Email from a travel entrepreneur to a startup founderNewsBy Viewpoints | May 29, 2013Share This article was originally published on NB: This is a viewpoint from Max Kraynov, managing director at AviaSales.ru, JetRadar, and HotelLook.Dear friend,Congratulations on having grown your startup to the point that you're now looking for funding for further growth. I'm proud of you.You're seeking investment at this point, and you say you want my advice.I'm flattered. My startup JetRadar/Aviasales has been profitable since 2007, and in March, we expanded into hotel metasearch with HotelLook.From what you've told me about your startup, you demonstrate an understanding of the customer's true needs, which is impressive.Let me tell you, not all entrepreneurs grasp the customer's needs.A case in point is anyone creating a trip-planning service, which is doomed even before it goes into beta. (TripIt is an exception, because its executives are geniuses and it was an early mover.)That area has had so many false starts it would be impossible for anyone now to break through the noise. Plus, generally speaking, any service that relies on slicing several data sets provided by third parties is vulnerable to being cutting off from that data -- a factor that scares investors.But I digress. You asked about funding.Even though we've never taken any sort of funding, I've learned a lot about the process and its related questions. Here are some thoughts on soliciting funding, types of investors, how investors will put a value on your startup, the key to getting a proper valuation, and pitfalls to avoid.The three kinds of investorsAs you seek funding, there are three kinds of investors you are likely to meet. You need to be able to recognize them: “people with money”, “re-investors,” and “professionals”.Avoid “people with money” at all costs. Such people are time bombs, as they don’t really know what to do with their money or how to measure your performance at making their investment grow. You have no chance on Earth to fulfil their expectations."Re-investors" potentially have a chance to help you, but be careful.A typical re-investor is someone who has been in business him-/herself and had an exit, which gave them their capital. Naturally, as good citizens, they want to pass on their knowledge, philosophy and skills to a younger generation.Don’t get your hopes too high, though: many reinvestors believe their past successes were a result of their personal qualities (smarts, foresight, business acumen) and less of what their successes probably were truly dependent on, namely, ones that can't be predicted, such as market conditions, meeting the right people, and getting the right contract despite the economic cycle.Not knowing their own limitations leads reinvestors to try to steer your business on your behalf. Some of them will lure you with their “contacts” and “experience in this very area”, but more often than not that’s just hot air and a waste of time.Some of them, luckily, won’t fight with you to hold the steering wheel and will honestly help. But make sure to check their references.Note: Re-investors tend to dominate accelerators and incubators, so this rule applies to most accelerators and incubators, too."Professionals", such as venture capitalists (VCs) and professional angels, are the best kind of investors. Seek them out. They're essential if you decide to attract capital.However, getting to the right professional can only be done via references.Here’s another test for your business: if no one agrees to refer you to professional investors they know, you’re either still a dark horse or appear un-fundable in their eyes, no matter what they may say to your face.What founders need to watch out forWhomever you land as your major investor, one thing to be on the lookout for is the investor’s insistence on integration of the companies in their portfolios – at a technology or a marketing level.This fallacy is directly linked to another fallacy stating that “investors can find potential in a business that the founders can’t."When these things work, they work, of course. But the chance of them working is very low. So blow your own horn and hold on to it.At the same time, a good investor can open many doors and help secure contracts. Yet even this statement should be taken with a grain of salt, because what really matters is how much money you can generate for the business counterparty, and less "who you know".What is a reasonable valuation for your startup? Putting a valuation on a company sounds simple. But trying to get a startup’s founders and its investors to agree on a company’s valuation is as difficult as herding cats.Finance professionals can list multiple ways of putting a value on a business. Unless you understand these methods (at least on a high level), you’re doomed.Have a Plan BHere is one truth that isn't in the finance textbooks, though: Your ability to continue to operate without funding matters to your valuation. A lot.This is another of the paradoxes of startup valuation. Investors give money to the people who don't "need" it the most. Self-sustaining businesses attract money, while businesses that are floundering repel it.You need multiple Plan Bs, in fact, to be sure you will survive without funding.Will your startup survive if: The company experiences zero growth in revenue over 1-2 years? The top 3 customers leave? The top 3 managers leave (assuming the CEO stays)? The long-awaited investment round takes 12 months to close? A competitor with deep pocket enters the market?Companies prepared for these contingencies can’t be bullied into accepting a lower valuation than they ought to because they negotiate from a position of strength.The reason is that the value of your business is around zero if there's no Plan B. If you won't survive without a fresh funding round, all that your competitors have to do is patiently sit near the river and wait for your remains to float by.To be clear, not having enough money to grow without a capital injection is okay. Investors like to invest in a situation where their money will fuel growth that likely wouldn't happen without their money. But investors shy away from a startup that doesn't look like it could last on its own.How much is your startup worth?The source of much of the conflict between investors and venture capitalists over the value of a startup is often rooted in differing perceptions around the following three parameters:1. The amount of money already burnt by the startup. So-called "sunk costs" are just that: sunk. It doesn't make sense to throw good money after bad. So what's already been spent shouldn't figure in the valuation of your startup.Having spent X amount of money doesn’t mean the startup is actually worth X dollars. Most likely, it is way lower than that.2. Do the founders have experience?Investors, with rare exceptions, only want to fund founders who have relevant experience in the product, in the market, or in startup management.Nowadays it’s very fashionable among startups to minimize the amount of time and money spent on creating a working prototype and to get the so-called “minimum viable product” (MVP) in front of potential users as soon as possible.Smart investors are comfortable with minimum viable product, but only with an important caveat: the startup founders must have already had relevant experience in the same vertical.Why? Solving a problem doesn’t mean having business savvy. Investors need to know: Is the problem something users would actually pay to have solved?Hence (luck aside) only the person with relevant past history has the foresight to convert the MVP into a product, and investors favor entrepreneurs with experience. (The exception is the Y Combinator approach, which is to cherry-pick the smartest students from MIT and Stanford and require them to attend startup boot camps.)3. The founders’ expectations of the commercial potential of their idea.Figure out your potential market size by doing research. Get estimates you can defend to investors as plausible. For an example, read this article on how to measure market size via profit-and-loss statements (P&Ls) for software-as-a-service companies.If your market is only, say, a few hundred million euros, then keep that information to yourself. It's a rookie move to define your potential market narrowly.If there truly is a business opportunity, meaning a market of substantial size and a potential for a product to scale, then start to work on your P&L now.One other point: Understanding the “exit” potential and the form an "exit" might take (trade sale, sale to private equity or IPO) is a huge divider between startups and investors.Unfortunately, these issues arise well into the life of a startup when it’s too late to “undo” the investment and go with someone else. Try to get an investor that shares your mindset at the start.To generalize wildly, Americans build to own while Europeans build to sell; Indians and Australians build to own while Russians and Singaporeans build to sell. You may have to look overseas to find investors who share your mindset about exits.Don't obsess over receiving a high valuatonReceiving funding based on a high valuation, while pleasing to the eye, usually comes with lots of strings attached -- primarily, the need to meet or beat ambitious forecasts, which, in turn, often involves picking low-hanging fruits and reducing long-term investments.Another problem: the real valuation of the business is oftentimes much lower than is implied by the size of the investment round.So if you see a company that got a $10M investment, it’s premature to assume it got this money on $50M valuation or higher: it could be $25-30M, which is less sexy for the founders. One hint of this could be knowing the preferred size of the round for the key VC players.A high valuation isn't necessary a sign of profitabilityHere's one key concept about valuations: It will surprise most newbie entrepreneurs that growing profitable companies may have a lower valuation than growing unprofitable companies.The key factor is the cost structure. Is money being spent on customer acquisition, product development, regional expansion, and a potentially achievable market share? If yes, the valuation may be higher because of long-term expectations.Check that your startup has the right cost structure if you want a high valuation.The rules for seeking investmentWhile there are rare exceptions, these apply to everyone:Rule 1: It's OK to be without revenue as long as you have: a clear growth driver that you understand and are able to control and proven past experience in controlling this growth factor. This implies that you understand what the P&L will be and the degree of turbulence in forecasted numbers.Without revenue you have to bootstrap, though. Regardless of the potential of your idea, without past experience at running a company, you look like a newbie. Don’t waste your time on courting investors.You may think your idea and your energy deserves funding. But as the man in Unforgiven says, "Deserved's got nothing to do with it."Rule 2: If you can’t get the money from FFF (friends, family and fools), forget about getting investment from angels or venture capitalists (VCs). Also, if you can’t get your co-founders to chip in, it's an even a worse scenario. Grab yourself a six-pack and get back to the drawing board.Alternatives to venture capitalFounders, after reading a book on finance, may find out (rightfully so) that debt financing is often cheaper than the typical venture capitalist's equity. These founders will start talking to their bankers earlier in the process, to avoid surprises.For tiny operations, using Kickstarter and similar crowdsourcing tools, or being accepted into an incubator that comes with funding, are also valid alternatives.Take heart. You've gotten this far. You can make it.I wish you the best of luck. Remember, as the founder of Twitter has recently blogged, "All the startup advice you read is wrong." Meaning, your particular circumstances are always unique, but by reading startup advice, you can get inspiration and fresh ideas about how to handle specific problems that may come up.I hope some of this advice has been helpful.Best from Sydney, MaxNB: This is a viewpoint from Max Kraynov, managing director at AviaSales.ru/JetRadar/HotelLook, flights and hotels search services. NB2: Entrepreneurs image via Shutterstock.