Business Rx: Early investors in for the long haul

April 28, 2013

Elana Fine, managing director of the Dingman Center for Entrepreneurship at the University of Maryland’s Robert H. Smith School of Business, took part in an online chat with readers last week. Here are excerpts:

Return on investment

Q. What kind of return do investors like to see within one year to 18 months of Series A funding? For example, if a start-up raises $3 million in Series A, at the end of 18 months, what’s the minimum profit margin the company should aim to achieve?

Elana Fine: Investors (meaning venture capitalists or angels in this case) actually don’t expect a return at all in 12 to 18 months. They are investing for the longer term — and understand that you will likely need additional investment before you exit (usually via acquisition or initial public offering). They invest in companies in big markets that might generate a return of three- to 10-times their investment. The investments are illiquid compared to the stock market and therefore riskier. In exchange for this risk and longer holding period — the cost of venture capital is high. Most venture investors don’t expect there to be profit margins right away because they understand the money it takes to scale a company.

Start-up ethics

Q. I am 30 and am starting my own consulting business focused on data analysis, writing, research and project management. I also have a flexible full-time job alongside my business. I started consulting when I lost my job a few months ago and found great success right away leading to a full-time offer that was too good to refuse. I do not want to stop my own business activities and have time for them, but I am wondering about the ethics of doing so.

Elana Fine: We work with a lot of companies who “moonstrap” their start-up — working on them after normal work hours. I think the big question is whether you are competing with your employer —that would certainly cross the ethical lines. I’d always go with the tenet of “honesty is the best policy.” If you are concerned, have an honest conversation with your employer. If you are running the business on your own time and it doesn’t conflict, it shouldn’t be a problem.

Recognize this?

Q. I have been following the Boston marathon bombings and think I have some good ideas for facial recognition software. I have a few friends who are coders and could help. Would a VC invest in this kind of business?

Elana Fine: VCs would (and have) invested in facial recognition and other identification software. However, they won’t invest until you have something up and running and have some initial customer traction. I’d start by doing a competitive analysis. There were a lot of companies that started in this space after the 9/11 terrorist attacks. It would be interesting to see where they are now and how far the technology has come.

Tips for consulting start-up?

Q. I recently started a consulting firm working for myself. I have been lucky and have gotten several contracts in the first few months. However, I’ve been marketing very broadly what I am able to do because I have been a nonprofit management generalist for five to six years. While that has been successful for now, would it be wise to hone in on a certain area to build up? Or, in the long-run, is it better to remain a generalist? Also, at what point is it recommended to work with subcontractors? Is it ethical not to tell clients when I choose to work with a subcontractor?

Elana Fine:I’m actually not sure on the ethics relating to subcontractors. I will take part one though. As a consultant, I think you do benefit by becoming a specialist, as long at it is in a large enough market where you can build a strong business. You need to start with a market-sizing analysis around your expertise and broaden or narrow based on your skill set and potential demand. This area has a lot of consultants, so you’ll really need to focus on refining your marketing message. I think your expertise also drives the price you can charge. Think of a handyman as an example — most often a generalist who can do a lot of different things in your house will have a lower price point. However, when you really want to redo your bathroom, you call in specialists who will be more expensive, but will know how to do the job.

Trends in angel financing

Q. What trends are you seeing in angel financing? Do you think we’ll see more funding this year?

Elana Fine: Honestly, I think angels are having an identity crisis. Angel activity across the country increased significantly in the past two years. Now they are facing a Series A crunch — not enough early-stage venture capital to fund all the companies that have raised money. This wave of investments also differs greatly from five to 10 years ago because the companies looking for Series A are at later stages now that software development costs have come down. Angels acted like Series A investors — so are they now looking for Series B investments? And if that is the case, what does that mean for valuation and their equity positions? Will their holding period be shorter? I’m hopeful, but I don’t think we’ll see as much funding this year until we start seeing the companies that were funded in last 24 months receive follow-on capital.

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