Raising venture capital can be both exhilarating and a thoroughly thought provoking experience.  Glen Kelman, the CEO of Redfin, an online real estate brokerage startup, weighs in on the best eight questions he was asked while raising his last venture round.  A very good read and questions we should all be asking ourselves in our ventures.

For startups, Christmas comes in November. Partners come back from vacation in September and deals start closing a few months later; since the credit crisis deferred fund-raising for most of the past year, November 2009 will probably end up being especially busy.

Redfin is one of the companies that just closed a round. Already the process has resulted in a huge shift in our mindset: from just surviving to building a juggernaut. That shift is one every startup can try on for size, whether it needs capital or not, by asking itself the same basic questions that VCs asked us.

VCs are good at asking questions. They are unimplicated in your dumb decisions, unmoved by your original sense of mission and far less concerned than you that a blunder could bankrupt you. They re-imagine your business in terms of all the other businesses they’ve seen, pulling the arms off one doll and the head off another to create a perfect money-making Frankenstein. And since the stakes are high, the whole philosophical exercise tends to result in action.

Here are the questions VCs asked Redfin that changed how we think about our business.

1. What’s your deadly sin?
Sequoia’s Roelof Botha said he only invests in companies that let consumers indulge in one of theseven deadly sins. He rattled them off with alarming familiarity. “You don’t want to be the site that people should use,” Roelof said. “You want to be the site they can’t stop using.”

2. Where’s the real money?
Venture capitalists’ focus on the size of our company’s addressable market made us realize that half of our potential revenues lay in the eight markets we’ve already opened. “What’s the rush to open Orlando,” a VC asked us, “when you still haven’t cracked 1% share here in Silicon Valley?”

Good question. A startup with 18 months of cash is like Val Kilmer in the opening stick-up scene of Heat, with only 80 seconds to get the bearer-bonds from an armored car; as a detective on the scene later marvels, “they ignored the loose cash.” That’s the way to be about your addressable market: not just greedy, but disciplined. Time is short.

3. What are your unit economics?
The financial statements we look at every month don’t tell us what a small business will look like when it grows up: sure we need to account for all sorts of fixed costs like how much we spend on engineers or maps, but what really matters is whether we make more money from a customer than it costs us to get and serve that customer. So to see if a business works on a large scale, VCs first want to understand it on the smallest scale.

For us, this meant explaining what Redfin made this summer on a single home purchase, with a per-transaction account of what we spent on marketing to get customers ($27), on local data ($153), on customer service ($2,906) and so on. We also calculated how much annual revenue we got for every monthly unique visitor.

We knew our margin before, but hadn’t broken the numbers down into their most easily handled form. This is important. Numbers are just numbers if they aren’t simple enough to act on; a linebacker with a simple playbook can react rather than think during the game. Knowing that the big number is how much we spend on our customer-service team refocused us on making sure wehired the right team and invested in its happiness.

4. What are the explanatory events?
A money-raising deck mostly consists of graphs with lines going up and to the right, scrunched two to a page to make the lines look steeper. The only reaction we expected to our version of these slides was awe. But Roelof asked us to annotate each graph with what statisticians call an explanatory event. What change in our business had caused revenues to shoot up? We claimed that publishing agent reviews had sent conversion through the roof. But when we dug into the numbers, we found the real explanatory event was a change in our service a month before –unlimited home tours. Making a simple picture of a business trend and then correlating that with a big decision helps you understand what levers really move your business. When there are no explanatory events, you’re just getting lucky.

5. Why can’t you grow faster?
The most important question venture capitalists ask is what prevents your company from growing faster. At first, I thought it was a demand disguised as a rhetorical question, asking Redfin to raise projections beyond what we could deliver. But when I got testy, Greylock’s David Sze said, “We’re not asking you to lie.” He just really wanted to know what the rate-limiting factor was.

We cycled through a few lame answers: “We prioritized margins over growth.” “We wanted to be realistic.” Then Redfin’s Sasha Aickin quietly pointed at the headcount line of our projections and said our rate-limiting factor is probably how quickly we can hire top-notch real estate agents. Everyone nodded. We got back from that meeting and began thinking about scaling agent hiring.

6. What are the accelerating effects?
It’s easy to grow 300% in your first year or two, when you’re starting with nothing, and people first hear about your service. What separates a potential colossus from other businesses is the capacity to keep growing at that rate in years four, five and beyond. When Reid Hoffman looked at Redfin, his primary question was whether there were “accelerating effects,” where growth begets more growth. For Amazon, the product reviews and personalization history it captured from its first users accelerated its second stage of growth. For Facebook and Twitter, the community itself constantly recruits new users. For companies like Zappos and hopefully Redfin, it’s word-of-mouth about our customer service. This line of thinking made Redfin focus on our most sustainable competitive advantages: not the usability of the site itself, but the data we gather from visitors to that site, and the rave reviews we get from those visitors who become clients.

7. What’s your secret sauce?
One of the godfathers of venture capital is, we were told, obsessed with secret sauce; the man apparently hasn’t put mayo on a ham sandwich in 20 years. So in preparing for a meeting with him, we tried to think of technology that only we could build. Previously I’d always thought this challenge was silly. Grinders like me believe in the lunch-meat not the sauce; we just try to focus on the right problems, and run faster than our competitors. In this view even Google, if it stopped coding for a year or two, would be caught. But while Redfin has gotten far by being relentlessly incremental—letting users filter property searches by pools or parking spaces—the pressure on us to do something proprietary helped us prioritize game-changing features that we’d put off in the past. We hope to come up with Something Big in 2010.

8. How do you win?
Thinking constantly about world domination can give you a little vertigo. The way I usually get through my day is by limiting my horizon to serving the next few customers, or increasing revenues in the next few months. Which means that even though the story of how we win should be etched on the inside of my eyelids, it’s more often at the back of my mind, as a nagging doubt that I’m focused on the wrong thing.

But the essential job of a CEO is to tell that story, to everyone who will listen, making it better all the time. If you are raising venture capital, that story is by definition highly improbable, involving such an absurd overthrow of the order of things that it’s almost embarrassing to say out loud. Rehearsing the whole narrative naturally focuses you on the holes in the plot.

Just try, for example, to say with a straight face how Redfin wins: we get the best data, and build the best real estate website (maybe). We hire our own real estate agents and pay them to focus on customer satisfaction, not sales (that’s a little weird but sure, why not?). Customers appreciate the difference, and en masse fire the traditional agent who has been sending them a bottle of wine every Christmas for 10 years, giving us 20% of all high-value real estate transactions (no way!).

Way.

*~*~*~*~*~*~*~*~*

It’s hard to express just how much settling those questions has galvanized Redfin to attack the monsters under our bed. Sure, we were dimly aware of those problems before, but we existed in a state of seething, unacknowledged tentativeness. Weeks of contemplating what it will take for us to win prepared Redfin to swallow the red pill, stuff the TaunTaun, hack the Kobayashi Maru. At very few moments in a company’s history does it makes its way so deliberately. Like the recovered patient who saw while sick everything she had always meant to do, we want to make the most of our new lease on life.

Source: TechCrunch

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One of the all time great opening lines is from Tolstoy’s Anna Karenina:

Happy families are all alike; every unhappy family is unhappy in its own way.

I am beginning to think that the opposite is true for (web) startups.  There seem to be surprisingly many roads to success.  But the canonical road to trouble appears to be taking your burn rate up *before* you have something that is really working.

Over the past couple of weeks I have seen two startups that are in very different positions, despite superficial similarities.  They both have fully launched services in interesting areas and with some traction but that have not yet really taken off.  They are both iterating on their services.  But one has spent $5 million already whereas the other has spent less than one tenth of that.

The mood between the two companies couldn’t be more different.  One is filled with excitement about a new twist on their service that they are pursuing at a current burn rate of less than $40K per month, which represents the highest it has been.  The other is struggling to make changes they know they need but their burn is still $100K per month, despite having come down significantly from where it has been.

Only time will tell whether the low burn rate company will succeed, but they have a great many more options available for themselves.  They could get acquired and have in fact had some offers (they do have some traction after all) and even a modest acquisition would pay back investors and leave something over for the founders.  They could raise just a bit more money and keep iterating for a long time.  Or if they happen to hit it right with their latest iteration they can quickly and cleanly raise a fair bit of money.

Nothing really new here in this post — this is after all the mantra of the lean startup movement — but it can’t be said often enough!  And this recent experience brought the contrast home so starkly that I felt compelled to write about it not just for others but as a reminder to myself.

Source: Albert at Union Square Ventures

We have spent a good amount of time discussing how to vet the the big idea, but we have spent precious little effort describing how to actually build a framework around testing it in actual use.  I’ve heard  Google often say, “Release early and iterate,” and while I agree, maybe if they had used the method described below by Ash Maurya, we would not have heard all the backlash “Buzz” drew.  What follows below is a strong methodology for customer development I would use for any web based startup.

Last year, Steve Blank threw out a challenge to Lean Startup Circle members to update his customer development checklist (Appendix B in his book) for their specific business. His checklist is built for Enterprise Software which doesn’t readily translate to other types of startups including web startups (especially when you get to Customer Validation).

After the talk, David Binetti pulled together a great group of people from Lean Startup Circle to create a Customer Development Checklist for web startups. I was honored to be asked. However, after a few exchanges trying to nail down the type of web startup to tackle first, we uncovered a number of tactical differences that made me come to the realization that defining such a model in a group setting is too hard to do. We would either end up with a highly generalized model or no model. I, for one, am not comfortable extrapolating a model from third-party accounts of what might have worked for other companies (like 37signals), and especially not without first-hand experience building a similar type of startup.

So I decided to take a stab at defining a Customer Development Checklist for my web startup.

First Some Background

This model is based on my experiences building and running 2 products: BoxCloud andCloudFire. Both use a subscription pricing model. BoxCloud was built using a release-early release-often development model and was initially launched with a Freemium pricing model – later changed to a free-trial only model. CloudFire is being built using a lean-startup/customer development model and was launched with a free-trial only model.

For SaaS product like mine, I strongly believe you need to
a) charge for your service, and
b) validate pricing sooner rather than later.

Free trials, Freemium, free introductory periods, etc. are all tactics to lower sign-up friction and should be applied (split-tested) judiciously on a case-by-case basis. However, my key takeaway is that even if you’re considering Freemium, you should validate the premium part of Freemium first before giving anything away.

I’ll cover Customer Discovery in Part 1 and Customer Validation in Part 2. Hopefully, I’ll get to write Parts 3 and 4 one day.

Customer Discovery: What should I build and for whom?

Here’s my Customer Discovery Flow (you’ll probably want to click to enlarge and skim it before reading on).

Click to Enlarge

The 3,000 Foot View
For a web startup, the purpose of Customer Discovery is to identify a problem worth solving, defining the “right” minimum viable product to build, and testing the business model using 3 separate Build/Measure/Learn loops. Most web startups rely on a product website for distribution and blogs, SEO, SEM, for initial customer acquisition channels- leaving price as the biggest unknown in the business model.

Sidebar: There is a somewhat loose definition of how the term MVP gets used. Many have used it (myself included) to refer to anything (a landing page, a problem presentation, screenshots, etc.) that allows you to learn about customers with the least effort. Here, I am using the stricter definition of MVP to mean the minimum set of features needed to learn from earlyvangelists. In other words, Release 1 of your Product.

It All Starts With Stating Your Assumptions

Before you can test what you think you know, you have to write it down. It’s normal to try and short this step but I found it to be a very worthwhile exercise. Apart from minor terminology changes, most of Steve’s questions in his hypothesis worksheets hold up even for a web startup. I am not going to reproduce them here but if there is interest, I’ll make my versions available as a separate download.

Test the Problem

This will look very similar to Steve Blank’s flow. That’s because when it comes to Customer Discovery I haven’t found a more effective way for maximizing validated learning than “Getting out of the Building”. This is coming from someone who used to prefer to stay in the building and talk to customers over email. Now, I have an 800 number tied to my mobile phone andschedule for face-time opportunities with customers.

With my last product, I used a teaser/landing page with some pre-launch buzz to collect email addresses and measure interest. While it was encouraging to have interested users, it told me nothing about what problem they had, who they were, what I should ship first, or what I should charge. What does 10 email addresses a day tell me? What does 20, 40, 100? Why did the other 70% abandon my landing page? Was it the product, was it the copy, graphics, something else. What?

Building a good landing page is hard. Unless you have exceptional customer insight (or are your own customer), iterating without talking to customers is slow and painful as you split-test one page against another with very little initial test traffic. Yes, it feels like more legwork to find people who will have a conversation with you but a 15 minute unscripted conversation has more validated learning pound for pound than all the data you can crunch from web analytics.

I have never tried using surveys with my landing page registrations because I hate filling them out myself. Plus, to make them easy to fill, you have to be very specific which assumes you know exactly what you want to know, which is hardly the case.

The beauty of Steve’s process, is that it tests the problem separately from your solution.
To paraphrase Dave McClure:

Customers care about their problems NOT your solution.

During the “Problem Presentation”, you state the top 3 problems, then shut-up and listen which is key to getting it to work. It works because you aren’t asking customers to validate or design a solution which addresses the “Customers don’t know what they want” argument. It works because it isn’t a pitch. Actually, I take that back. It is a pitch. But it’s the customer that’s pitching their problems to you. I know I’ve hit the right “problem nerve” based on how passionate a customer gets during an interview.

I like to structure my “Problem Presentation” like this:

1. State the top 3 problems
2. Ask customer to prioritize problems and identify any higher priority problems
3. Have customer describe how they solve the problem today
4. Very briefly describe how you might solve the problem
5. Ask Customer whether your approach would solve their problem
6. Would they use your solution if it were free?
7. Would they pay $X/yr?
8. Ask for referrals to other customers

Build Your MVP

Unlike Enterprise Software, which can be chock full of features, web startups need to focus on the smallest feature set needed to learn from earlyvangelists or the MVP. After the first reality check, you should end up with a prioritized top 3 problem list which drives the features for your MVP. I stress the importance of then building out the MVP to the point where it’s demo-able. It will be hard for customers to visualize your solution without one. Screenshots and mockups may be used as stand-ins only if a demo is absolutely out of the question.

Test Your MVP

With the MVP built out, you then go test it against the original set of interviewees plus some.
I like to structure my “Product Presentation” like this:

1. State the problem
2. Use the demo to tell a story of how your solution solves the problem
3. Test pricing again
4. Ask for referrals to other customers
5. End with a call to action: sign-up, or commitment to sign-up

Tip: I practice delivering the demo using screencasting software which not only lets me iterate till it’s short and crisp, but I also end up with a video I can use later on the product website.

Iterate or Exit

The last step in Customer Discovery is to summarize what was learned and make a decision to iterate or exit.

Source: Ash Maurya

The internet gives and the internet taketh away.  Each year as services provided grows on the net, the amount of free content is tracking at an even greater pace.  Companies such as Apple and even Amazon are fighting hard to reverse this trend with new offerings, but the pace of free is all consuming.

If you are a startup looking to charge for content via the web, these stats from Nielsen provide good insight as to what may or may not work.  Adam Ostrow over at Mashable posted this short piece addressing the issue.

Movies, music, and games top a new list from Nielsen of the content types that consumers are most willing to pay for online. The data, which comes from a survey of 27,000 consumers across 52 countries, also indicates that content created online – like blogs, podcasts, and video – are least likely to attract consumer’s dollars.

At face value, the findings might seem like good news for old media companies that are increasingly eying paywalls as a source of salvation, as consumers did indicate more of a willingness to pay for online newspapers, magazines and radio than their user-generated counterparts. You can see all of the findings in this chart:

However, Nielsen also found that “nearly eight out of every ten (79%) would no longer use a web site that charges them, presuming they can find the same information at no cost.” In other words, unless your organization breaks lots of exclusive and important stories, charging for content will be a major uphill battle.

How do the findings compare to your willingness to pay for various forms of content? Let us know in the comments.

Source: Adam Ostrow

Please find another real-world perspective on getting funded.  For many, the method here described is a most likely scenario.  This particular article by Clate Mask, the co-founder and CEO of software company Infusionsoft, makes three points at the end that I believe drive home a clear path to a fianancing success. “Get customers, show revenue and prove your model first.”  A single real world win is worth a thousand projections.

While many entrepreneurs dream of raising capital from the outset, the reality is that most startups must be bootstrapped long before an angel investor or venture capital firm will give them the time of day.

At Infusionsoft, we bootstrapped the company in the beginning and eventually secured $17 million in two rounds of venture capital funding.

As we worked up to the venture capital level, we were obsessive about growing  customers and revenue (thus taking risk off the table for future investors). Early on, I saw this as the most effective way to both raise money and hold on to shares of the company. I fell in love with the idea of only taking as much money as necessary to get us to that next stage of business.

In doing this, we noticed we went through four steps of financing:

* Banks: Small credit lines allow you to discover your market
* Friends/family: Once you’ve got the market identified, this funding allows you to develop a prototype
* Angel: Once that was complete, we secured $1 milllion to prove the prototype
* Venture Capital: This money allowed us to scale the business and become profitable

By the time we got to the venture capital stage, we had a number of investors that were interested in us, because of our recurring revenue.

When you get right down to it, getting funded is a risk/reward proposal to the investor. You can either work really hard on the risk part of the equation (i.e. have revenue) or you can focus on reward (i.e. ‘we have the next Google’). The biggest challenge an entrepreneur faces is you must present an equation that is makes sense to investors.

In this economy, revenue is the most compelling argument you can make. Investors are nervous – and work hard to mitigate risk (much like banks). Investors that historically could be counted upon to put more money into the VC funds are often no longer able to do so – meaning VCs don’t have as much freedom to focus on the risk.

The timing for our series B fundraising round could have been better. We began loosely talking about beginning the search for a second round in the summer 2008, but actually went out in early September. In hindsight, we should have gone out a month or two earlier – because by that time the economy was in crisis mode.

Turns out my approach to getting just enough money for each stage proved to be less than prudent in this case, as it prevented us from going out at the right time in the market.

We didn’t need to raise any money when the market was good, but by the time we decided it was time, the market was three weeks away from collapsing. Ultimately, we probably would have raised more cash for the same equity had we gone out a month or two earlier.

The big lesson: only take the money you need to get to the next round – with the caveat that you need to pay attention to what the market is doing because it’ll affect your valuation.

Taking money down the road may be more expensive than taking less now. So even if you still have plenty of cash in the bank, you need to watch what the market is doing and understand how that impacts your valuation.

The other lesson learned is the importance of selling. When you don’t have cash in the bank, you’d better know how to sell. It’s amazing how many entrepreneurs who raise capital are great in academic discussions but terrible on a sales call. The art of persuasion is not what business school is teaching, but it’s what drives the success of the business.

Often when you have raised VC, it’s easy to fall into the “strategy” trap. That’s where the team spends most of its time engaging in relentless discussions on strategy and big ‘game-changing’ things, which is fine, but who’s selling? When you haven’t raised VC you get your butt on the phone and you persuade people to buy your stuff. That’s what we did in the early stages of Infusionsoft, and despite our two rounds of venture capital funding, we still make sure to keep that part of the business running without interruption.

Selling is what drives the business. It also drives an efficient use of your VC firm’s capital later on.

The bottom line? Get customers, show revenue and prove your model first. That’s easier said than done, but in the end, it’s the best, most viable way to getting the capital you need to take the business even further.

Source: Clate Mask

I started my first company at 27 with a grand total investment of $13,000, which by the way, I had to borrow.  My goal was to make my first million by the time I hit thirty.  So did I make it? No.  Turns out I was 3 months late.

Believe me when I tell you, that I can remember every single second of what that struggle was like.  I learned lots of lessons along the way, and in a future article I’ll share with you a few of them.  For now, Eve Tahmincioglu over at Entrepreneur, has written an article on this topic that I believe can help you to get there quicker.  Let the fight begin.

Are you working to get your business to hit the coveted $1 million mark in sales? If so, then heed the following advice from people who have either pulled off the feat or are experts in the field.
Take Randy Horn, who toiled for six years before his board game business hit the $1 million mark–a milestone that came and went without much pomp and circumstance.

“I don’t remember throwing a party,” said Horn, the owner of Los Angeles-based Zobmondo!! Entertainment and creator of the Would You Rather …? board games. “It felt satisfying to have grown to that size, but I quickly moved on to planning for the next year.”

Horn, whose firm now generates $6 million in annual sales, worked out of the bedroom in his apartment for eight years, still has just one employee, and has been all about growing slowly and methodically. “It was always a priority for me to maximize my profit, never a priority to get huge quickly,” he stressed. “My goal was simply to create a good business, be my own boss and make a good, solid living.”

It’s exactly that kind of focused, methodical approach that many entrepreneurial experts say you need if you want to achieve the seven-figure mark.
“What’s especially true in this economic environment is, in order to achieve your sales-figure goals, you have to demonstrate a long-term focus and a commitment to real value creation,” said Lori Kiyatkin, assistant professor of corporate strategy and entrepreneurship at Towson University in Maryland.

Kiyatkin said she would ask three key questions if an entrepreneur walked into her office and asked, “How do I make my first million?”

1. What is your company mission?
2. What is your ability to actually create real value?
3. What is it you’re doing and why?

“After I got good answers to those questions, I would encourage the entrepreneur to focus on that and identify objectives that match that mission,” she advised.

Horn’s mission was to sell board games, but he didn’t come out of the gate in 1998 targeting big boys like Target or Wal-Mart. He called 5,000 independently run toy stores during his first year of business and sold 11,000 games. “My view was I needed to lock in some success to use that to sell to bigger stores and use that success to sell to even bigger stores,” he said.

Five years after placing his first board game in a mom-and-pop shop, he landed a deal with Barnes & Noble, and Target called a year later. The rest is million-dollar history.

His advice to entrepreneurs wanting to bring in the big bucks:

Get ready to get to work. “There’s no quick and easy shortcut. I worked hard calling stores and selling one game at a time.”

Don’t shoot for a million. “Hunker down and figure out how to create a sustainable, profitable business.”

Horn also wasn’t big on going into debt or turning over a large chunk of his business for an equity stake. “I used my profit every year to grow a little bigger and a little bigger,” he said.

But taking on credit isn’t all bad, advised Terry Mackin, managing director of mergers and acquisitions for Generational Equity. “Don’t be afraid to use credit to leverage your growth,” he maintained.

Mackin also had these suggestions for entrepreneurs:

• Research competition to find out what makes you different and use that as the foundation of the message you communicate to your customers.
• Identify a sales target market and dedicate a substantial amount of your financial and professional resources toward building your brand.
• Constantly look for new avenues of technology, distribution and cost savings that will allow you to maximize your bottom line.

Boosting your customer base is also critical, and what better way than e-mail, suggested Nell Merlino, CEO of Count Me In and co-founder of American Express OPEN’s Make Mine a Million $ Business program. She advised e-mailing customers with value-added promotions, focusing newsletter content on what the core business is, asking for feedback, and closely tracking e-mail statistics.

Anthony Mongeluzo, the owner of Medford, New Jersey-based Pro Computer Service, which employs 17 people and has $2 million in annual revenue, believes it’s all about being generous to your prospective clients.

“I took a lot of time–instead of asking for business–to meet other CEOs and learn about their business model, so I can find them business,” he said. “The more business I referred, the more came back to me.”

Source: Eve Tahmincioglu