Robert Ochtel’s Blog

An Experienced Approach to Venture Funding

ROI versus Market Traction – Which is the Real Differentiator to Potential Investors?

Most entrepreneurs realize that their potential investors require a substantial return on investment (ROI) for the money they put at risk by investing in their start-up company. This is a given, and even to the most naive entrepreneur this makes sense.  On the other hand, what these same entrepreneurs do not often realize that it is market traction and not ROI that is the real differentiator for potential investors.  Gaining market traction early can definitively make the difference between a successful start-up company and one that languishes on and on, continuing to spend investor’s monies, with no real return in sight.  This article addresses some of the reasons why market traction is the real differentiator for your potential investors.

Is Developing a ROI for Your Company’s Sufficient to Secure Funding?

As part of promoting your start-up company to prospective investors, you need to determine what the potential financial return on investment is for these same investors.  This concept, although not foreign to most potential entrepreneurs, does cause pause for most first time entrepreneurs, as they rarely understand corporate financials and often leave this task for last, expending little effort to develop representative, defendable financial statements.   In general, it is well understood that to get the attention of potential venture investors it is necessary to present a return on investment opportunity that provides at least 5 to 10 times return on their invested capital in a 3 to 5 year period, respectively.  These numbers reflect expected venture-based financial returns and should be only used as a reference point, as venture investors seldom receive these types of returns on their investments. Some venture investors expect more, some will take less, but the key here is to develop financial pro forma statements that necessarily meet the expected returns of potential investors and at the same time are defendable.  Therefore, developing a ROI that represents these traditional industry accepted investment return norms is necessary for any entrepreneur expecting to get the attention of potential investors, but on the other hand your start-up company’s ROI may not be sufficient to secure an investment from these same investors. The reason for this is that these expected financial returns are only one baseline component for opening the door to secure investors attention and in general are not considered a real differentiator when considering the various investment opportunities that are available to your potential investors.

 ROI Projections May Not Stand-up to Financial Due Diligence?

As stated, ROI projections are expected by all potential investors when considering any start-up company as an investment opportunity.  Depending on the entrepreneur’s research and diligence in putting together their ROI projections, many times these same financial pro forma statements will not stand up to the scrutiny of a sophisticated investor.  Too often the financial projections, put together by inexperienced entrepreneurs, are unrealistic in their market penetration objectives, too optimistic in their gross margin projections, and more often than not, do not represent typical industry standards when compared to the market leaders in the same given market space. As an entrepreneur, you must realize, as a matter of first priority, by potential investors, that your financial pro forma statements will be subjected to a significant amount of financial scrutiny by these same sophisticated venture investors.  This should cause you to pause, as by not passing this initial financial review bar can make the difference between receiving a pass from potential investors or receiving an invitation for an initial meeting.

 It should be also noted that during their financial due diligence process most investors discount an entrepreneur’s start-up company financial projections by at least 40%, from the presented projected returns.  This discounting reflects their expected financial risk, the market risk, development risk, etc.  Therefore, your financial pro forma statements, as presented, are often deemed “rudimentary projections” by these same investors, and they will rely on their own financial management expertise and financial models to determine the potential expected returns for your start-up company. This financial due diligence analysis may cause your pro forma statement to not pass the smell test for these same investors. Therefore, again ROI statements are only used as one component in considering your start-up company as a potential investment opportunity, and more often than not are not a true differentiator.

Market Traction is a Key Differentiator for Potential Investors

Unlike financial projections that are based on an underlying set of assumptions that can be arguably acceptable or unacceptable to your potential investors, securing market traction with a customer base is one item that gets investors attention.  The fact that you have secured a paying customer or multiple paying customers gives investors some hard evidence, based on the realities of the market, in which to make an investment decision.  On the other hand, only relying on financial projections, based on a given set of assumptions, requires these same potential investors to take a leap of faith in the investment decision making process.  By securing customers early on, this gives your potential investors much more assurance that there is demand for your technology, product or service offering in the market and substantially reduces the investment risk, if only in their minds.  Therefore, as an entrepreneur, looking to secure funding for your start-up company, the one key differentiator that will set you apart from the competition is securing a customer or multiple customers early on in the funding process.    

 Market Traction Proves You Know the Market

Securing market traction early proves one thing to your potential investors – that you know the market.  Unlike financial ROI projections, securing paying customers is not based on assumptions, it is based on real interaction with your target customer base and can be used as a lynch pin to secure funding from venture investors.  This shows your investors that there is “perceived” value for your start-up company’s technology, product or service offering in the market.  By securing paying customers early, you have proved to these same investors, at a first level due diligence that you have at least indentified a market “need” and/or solved a “problem” in the market, and at the same time, customers are willing to purchase your start-up company’s same product offering. Determining the long term market trends and whether your technology, product or service offering provides a sustainable competitive advantage in the market must still be reviewed by your investors, but by securing customers early you have proven that your technology, product or service offering, as a minimum addresses a market need and can then be used as basis to secure additional market traction and expand your customer base.

Market Traction Necessarily Facilitates Your Start-up Company’s ROI

Securing market traction also necessarily facilitates your start-up company’s return on investment projections.  More often than not, start-up companies are unable to secure paying customers as early on as originally projected in their financial pro forma statements.  Given that ROI projections are all about generating revenue early in time, by securing market traction with your technology, product or service offering you are necessarily facilitating your start-up company’s ROI projections.  This is essential and a true differentiator, as having the ability to sustain your start-up company’s projected financial returns, in a timely manner, is the most important risk consideration for your potential investors.  Too often start-up companies get caught in the “Catch 22” in which they need to secure customers, but the market has not developed – both of which will have a detrimental effect on their financial projections.  Therefore, by securing customers early you can gain the necessary market traction in which to validate your start-up company’s projected financial returns and secure funding from investors. This is a true differentiator for your potential investors and substantially reduces investment risk.

As discussed, developing ROI financial pro forma statements are necessary to present your start-up company to potential venture investors.  But, due to the nature of financial pro forma statements, they may not sufficient to secure funding from these same venture investors.  On the other hand, securing paying customers early and proving you can gain market traction is a key differentiator for investors as it validates to these same investors that you know the market.  At the same time, securing customers facilitates your start-up company’s projected ROI and substantially reduces the investment risk for your potential investors. Therefore, if you want to get the attention of venture investors and differentiate your start-up company from the crowd, prove you can get early market traction with your customer base.

This information was taken from Robert’s new book: “Business Planning, Business Plans and Venture Funding – A Definitive Reference Guide for Start-up Companies”.  Available at www.amazon.com.  For more information on the book go to http://www.carlsbadpublishing.com

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July 6, 2009 - Posted by | Customers, Market Traction, Venture Capital, venture finance, Venture Funding | , , , , ,

2 Comments »

  1. Traction proves value, projections prove you can use a spreadsheet. My venture fund Liquidity Works http://www.liqudityworks.com will only invest in those projects where we bring a huge validating customer to give the company traction. This is our approach to hedging our investment risk. We have Private Equity firm relationships that own huge companies thereby allowing us to sell value to owners who can appreciate early stage opportunities and who can understand and absorb the risk that young companies present. I’m glad someone gets this approach and is promoting the concept of traction over projections.

    Comment by Kyle Harris | July 6, 2009 | Reply

  2. Terrific site! Nice job, keep it up!

    Comment by Michelle25 | July 18, 2009 | Reply


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