We all know that every startup is risky. No risk means no reward. Yet every investor has his own “rules of thumb” on what makes a specific startup too high a risk for his investment taste. You need to know these guidelines to set your expectations on funding.

Of course, if you intend to fund the business yourself, or have a rich uncle, external investment funding concerns are not a problem. Yet, it’s still worthwhile to understand the issues so you can minimize your own risk of failure. Here is a summary of the “big picture” high risk considerations:

1. Inexperienced team. I’ve said many times that investors fund people, not ideas. They look for people with real experience in the business domain of the startup, and people with real experience running a startup. An expert in software is considered high risk in manufacturing, and a Fortune 100 executive running a startup is high risk.
2. Historically high failure rate category. Certain business sectors have historical high failure rates and are routinely avoided by investors. These include food service, retail, consulting, work at home, and telemarketing. On the Internet, I would add new social networking sites, and new matchmaking sites.
3. Dependent on government regulations. If your business model is dependent on government approvals, that can take a long time, or require political connections. All new medicines, for example, require expensive and extensive testing for side effects before FDA approval. Of course, successful approvals may also mean high returns.
4. Large initial investment required. If your startup involves new electronic chips, that may require a huge investment (more than $1B) to ramp-up manufacturing. By definition, all but the largest investors will pass, and it becomes high-risk to all investors. New drugs often fall in this category, due to long clinical trials and FDA approvals required.
5. Businesses with small return potential. Businesses with a low growth rate or a small opportunity (less than $1B) are considered high risk by investors, who get measured on portfolio return over time. That eliminates from consideration family businesses, small niches, and business areas with declining growth.
6. Poor public image businesses. Most investors like to maintain a squeaky clean image, so would consider it high risk to invest in businesses on the margin of legality or social acceptability. Don’t expect investor enthusiasm for your gambling site, porn site, gaming, or debt collection business.
7. Operations in another country. Investors in one country are generally reluctant to invest in a company outside their realm of operational knowledge. We all know that the success “rules” in Russia are different from the USA, so cross-boundary investments are considered high risk, even if you have operating experience there.

These rules of thumb should not be viewed as barriers, but just another factor that needs to be addressed specifically in your business case and investor presentation. It’s better to be proactive on these, rather than hope your investor is too naïve to notice. Your challenge, if your interest is in one of these areas, is to point out quickly why the high risk is mitigated in your case.

In summary, it pays to have some insight into how investors will likely see you, since this allows you to prepare the best case, both for your own decisions, and for approaching an investor. It’s never smart to switch your plans to a “less risky” business that you know nothing about, because your lack of experience there simply moves that alternative to the high risk category.

If you can’t handle risk, don’t do a startup. But even if the risk energizes you, do it with your eyes wide open. Even the best adventurers do their homework before starting down a new path. Known obstacles are a lot easier to overcome than surprises. Enjoy the challenge.

If you are looking for an outside investor, you need to know how they see you. Different types of investors look for startups at different levels of maturity. If your startup is at the wrong stage for the investor you are approaching, fishing for money is a waste of time for both of you.

For instance, if your company is only a few weeks old and you have zero customers and your product offering is still in design, don’t expect someone to hand over $10 million to fund your efforts. It wouldn’t work anyway, since your valuation at that stage would be less than the funding, meaning you would have to give away all ownership for the money.

You also will find that the stage your startup is in dictates where you go to seek funding. Funding sources specialize in certain growth stages. Angel investors typically provide early-stage funding, while venture capital firms typically come in at later stages.

Of course, growth and development are really a continuum. Yet most investors will tend to categorize your progress into one of the following five stages:

• Idea stage. This is the initial excitement period, the time when you dream of riches and fantasize the life of a business owner, but you have no real plan. At this stage, no professional investor will touch you unless you have a beautiful track record of success with previous startups. Funding will only come from you, or friends, family, and fools.
• Early or embryonic stage. Investments at this stage are typically called seed investments. Funding of $250,000-$1 million is available from angels, if you have credentials and have done the homework of a good business plan, financial model, and executive presentation. Anything less the $250,000, or any amount at this stage with no credentials, still has to come from friends and families, loans, or federal grant sources.
• Funding or rollout stage. This is the realm of venture capital professional investors, with funding amounts of $1-10 million, often referred to as the “A-round,” or first institutional funding. At this stage, your startup better be selling a commercial offering, have price and cost validated, with significant customer sales and a real revenue stream. Lesser amounts remain in the angel realm.
• Growth stage. Additional funding rounds for growth are often called the “B-round” through “G-round”, with each being in the $5 million to more than $50 million from venture capital and other sources. Companies at this stage must have a large market, good traction, and be focused on scaling infrastructure and market adoption. This normally means more than 30 employees, and more than $1 million in revenue.
• Exit stage. This is the final stage of investment in venture opportunities, and is the point where investors expect to see the return and gain from the original investment. At this stage, you need investment bankers to negotiate a merger or acquisition (M&A), go private, or help you go public with an Initial Public Offering (IPO).

As startups pass through each stage, they must attract appropriate financial partners that can provide the increasing credibility, capital, and industry networks to support movement to the next stage. Typically, they must also change and tune their executive team, to keep up with the increasing demands of a growing company on process discipline and sustainable success.

Another important thing to remember when selecting investors is that not all money is the same. VC money, for example, usually comes with high expectations of milestones met, board seats, and dominant control. Angels may be less demanding, but typically add less value. Friends and family hopefully believe fully in you, and just want you to show them success.

Obviously, if you bootstrap your business, you can avoid all these stages and the investment implications. Otherwise, not paying attention to the expectations associated with each stage will likely jeopardize your one chance to make a great first impression on potential investors, and landing the big one. Do it right and enjoy the journey.

Every investor is looking for the “dream team” of executives to put his money on. Often I find that experienced investors flip to the management page of a business plan, even before they read the product description. That’s how important the people are. What are investors looking for in the CEO and the rest of the top executives?

• Been there, done that, and won. This may not seem fair to all you first-time entrepreneurs, but wouldn’t you choose to bet on a horse that has been in races before, and won, rather than an unknown in his first race? The size of the race is also important. Fortune 1000 CEOs usually don’t make good startup CEOs, and vice versa.

• Experience and expertise in this business area. You may have great credentials as a public servant in your home town, but that won’t get you money to build a social network on the Internet, or start a software company. You can learn a lot about a new technology from Wikipedia and scouring the Internet, but probably not enough to qualify you as CEO of a new company in that area.

• Network of followers and business associates. Introverts and loners need not apply. Your job as CEO involves heavy doses of selling the merits of your company, lobbying (begging) for money, and convincing other executives to help you or join you.

• Bundles of energy, money, and talent. The startup road is guaranteed to be long and hard. Investors look for someone who is able and willing to put “skin in the game”, looks and sounds like he can weather the storm, will always see the bright side despite adversity, and never gives up.

• Able to communicate a vision. To be respected at the top of the pyramid, a CEO must be able to clearly communicate the vision of the company to inspire investors, the team, and customers. Of course, before you can communicate a vision, you have to have one.

• Relentlessly resourceful. Not merely relentless and passionate about your journey, but able to overcome novel difficulties (per Paul Graham). Being relentlessly resourceful is definitely not what you learn in big companies, or in most schools.

• “The buck stops here.” The CEO has to be confident and clearly the final decision maker. Investors don’t like “equal partner” situations, or worse yet, family pairs in top positions. The CEO is expected to make the presentations to investors, and answer questions decisively.

What if you can’t convince Jim Clark (Silicon Graphics, Netscape, WebMD, MyCFO, Juniper Networks) to run your startup? The most common solution is that you “bootstrap” your business, or fund it yourself, at least to the point that your “traction” is evident (you have a product, you have customers, you have revenue). Another alternative is to rely on that famous first tier of investors, called friends, family, and fools.

Everyone loves that dark horse who comes from the rear to lead the pack and win the race, but very few people will bet on him up front. But don’t let that discourage you. Even Jim Clark started as just another associate professor of electrical engineering, but he teamed with some bright people, and proved he could beat the odds.

If you don’t have the credentials today, team with someone who does. The strength of your idea alone won’t suffice to bridge the funding gap. There is no substitute for experience and mentoring. The quicker you get it, the sooner you can be the next Jim Clark and write your own check.

After you have successfully attracted angels or venture capital with your business case, your million dollar product idea, and you have a signed term sheet, there is still one more hurdle to overcome before investors write the check. This is the dreaded “due diligence” process.

For no good reason, this process seems shrouded in mystery, when in fact it is nothing more than a final integrity check on all aspects of your business model, team, product, customers, and plan. In my view, understanding due diligence can only improve information flow, and leads to a better long-term partnership with your investor.

Remember that up to this point, the investor has primarily seen and talked to the founder and CEO, and studied written documents. Before smart investors write a check, they, or a trusted consultant, will want to meet and talk with your key team members, several customers, and evaluate the real product. If results don’t match what they have been told, all bets are off.

This is where they find out if your team is all behind you, your customers are truly excited, your product is ready to ship, and there aren’t any skeletons in the closet. All private equity groups go about due diligence in their own way, but there are a few key areas of focus that entrepreneurs should always expect:

• Team strength and health. For small teams, every team member will likely be interviewed. Investors are looking for your depth of talent, loyalty and commitment, strengths and weaknesses, teamwork, and management style. A dysfunctional team, or even one naysayer in a critical position can stall your investment.
• Product or service readiness. Technical due diligence typically starts with a full one or two day review with the engineering and product marketing staff. Investors are evaluating your process as well as your product. The goal is to feel 100% confident that the product has the features and quality you assert, and the team and process to keep it true in the future. Finally, they need to validate intellectual property protections and status.
• Market need and size validation. A good investor can do a lot to help a company, but can’t make customers buy products. Investors will likely talk to dozens of potential customers, starting with your reference list (undoubtedly well prepped). They will also speak to technical leaders and industry contacts where they have prior relationships. No validated pain, no deal.
• Sustainable competitive advantage. The kiss of death is for investors to find unanticipated competition you neglected to mention. They try to confirm from industry analysts that your differentiators are indeed unique, and that there are no future competitors or big gorillas in stealth mode just around the corner.
• Business and financial status. How well have you met previous financial and business milestones? Investors will validate pre-existing investments and stock ownership to create an accurate market capitalization sheet for your company. Founders with bad credit, active lawsuits, or recent bankruptcies dramatically increase the risk.

As you go through the due diligence process, there are some practical tips to keep in mind. First, be proactive in asking if you have answered all the key questions, and ask how you compare to others. Get to the truth early. Waste no time. Use the feedback to strengthen your presentation and your company.

Secondly, conduct your own due diligence of the investor. This process is the foundation for the long term partnership, so both sides need the same level of comfort and trust. The investor relationship is akin to marriage. It’s nice to have a little mystery in your marriage, but you better understand each other on the fundamentals.

In the world of business, you only get one chance for a great first impression. The stakes are high – you are asking an investor for money, a customer for an order, or another executive for a partnership. Badly written letters, long rambling or emotional emails, or an obvious lack of spell checking will brand you as a poor business risk before the message is even considered.

No one is born with business writing skills, and everyone can learn them. Yet this seems to be one of the most common failures I see in business professionals. I get serious letters to investors, requests for assistance, and business plans almost every day which violate the basic rules of business communication. We both lose when that happens.

Thus, I thought a quick refresher on business writing basics might help you more than any tip on the next big thing on the business horizon:

1. Select clear purpose and focus. Before you start writing, it’s important to ask yourself what you intend the document to accomplish. What action you want the reader to take as a result of your message? Make every word focus on that purpose. Get to the point in the first sentence, and restate it in the last.
2. Tailor writing to your audience. The audience makes all the difference. People subconsciously tailor their conversation, and same rule applies to writing. Consider your recipient’s motivation, culture, socio-economic status, education level, gender, and relationship to you. If you don’t know this information, aim high rather than low.
3. Organize toward a specific outcome. Think about the conclusions you’d like your readers to reach by the time they finish your writing. In general, you will either inform or persuade, and you should have one of these two approaches in mind as you write. Always use the same basic elements of opener, body, and conclusion.
4. Make it look good. A poorly formatted document, unsightly fonts, and lack of white space will kill even the best writing. Place all the parts of the message in the correct positions. Use short paragraphs for readability and spacing. Put information where your reader expects to see it. Show your readers respect, and you’ll get respect back.
5. Action items should be highlighted and positive. Underline action items, or even separate them in bullets to give visual cues to their importance. Readers will focus better on positive words rather than negative, so state negative messages in the most positive light to make them more palatable. Focus on what is, rather than what is not.
6. Develop a friendly business writing voice. This will create a sense of familiarity for readers, making them more open to what you have to say. Inject confidence, and courtesy, always using non-discriminatory language to avoid offence and apparent bias. Write at the audience reading level or below.

In general, I don’t recommend phone text messaging or Instant Messaging for business purposes, unless the recipient already knows you well. Emails are acceptable, but keep these to one page, addressed to one person, with meaningful subject lines, and use that spell checker.

Always remember that even the best written message can’t convey the body language and emotions of the sender. If the subject is sensitive or the message can be easily misinterpreted, don’t use email or anything written, but pick up the telephone or meet in person instead.

Who you are and who you can be, depend on the image your writing communicates to the mind of the receiver. That image is set more by the way you write, than by the content of your message. For business, skip the story telling and the colorful language of Mark Twain, unless you want to date your company and your savvy to his era.

New product startups rightfully begin with a heads-down focus on creating the ultimate product – whether it’s a new technology, a new look and ease of use, or a new low-cost delivery approach. Most then add customer service at the rollout, but very few really understand what it means to be truly customer centric, and even fewer really achieve it.

Customer centricity is far more than providing excellent customer service, although that’s a step in the right direction. Customer centricity is a strategy to fundamentally align a company’s products and services with the wants and needs of its most valuable customers, with the aim of more profits for the long term.

As I was reminded recently by Peter Fader’s new book, “Customer Centricity” from the Wharton School, Wal-Mart and Costco aren’t really customer centric. They do provide the right products at the right price to save all customers money (with good customer service), but they don’t try to find their most valuable customers, and nurture them to buy more or bring in friends.

Customer centric means building loyal customers, like Apple appears to have done recently. It means recognizing that all customers are not the same, and that all customers are not always right. It means pursuing Fader’s four tenets that can lead to even greater long-term success and profits than a great product at a low price:

1. Accept that all customers are not the same. By recognizing the fundamental and inevitable differences among your customers, you can give your organization a strategic advantage over your product-centric competitors – who may know little to nothing about the customers who account for their success and survival.
2. Focus on individual customer value. By understanding that there is real and quantifiable value to be found in individual customers, you can better focus your long-term marketing efforts on precisely those customers who will generate the greatest long-term value.
3. Quantify the value and cost of acquiring every new customer. By working to quantify the value of each and every one of your customers, you can gain enormously valuable insight about how much you should be willing to spend to keep an existing customer and how much you should be willing to spend to acquire a new customer.
4. Personalize your offering to each customer or group. By moving forward with a highly focused customer relationship management initiative, you can gather and leverage more information about your customers. This will allow your company to serve those customers in a more personalized (yet genuine) manner than any competitor can.

In reality, you don’t need to get to know each individual customer. But you do need to segment your customers into homogeneous groups. Then you can decide on a marketing program, loyalty program, or a level of attention that is appropriate to each group, for acquisition, retention, and profitability.

Remember, this is not a one-time effort. The needs and interests of your customers are ever-changing, so you have to constantly re-align your resources to build mutually beneficial relationships. Don’t focus only on your products and operational efficiencies, unless you already have the brand image and leverage to prosper with price as the key differentiating factor.

Success hinges on progressing past lip-service, to the real work of building a customer centric organization to execute the focus. That means setting up operational and financial metrics, educating team members, and rewarding the right actions. Can you name three elements today in your startup that go beyond good customer service? If not, competitors are approaching.

Once you have a potential investor excited about your team, your product, and your company, the investor will inevitably ask “What is your company’s valuation?” Many entrepreneurs stumble at this point, losing the deal or most of their ownership, by having no answer, saying “make me an offer,” or quoting an exorbitant number.

I’ve written about this before, but it’s a mysterious subject, and I’m always learning more. This time I’ll use a hypothetical health-care web site company named NewCo as an example to illustrate the points.

Two founders have spent $200K of personal and family funds over a one year period to start the company, get a prototype site up and running, and have already generated some “buzz” in the Internet community. The founders now need a $1M Angel investment to do the marketing for a national NewCo rollout, build a team to manage the rollout, and maybe even pay themselves a salary.

How much is NewCo worth to investors at this point (pre-money valuation)? What percentage of NewCo does the investor own after the $1M infusion (post-money ownership percentage)? Well, if the parties agree to a pre-money valuation of $1M, then the post-money investor ownership is 50% (founders give up half interest, and lose control). On the other hand, if the pre-money valuation is $4M, the founders ownership remains at a healthy 80% level.

So what magic can the founders use to justify a $4M valuation (or even the $1M valuation) at this early stage? Here are the components and “rules of thumb” that I recommend to every startup:

1. Place a fair market value on all physical assets (asset approach). This is the most concrete valuation element, usually called the asset approach. New businesses normally have fewer assets, but it pays to look hard and count everything you have. NewCo might be able to pick up an initial $50K valuation on this item.
2. Assign real value to intellectual property. The value of patents and trademarks is not certifiable, especially if you are only at the provisional stage. NewCo has filed a patent on one of their software tool algorithms, which is very positive, and puts them several steps ahead of others who may be venturing into the same area. A “rule of thumb” often used by investors is that each patent filed can justify $1M increase in valuation, so they should claim that here.
3. All principals and employees add value. Assign value to all paid professionals, as their skills, training, and knowledge of your business technology is very valuable. Back in the “heyday of the dot.com startups,” it was not uncommon to see a valuation incremented by $1M or every paid full-time professional programmer, engineer, or designer. NewCo doesn’t have any of these yet.
4. Early customers and contracts in progress add value. Every customer contract and relationship needs to be monetized, even ones still in negotiation. Assign probabilities to active customer sales efforts, just as sales managers do in quantifying a salesman’s forecast. Particularly valuable are recurring revenues, like subscription amounts, that don’t have to be resold every period. This one doesn’t help NewCo just yet.
5. Discounted Cash Flow (DCF) on projections (income approach). In finance, the income approach describes a method of valuing a company using the concepts of the time value of money. The discount rate typically applied to startups may vary anywhere from 30% to 60%, depending on maturity and the level of credibility you can garner for the financial estimates. NewCo is projecting revenues of $25M in five years, even with a 40% discount rate, the NPV or current valuation comes out to about $3M.
6. Discretionary earnings multiple (earnings multiple approach). If you are still losing money, skip ahead to the cost approach. Otherwise, multiply earnings before interest, taxes, depreciation and amortization (EBITDA) by some multiple. A target multiple can be taken from industry average tables, or derived from scoring key factors of the business. If you have no better info, use 5x as the multiple.
7. Calculate replacement cost for key assets (cost approach). The cost approach attempts to measure the net value of the business today by calculating how much it could cost for a new effort to replace key assets. Since NewCo has developed 10 online tools and a fabulous web site over the past year, how much would it cost another company to create similar quality tools and web interfaces with a conventional software team? $500K might be a low estimate.
8. Look at the size of the market, and the growth projections for your sector. The bigger the market, and the higher the growth projections are from analysts, the more your startup is worth. For this to be a premium factor for you, your target market should be at least $500 million in potential sales if the company is asset-light, and $1 billion if it requires plenty of property, plants and equipment. Let’s not take any credit here for NewCo.
9. Assess the number of direct competitors and barriers to entry. Competitive market forces also can have a large impact on what valuation this company will garner from investors. If you can show a big lead on competitors, you should claim the “first mover” advantage. In the investment community, this premium factor is called “goodwill” (also applied for a premium management team, few competitors, high barriers to entry, etc.). Goodwill can easily account for a couple of million in valuation. For NewCo, the market is not new, but the management team is new, so I wouldn’t argue for much goodwill.
10. Find “comparables” who have received financing (market approach). Another popular method to establish valuation for any company is to search for similar companies that have recently received funding. This is often called the market approach, and is similar to the common real estate appraisal concept that values your house for sale by comparing it to similar homes recently sold in your area.

Remember that all the components, except the last, are cumulative. Even if a given investor excludes some of the components from consideration in your case, your credibility will be bolstered by the fact that you understand his interests as well as yours. In any case, the analysis will prepare you for the heavy negotiation to follow.

Precision is not the issue here – the task for the entrepreneur is to build a company that is worth at least $50M before thinking about an exit — no investor wants to spend more than five minutes arguing the fine points of the last valuation dollar.

So what is a reasonable valuation for a company like NewCo? My advice for early-stage companies like this one is to target their valuation somewhere between $1.5M and $5M, justified from the elements above. A lower number suggests that the founders are giving away the company, while a much higher number may suggest hubris or lack of reality on the part of the owners.

Of course, we have all read about the “new” company with $100M valuation, but I haven’t met one yet.

The first question most people seem to ask when contemplating a new startup is where they will get the money. That’s certainly a valid question, but all the money in the world won’t make your business a success if you hate what you are doing, and you aren’t prepared to do the job. I suggest that there are several other questions even more important than the money one.

The best way to assure the success of your startup is to do something you love, as opposed to something that will make you a lot of money. Of course, all these things and many more are critical, so it’s important that you keep your priorities straight. Here are the right questions to ask yourself, in the right order, before asking others about money:

• Do you understand and aspire to entrepreneur lifestyle? Being a startup founder is not a job, but a lifestyle, like getting married versus staying single. In fact, it’s more like being single, since founders usually have no one to lean on, no one to make decisions for them, no one to blame, and no vision to follow but their own.

• Do you have a passion for your idea and business opportunity? There is no joy in starting a business, if you can’t stand the people, business climate, or the day-to-day responsibilities of the job. Some people relate to service businesses, while others are more comfortable with manufacturing or construction.

• What type of business startup best fits your mentality? Beyond the traditional new product or service model, you can always buy an existing business, purchase a franchise, join a multi-level marketing (MLM) company, or simply go out on your own as a consultant. Each of these has their unique challenges and payback. Ask around.

• What level of experience and training do you have for this business? Be wary of stepping into an unknown business area, just because it looks easy or promises a big return. The real secrets of any business are not in textbooks, and you can’t believe everything you read on the Internet. Experience is the best teacher.

• Do you have real self-confidence and self-discipline? Starting a business is hard work and will require sacrifices. You will be operating independently, making all the decisions, and shouldering all the responsibility. Will you be able to persevere and build your new venture into a success?

• Do you have a viable plan? If you haven’t yet written down a business plan, you probably have no idea how much money you really need, or even if the opportunity is real. I believe the process of writing the plan is more valuable than the result, because it forces you to think through all the elements, and make sure they fit together and fit you.

• How much money do you really need? From your plan, calculate the absolute minimum amount you need to make your plan work, and then buffer it by 50%. Consider the non-cash alternatives, like offering equity instead of cash and bartering for services. Fundraising is extremely difficult, which is why most entrepreneurs do bootstrapping.

If you have made it this far, it’s fair to now start asking people where and when you can find the money you need (if any). Professionals will tell you that the sequence is friends and family first, angel investors second, and only then venture capital. Each of these has a cost in time an effort.

The process for all of these is networking (not email blasts or cold-calling investors). Start with the local Chamber of Commerce, industry associations, or investor seminars. Just attending doesn’t work. Use your entrepreneurial spirit to start some exchanges and relationships that can lead to your next step.

Starting a business is a marathon, so do your preparation and training before you ask for that bottle of water. Finding money is tough, but it’s not the hardest part. The hardest part is to do it all while enjoying the journey. Get busy, and have fun.