.  Build a solid team from the ground up, and it will be easier for you to find investors for venture capital. 

A new company started by a fresh, enthusiastic entrepreneur will often choose a private corporation as its business form.  With a start up company, the entrepreneur will not only have to fill key management and director positions, but also seek out a board of advisers. These are the people upon whom the entrepreneur will heavily rely to take his or her new business idea to the next level, as well as even help in obtaining venture capital.

The board of advisers can help transform a start up company into a viable investment opportunity for a venture capital firm. Their experience, status, and networking contacts are always a benefit, especially during the funding phases. Here are some other top qualities you need on your start up board:

Share the Vision

Does the candidate share your vision with your product or service? It’s essential that you get board members involved who are receptive to your enthusiasm for your idea.

Successes and Failures

A good board member is one who is not only successful, but has his or her share of setbacks. This kind of experience is invaluable in providing advice for the new entrepreneur in making wise decisions.

Experience with Growth Companies

If you are able to locate board candidates who have previous experience with growth companies, all the better! Their advice will be key in getting your company in front of a venture capital firm for an investment opportunity.

Specialty in Operations

Experienced board candidates will usually be executives or even CEOs of existing companies, but they should have a particular specialty. Consider your industry. The advice from a finance executive, medical operations manager, law firm partner, insurance company VP, or technical research executive could be the catalyst in getting approval from a venture capital firm.

Committed and Available

The board members you choose may share your vision, but not be able to commit to the duration of a board term. Their availability with other projects or commitments may prevent them from giving you the attention you need with your new start up.

Don’t be tempted to ask a great choice to become a board member just because of his or her status. Make sure they can commit to your business growth as well.

Be wise in your choice of board members. Your key board advisers could be the people who help your new business idea turn into the success you dream.