This is the third in a three-part series on how I make investing decisions for follow-on investments. The first article described how I evaluate the entrepreneur. The second article described how I think about market timing. This third article analyzes sustainability.
Deciding on putting additional money in a startup is a more difficult decision than putting it in the first time. For the entrepreneur, raising the second round of angel funding is often harder than raising the first round. This is because there is now more hard data available.
The more data available, the more the initial assumptions can be challenged. More questions can and should be answered by the entrepreneur and his team. If these questions can’t be answered, then I must realize my follow-on investment is still largely dependent on the entrepreneur.
Positive Cash Flow Equals Success
When the entrepreneur is asking for more money, I want to remember the reason I decided to do the deal in the first place. Then I compare my initial reasoning for investing in the deal to where they are now. The initial investment was all about vision and promises. The second and all follow-on investments are about performance and results.
I sometimes tell entrepreneurs, “I never saw a company go out of business which had month-to-month positive cash flow.”
Most of the startups I invested in were focused on getting to profitability. Get profitable, and they become self-sustaining. I am comfortable investing this way and have built wealth investing in these types of companies.
The VC Sweetspot
But I realize there are startups which have so much market potential that the primary strategy is very fast growth and market dominance. There are also startups which require a much longer time to build out their intellectual property before getting to sustainability.
These two startups recognize right from the beginning they will need a continuous flow of capital. They expect angel investors to fund them from startup to a Series A professional money investment. To get to a Series A, the startup has to have pretty much everything figured out in their strategy. Now they need money for growth. That’s the sweet spot for VCs.
Helping the Entrepreneur Cross the Chasm
As an angel, I am one of the investors who helps the entrepreneur cross the chasm to sustainability. When a startup figures out how to build, sell, install, and maintain a market solution, they are either profitable or ready to grow quickly.
When I make my initial investment in a startup, I know what the funding plan will be going forward. This company will either be driving for profitability or seeking VC funding. The follow-on investment decision always happens when one of these two goals is not yet reached, and the company is out of money.
So my third follow-on investment criteria is focused on future sustainability. I have one set of questions for a startup aiming for profitability and another for a startup aiming for a Series A.
7 Questions for the Startup Seeking Profitability
- Does the entrepreneur understand how to be profitable?
- Does the entrepreneur understand cash flow management?
- Is the team, the whole company, focused on making a profit?
- Is sustainability part of the daily vocabulary of the employees?
- Is the strategy employed reflective of a profit mindset?
- Can this company continue to grow from the projected cash flow?
- How much more investment money will it take to get to profitability?
10 Question for the Startup Seeking Series A
- How big is the potential exit for this opportunity? Are they a unicorn?
- Are there other VC funded companies in this market?
- How are those VC funded companies performing?
- Is there still a big problem the market is aiming to solve?
- Is the strategy working? Is the team making progress toward proving they know what they are doing?
- Do I believe this company will ever be profitable?
- Are there more efficient competitors in the market?
- Are there spoilers in the market, such as over-funded competitors?
- Is the company fielding calls and visits from VCs?
- Have they been discovered, and are they being vetted?
When I am being asked to do follow-on funding, I am looking to be assured of sustainability. Sustainability can come from customers who will get the startup to profitability. Sustainability can also come from new VC investment. I don’t care where it comes from, but it must come from one of those two sources. If it doesn’t, then I can be assured I will be asked to do another follow-on investment, and my analysis process will begin again.