Three kinds of companies

VC and Angel investors put prospective companies in three buckets, and they only invest in one of them. Entrepreneurs looking for money should think about where they fit. The three types of companies are; Lifestyle, Cash Flow, and High Growth. When companies are just starting out it is sometimes not clear which category they will fall into. This is why investors spend a lot of time studying market size data and asking questions about customer scenarios.

Lifestyle companies provide a nice job and great compensation for the owner and top people. They might have a solid history of profitability, and a solid product or service. But, without significant changes these companies will never grow 5X or 10X from where they are now. VCs and Angels will not invest in this type of company. These companies should look for Friends and Family money, asset based loans from banks, or vendor financing.

Cash Flow companies are very profitable and throw off consistent cash flow. They grow at a reasonable (10% to 20%) rate and the cash flow covers all growth needs. After years of steady growth these companies might decide they need capital to staff up new sales offices in an attempt to double their revenues over a couple years.

VCs and Angels are not likely to be interested in this situation even though there is little risk. Little risk equals little reward. They are looking for 3X to 5X returns over a few years with an occasional 10X winner. From an investor point of view, a minority percentage ownership in a privately held company, where insiders control the BOD, is not attractive. The company can decide to keep all the cash flow or pay it out to executives. The investors are unlikely to see any of it, or enough to make the investment interesting.

Cash Flow companies should look for bank financing, asset based lending, or convertible secured loans from angel investors. Some angels will do secured loans with an optional conversion to equity feature.

High Growth companies have the opportunity to grow 50% to 100% per year for several years. They have products in fast growing markets where innovation and/or disruption is happening. It is a high risk, high reward, environment. Innovation often leads to entirely new markets or usage scenarios where value is added to an existing process. Disruption usually means that a new technology is applied to an existing problem or process where incumbent products will be replaced. Either way it is a high growth opportunity.

Investors need to understand the total addressable market and guess at what percentage of that your company can win.  They will spend a lot of time understanding the competitors and possible acquirers of the company. From the beginning investors are looking for multiple exit strategies.

VCs and Angels are really only interested in investing in high growth companies. They both want growth and big payoffs. The only difference between Angels and VCs is the size of their investment. They both evaluate investments in the same way and want the same types of exits. However, Angels are willing to make seed stage investments of $250K to $1M, sometimes even up to $2M, while most VCs will not consider anything less than $3M to $5M.

Both Angels and VCs want significant ownership and  BOD representation. Angels tend to get more involved in day to day activities during the seed stage and get you ready for future VC investment. VCs tend to get involved later in filling out the rest of the management team, helping you arrange partnerships, and paving the way for acquisitions.

All this stuff should be pretty obvious to people who have been in the technology business for a while. But, you would be surprised how many Lifestyle and Cash Flow companies try to pitch their companies to Angels for investment. Angels have a soft spot in their heart for entrepreneurs so they will often listen, but almost never invest. Save yourself the time. Unless you are in a high growth potential market space, don't bother pursuing Angel or VC money.

Good luck!!

Comments

[Lloyd D Budd]

Hi Don,

I would love your insight into why the lifestyle and cash flow companies come to the VC in the first place? What are the needs they are typically trying to satisfy?

Thank you,
Lloyd

[Don Dodge]

Lloyd, good question. Most "life style" companies don't approach VCs, but some do thinking they have more than just a lifestyle company. Most times they don't...they are just delusional, or more likely, inexperienced in the ways of VC investment.

I know of several other companies who have asked my help to approach VCs. They have good cash flow businesses and want to take it to the next level and get into the high growth stage. They figure that if they just had another $5M to hire more sales people and more engineers and support people they could leapfrog to the next level. In most cases it will not happen.

Most times they don't understand the changes that must be made to get to that next level. Meaning, they will need to replace most of the management team...perhaps even themselves.

There are fundamental differences between a startup high growth management philosophy and a steady, profitable, slow growth approach. The differences effect everything you do...every day. It effects the kind of people you hire, how you compensate them, the kinds of investments you make, your willingness to lose money for a while, your comfort zone...everything.

A lot of these lifestyle or cash flow company people have never experienced the terrifying risks that high growth companies take. It is completely scary to them. yet, they like the idea of being a high growth company. They just don't understand all that comes with it.

In the end most people find their comfort zone and do very well within it. Different strokes for different folks.