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In the ten years I've been involved in the venture capital industry, I've been blessed to meet thousands of entrepreneurs, each believing they had the "next great thing". In fact, I can safely say that in the hundreds of funding pitches I've heard, no founder has ever said "ehhh, it is just an okay idea". It simply doesn't happen. Entrepreneurs, by necessity, have to embrace their venture wholeheartedly, sometimes believing in it blindly. Investors, on the other hand, need to apply a more objective methodology in evaluating the opportunities before them.

Pre-2000, proof of concept meant "I turn on the light switch, and the light goes on", i.e. technical feasibility was often sufficient to confirm an opportunity's viability. In the modern day however, proof of concept has become "I turn the light switch on, the light goes on, and customers are paying me to read under it". Customer validation has become the precursor to investment. But what if you aren't ready for customers yet? How can you objectively review your opportunity to gauge its true potential? For that, I recommend following Silver's First Law of Entrepreneurship.

Silver's Law

David Silver is the founder of the Santa Fe Capital Group, an angel capital firm based in New Mexico. He is also the author of thirty books on entrepreneurship and finance. The latest "Smart Start-ups: How Entrepreneurs and Corporations can Profit by Starting Online Communities" provides, amongst other valuable insights, a formula for evaluating a venture's potential. It is dubbed, Silvers' First Law of Entrepreneurship.

"I invented these rules for assessing the quality of business models, and they have served me well over time in my angel investments", Silver says. I asked him to elaborate, and he said, "Well, Sean, let's put it this way: I have had to kiss fewer frogs to get to the princess."

The formula

V = (P x S x E) + DEJ + (FMS)

Where:

V = the value of your venture, from 1-45

P = the size of the problem, out of 3

S = elegance of the solution, out of 3

E = experience of the founders, out of 3

DEJ = Demonstrable Economic Justification, scored from 1-8

FMS = Forward looking, Multiple Revenue Streams, scored from 1-10

The Size of Problem, which is scored out of three, relates to the size of the market, the size of the problem being addressed and the size of the opportunity. This is really the number of people affected by the problem multiplied by the cost of the solution. A large result, one billion dollars or more, would receive a P factor of three. A niche market, worth $250M or less would receive a P factor of one.

The Elegance of the Solution factor addresses barriers to entry, how duplicable your solution is and your time to market. A first to market technology that is proprietary and difficult to replicate would receive a 3 for S.

The Experience of the Founders, founders with experience running a startup, taking a product to market and/or domain knowledge in the industry being approached are all desirable. One point is given for each when tabulating E.

Once you have evaluated the three key factors (Problem, Solution, Experience) you next turn your mind to reviewing eight possible indicia of Demonstrable Economic Justification. Assign one point for each of the following statements that are true:

1. Existence of a Large Number of Receivers. Are there many potential consumers of your solution, and are they aware of the problem that your solution addresses?

2. Homogeneity of Receivers. Will the consumers of your solution accept a standard product or service, or will you have to customize it? This speaks to the scalability of the venture.

3. Existence of Qualified Receivers. Are future customers aware they have an issue? Do they want a solution, or are they happy with the status quo?

4. Difficulty to sell. Can anyone sell your solution? Is it easy to understand, or will sales cycles be long?

5. Absence of Institutional Barriers to Entry. Once you build your product, is it free from regulatory requirements, or do you need an agency (ex. the FDA) to approve it prior to sale?

6. Viral Marketing Potential. Will the solution be so revolutionary that each user will tell 2 or more people to try it?

7. Invisibility. Are you able to build in "stealth mode" i.e. by slowly sneaking up on current incumbents?

8. Optimum Price-Cost Factor Are the margins above 80%?

Next up, founders need to examine the FMS, which Silver defines as "Float Many Clubs", but which really represents: the ability to be prepaid (i.e. through subscription revenue); the number of potential revenue channels your venture has and the ability to involve the customers in loyalty programs (i.e. subscribing to newsletters). A business which requires an annual prepaid subscription has lots of opportunity for monetizing the customer base, and multiple points of contact would score a 10. For example, a company that registers domain names would have a 9 or 10 for FMS, since domains are paid for in advance (often for 2 or more years). Once you sell a domain, selling a website or email hosting is a natural value add. Then you have the customer's contact information and can involve them in marketing services.

The optimum result for Silver's Law is 45. A 45, according to the author, indicates a possible billion dollar opportunity. Anything less than a 35 on the Silver Scale, should be expanded, reconsidered or leveraged more fully before proceeding. "It seems to me", says Silver, "Those entrepreneurs who are creating business models for online communities and mobile social networks are doing a better job of it than in any other period of intense new business formation activity that I can recall." I ask him to give me some examples, and Silver answers, "Women entrepreneurs, in particular, are building online business models that in many respects emulate the successful offline business models of the 1960s such as Weight Watchers International, Mary Kay Cosmetics and the Billy Graham Crusade, for communities dedicated to weight loss, feeling prettier and spiritualism".

Silver's Law in Action

Intrigued, I tracked down the CEO of Forgefinder Inc., Kyle Gillman. Forgefinder operates an online reverse auction engine that enables buyers of components from multiple vendors to drive down raw material prices through a controlled bidding process. Forgefinder was selected for funding by Santa Fe Capital Group's angels after it scored 40 on Silver's test a few years ago.

"To be honest, at first I thought David's scoring systems was frivolous", says Kyle Gillman, Forgefinder's founder and CEO, who earned a law degree at the University of Pittsburgh prior to conceiving of a community of buyers and sellers in a range of industries from forgings to cancer drugs. "But once I began scoring the various parts of Forgefinder's business model, I discovered that it was a valuable intellectual process", Gillman adds. It appears that Forgefinder deserved its high ranking on the Silver Scale. Today, Forgefinder has established itself as the leading online auction company having won business from the likes of: Ford, MG Rover, Bosch, Massey-Ferguson and New Holland Case among many others in capital equipment, such as One Oncology in cancer drugs and McVities, Crawfords and Swainson's in food.

The Bottom Line

As my mother said, "Founding a venture and being an entrepreneur is the third hardest thing a person can do" (for numbers one and two see my earlier article on Marriage and Startups). So, the last thing you want to do is found a venture doomed to mediocrity from the start. Before investing time, energy and heartache into launching a new venture, ensure that you aren't the only one "drinking the Kool-Aid™" by applying Silver's Law. You can do so online at: http://www.smartstart-ups.com/scoring.html or by giving Silver's follow-up text, Smart Start-ups a read (it's worth it).

Sean Wise, BA, LLB, MBA is the Managing Director of Wise Mentor Capital, a national venture capital consultancy focusing on bridging the gap between entrepreneurs and capital. Sean speaks at more than 20 Entrepreneurial Bootcamps and events across North America annually. His monthly column covers a wide range of topics on entrepreneurship and venture capital as does his blog found at www.SeanWise.com. Sean's new book on Entrepreneurship & Venture Capital is currently available at www.AMAZON.com.

PREVIOUS COLUMN

How to drive up the value of your equity

In the last 24 months we've seen MySpace sell for over $500 million, YouTube for $1.6 billion and eVault for $185 million. M&A is once again hot, which raises the question: What determines the final price (often referred to as the "terminal value") in a sale? And, more importantly, what can founders and funders do to drive such price up in advance? Well, let's start at the beginning. Venture Capital, like Angel Investing, is a four stage process designed to:

1) Attract deals
2) Screen for the best and invest
3) Grow the company (and the value of the investment)
4) Exit to recover the investment plus return

There are typically three ways an investor can exit and claim his winnings:

1) Sell the company ⇒ i.e., sell 100% of the equity to another company (known as an "M&A" transaction standing for Merger and Acquisitions); or
2) Take the company public ⇒ i.e., sell some of the equity to the public (known as an "IPO" transaction. standing for Initial Public Offering); or
3) Equity buy back ⇒ i.e., the company buys back the investment.

By far, most investors prefer M&A over IPO, and IPO over buy back. The reason for this is simple — liquidity (i.e., getting paid). In an M&A transaction, the investor receives cash and/or highly liquid shares (usually publicly traded), thus allowing them to "get out" and make their returns. In an IPO transaction, the investor typically must continue to hold their shares in escrow for a period of time, but the shares have a "trading price" which allows the investor to mark up their investment, which makes it the second best option. An equity buy back is rare. After all, if the company can afford to buy out the investor for five times his initial investment, then it stands to reason that the company has large cash resources. That said, if it has large cash resources, it may be better to ride out the investment until some other exit, yielding higher returns. So how do you determine the terminal value of a company?

We all know that valuing privately held tech companies is an art, not a science. We all know that there is also a great deal of negotiation theory involved. Finally, we all know that there are several prima facie facts that often drive price, including:

• Current revenue
• Amount of proprietary, defensible technology
• Potential revenue, both today and in the near term
• Quantity and Quality of User base
• Amount of capital invested to date

But what of secondary factors; those factors those that aren't so obvious? What can management today do to maximize liquidity price tomorrow? That's exactly what Ryerson University Professor Dave Valliere and I set out to determine.

The Research:

For the past two years, in conjunction with Na Ni from the University of Manitoba, we undertook a study of venture capital exits in Canada from 2000-2006, examining the non-primary factors and their influence on terminal valuation.

"The hypothesis of our study" explains Dr. Valliere, who conducts research and publishes extensively on the venture capital industry "was based on the theory of 'information asymmetry', where the price of goods in a marketplace is affected by how much prior information the buyers and sellers have about each other. When there is a lot of unknown or hidden information, the prices are lower. We wanted to explore the effect of prior relationships between buyer and seller: the direct effect of such relationships on information asymmetry, and how this affected M&A prices."

"The idea was simple, but was unproven." adds Valliere, "We explored the effects that prior relationships between the buyer and the target firm had on exchanging and verifying information, and which type of relationship made the buyer more willing to pay a higher price." The types of prior relationships investigated over the two-year research project included:

• supplier to buyer,
• customer to buyer,
• competitor, provider of complementary products,
• partner in an alliance or JV,
• buyer previously invested in the target company,
• buyer has a previous seat on the Board,
• buyer previously employed the founder of the target company, or
• management of the buyer is personally related to management of the target company.

Board members were surveyed and the results were analyzed using an advanced statistical technique called "fuzzy set theory" to identify which combinations of prior relationship factors were most likely to lead to the largest terminal value (i.e., a high sale price). The analysis also made adjustments for conditions in the IPO and VC markets at the time of sale, which may have affected M&A prices in general (remember that most buyers of start-ups are public companies and thus M&A price is directly affected by poor public markets). This helped ensure we compared apples to apples.

The Findings:

The results were less than astounding, but do provide a good guide for those looking to maximize final sale price of your start-up. Setting aside primary factors (revenue, IP, etc.) the research showed:

(1) Having many types of prior relationships generally leads to higher prices than having just one type of prior relationship (even if that one relationship goes back a long time).
(2) Being a complement (selling a complementary product) is alone sufficient for getting a high price.
(3) Being a supplier may be sufficient too, but the positive effect on terminal value is far less certain than being a complement.
(4) Being a past partner helps, but only if also a complement or supplier. Otherwise, partnering adds little to the M&A price.
(5) The same holds for being a past investee or a previous employee of the buyer.
(6) The other factors (e.g., being a customer of the buyer) have no direct statistical effect on sale price.

The Real World:

Sounds interesting, but I wanted to verify these academic results in the real world before I was prepared to sign off on it. To do that, I approached Leonard Brody, who was part of the founding executive at Onvia, which sold to Bell for an undisclosed amount, Tanner Philip from BC Advantage Funds who oversaw his fund's exit from BrightSide Technologies last year and Benoit Hogue from Propulsion Ventures, whose sale of Airborne Entertainment lead to it being named "Deal of the Year" by the Canadian Venture Capital Association..

"Anecdotally," says Philip, who's fund was the only institutional investor in BrightSide Technologies — sold to Dolby Laboratories in May, "I would say that it is easier to negotiate and close a deal with a buyer that has some type of synergy with the selling business, as your study indicates. Complementary products or channels, common customers or a direct customer relationship are at the top of my list for synergies."

This is something that Brody agrees with, "it is critical when looking at exit opportunities to be confident that there are shared outlooks between the two companies. This is particularly true for the founders. Almost all companies now are asking founding members to earn out their capital upon a sale. If there isn't a shared vision about the path forward, it is guaranteed, you will not realize the full amount owed."

Benoit Hogue, from Propulsion Ventures of Montreal (the group that sold Airborne Entertainment for more than $90M) agrees with the importance of prior relationships but adds: "I believe that 'information asymmetry' may be reduced not only through prior relationship but also through strong due diligence. In M&A transactions, the buyer will most often have the expertise and resources to do high quality due diligence and pay the appropriate price. Prior knowledge is just one way to solve this issue. A good mechanic will know if is a used car is a lemon even though he does not know the driving habits and history of the previous owner."

The Bottom Line:

Founders and funders should keep their eyes on the prize. M&A is the exit method favored by investors nine times out of ten, and preparing for it early can help maximize the sale price. Based on evidence both anecdotal and statistical, start-ups should remember that, when it comes to relationships: It is more important to be broad than deep. When starting to prepare for sale, prioritize potential strategic buyers for your firm using these screening criteria:

1. Complement
2. Customers of yours
3. Partners
4. Previous investors in your firm
5. Former employers of your founder(s)

This will identify the firms that face the lowest information asymmetry, and are therefore willing to pay the highest price, yielding the best returns for all shareholders.

Sean Wise, BA, LLB, MBA is the Managing Director of Wise Mentor Capital (www.WiseMentorCapital.com ), a national venture capital consultancy focusing on bridging the gap between entrepreneurs and capital. Sean speaks at more than 20 Entrepreneurial Bootcamps and events across North America annually His monthly column on www.theglobeandmail.com/smallbusiness covers a wide range of topics on entrepreneurship and venture capital as does his blog found at www.SeanWise.com. Sean's new book on Entrepreneurship & Venture Capital is currently available at www.AMAZON.com