One of my biggest challenges aspiring entrepreneurs face is figuring out which ideas to pursue and which ideas to put on the back burner. We at KCC have the luxury of working with a bunch of really smart people, so new ideas for things that we could do come up all the time. From potential partnerships to new product and marketing ideas, I feel like we’re swimming in opportunity.

But, like every other entrepreneur in the world, my challenge isn’t a lack of new ideas, it’s figuring out which ideas are worth spending time and money on.

This is true whether you’re a bootstrapped startup that’s funded with credit cards and loans from friends and family, or the next darling of Silicon Valley that’s sitting on a war chest of millions in venture capital funding.

No matter who you are or how big you hope to grow your business, figuring out what product to build and what services to offer is a huge challenge.

Of course, you could just rely on your gut. Sometimes that’s not a bad option, but making a good guess at what your company should do can just as often lead to failure. And, since the vast majority of businesses fail within five years of opening, why not take a few extra steps to discover if you really have a great idea before you risk your time and money following your hunch.

Starting any business takes a huge leap of faith. You’re jumping off of a mountain and hoping your parachute will open and lead you and your business to success. Given that you could be doing many, many things with your time, how do you decide what to do and what’s really a great idea?

Here’s KCC’s guide to figuring out if your idea is any good and if it’s worth moving to the next level.

1. Start by documenting your key assumptions about your business

When you’re first considering a new business idea, skip the formal business plan and start with a one-page business plan or a simple elevator pitch to jot down the basic components of your idea. At a minimum, you’ll want to cover the following:

• Why are you doing this? What’s your mission? All new businesses need a sense of purpose. Are you trying to improve people’s lives in some way? What are the core differentiators of your business that set you apart from the next person trying to build a similar business?
• What problem are you solving? You need to be solving some sort of real problem that exists in the world. If you aren’t solving a problem for potential customers, then how will you get people to buy your product or service?
• Who are you solving this problem for? As important as having a problem to solve, is having customers that have this problem. Knowing who your ideal customer is and how you can find them is critical to starting a successful business.
• How are your potential customers solving their problem today? This is where you want to write down a few notes about your competition. What choices do your customers have today? How is your solution better?
• Do you think you can make money? You don’t need to worry at this early stage about in-depth financial forecasts, but you should do some basic back-of-the-napkin calculations to make sure your idea can be profitable.

The key to this initial step is to write down you key assumptions quickly—30 minutes should be enough to write down your ideas. You don’t need to write a lot (certainly not more than a page). Just get your ideas out there so that you have an idea about your key assumptions because the next steps involve getting out into the real world and seeing if your assumptions are accurate.

2. Talk to your potential customers

Shockingly, talking to potential customers about your new business idea is the step that most entrepreneurs skip. Not talking to your potential customers raises your chances of failure substantially, so head out the door and start talking to people as soon as you can.

When you interview your potential customers, you’re trying to validate your key assumptions that you documented in your business pitch. Do they actually have the problem you assume they have? How do they solve their problem today? What do they think of your idea?

Be sure to talk to as many potential customers as you can so you get multiple points of view. You’ll also gain invaluable insight into what your customers’ offices and workspaces look like, how they work, and how they make buying decisions and shop.

As you learn about your potential customers, you should go back and update your pitch. You might tweak your definition of the customer problem, your solution, and even the competition.

3. Show your prospective customers a prototype of your product, if you have one

If you can, and it makes sense for your business, try and share an example of your solution. If you’re building a product, maybe you can share a prototype or some images of what the product looks like. If you’re offering a service, describe the results of your service and what the deliverables would be if your prospect hired you.

Ideally, you want to get your potential customers on the same page as you and get them to critique your idea. The more real you can make your idea for your potential customers, the higher quality feedback you will get.

4. Figure out what people are willing to pay

As you talk to your potential customers, try and figure out what they might be willing to pay for your solution. This can be pretty tricky, because ideally everyone wants everything for free!

But, there are some tricks you can employ instead of just asking outright. First, if there are competitors in your market, you can look at their pricing and then decide how you want to differentiate your company. You can also look at the value you are providing to your customer and create a price based on that.

When you have a price in mind, ask your prospective customer if they would order your product or service right now for your price. You might find that people will say yes right away, or they will tell you what they think the price should be. If you pay close attention, you’ll also be able to tell if the customer thinks they are getting a good deal or if your price is a bit of a stretch.

5. Find people who think your idea sucks

As you bounce your business idea of off friends and family, it’s easy to end up only hearing positive feedback. Even potential customers might not want to hurt your feelings and not give you their completely honest opinion.

This is where finding a few naysayers is important. Find people who don’t like your idea and get them to poke holes in it. Why do they think it’s going to fail? What do they see as your weak points?

You don’t necessarily have to address all of the weak points that these detractors find, but you need to gather feedback from people who think you can improve. Not everyone is going to be your customer, but it’s better to head into a new business endeavor with open eyes. Are there potential pit-falls that you haven’t thought of yet? If you encounter a prospective customer that doesn’t like your product, how will you respond?

Getting feedback from people who don’t like your business idea can help you figure out how you will address these issues and what your answers will be as you build your business.

6. Find out how much money it is going to take to launch your business

As you gather customer feedback and refine your pitch, you’re hopefully honing in on a great business idea.

Vetting and refining your idea before you start your business will greatly enhance your chances of success and ensure that you have a solid idea.

At this stage, you should know if you have a winning idea on your hands. But, now you need to figure out if the business can be financially viable and what you need to get it off the ground.

This is the stage where you’ll move beyond your initial business pitch and start building out some more detailed financial projections to figure out how much money you’ll need to get up and running. At a minimum, at this stage you’ll want to create a sales forecast, an expense budget, and a cash flow forecast. These three forecasts will help you figure out what it’s going to take to start your business and keep the doors open as you get your first customers.

7. Start as small as possible

It’s tempting to dive in at the deep end and build your complete business the way you imagine it will be. After all, you want to realize your vision that you’ve been working so hard on. You’ve been talking to potential customers and selling them on your dream, and now it’s time to make it real.

Try and resist this urge, if possible. Starting small and continuing to gather feedback from customers is a key component to growth. With a smaller start, you’ll be able to change direction faster and react to customer feedback quicker.

Starting small also gets your solution (at least the bare-bones version of it) out into the market quicker. The faster you can get to market, the faster you’ll gather feedback.

When you open your doors for business with a “start small” approach, you’ll feel like you’re not “ready.” But, more often than not, you’ll find that customers might not even notice. And, the ability to pivot and change directions quickly is much more valuable to your long-term success than trying to get everything right the first time.

 8. Stay flexible

The final key to making sure you have a good idea that will grow into a successful business is to stay flexible. The best business owners check their ego at the door and are able to listen to customer feedback. But, this doesn’t mean that the customer is “always right.” Far from it.

Instead, listening and being flexible enables you to adapt as you go and change directions as needed. You don’t want to react to one customer’s opinion, but you do want to look for broader trends in the opinions of as many customers as possible.

You may even decide that certain types of potential customers aren’t part of your target market. You may decide that you only want to sell to bigger businesses, for example, and you can adjust your pricing and marketing to reflect that.

Conclusion:

This approach to figuring out if you have a good business idea means starting much smaller than you might have originally thought. It also means that you don’t sit behind your desk building a business plan without getting out and actually talking to your customers.

This is lean planning at its core: Start with just the fundamentals of a plan and then verify that your idea is good before moving on to the next step.

Contrary to popular belief, business plans do not generate business financing. True, there are many kinds of financing options that require a business plan, but not all invests in a business plan.

Investors need a business plan as a document that communicates ideas and information, but they invest in a company, in a product/service, and in people.

Small business financing myths:

• Venture capital is a growing opportunity for funding businesses. Actually, venture capital financing is very rare. I’ll explain more later, but assume that only a very few high-growth plans with high-power management teams are venture opportunities.
• Bank loans are the most likely option for funding a new business. Actually, banks don’t finance business start-ups. I’ll have more on that later, too. Banks aren’t supposed to invest depositors’ money in new businesses.
• Business plans sell investors. Actually, they don’t—a well-written and convincing business plan (and pitch) can sell investors on your business idea, but you’re also going to have convince those investors that you are worth investing in. When it comes to investment, it’s as much about whether you’re the right person to run your business as it is about the viability of your business idea.

I’m not saying you shouldn’t have a business plan. You should.

Your business plan is an essential piece of the funding puzzle, explaining exactly how much money you need, and where it’s going to go, and how long it will take you to earn it back. Everyone you talk to is going to expect to see your business plan.

But, depending on what kind of business you have and what your market opportunities are, you should tailor your funding search and your approach. Don’t waste your time looking for the wrong kind of financing.

Where to look for money

The process of looking for money must match the needs of the company. Where you look for money, and how you look for money, depends on your company and the kind of money you need. There is an enormous difference, for example, between a high-growth internet-related company looking for second-round venture funding and a local retail store looking to finance a second location.

In the following sections of this article, I’ll talk more specifically about six different types of investment and lending available, to help you get your business funded.

1. Venture capital

The business of venture capital is frequently misunderstood. Many start-up companies resent venture capital companies for failing to invest in new ventures or risky ventures. People talk about venture capitalists as sharks—because of their supposedly predatory business practices, or sheep—because they supposedly think like a flock, all wanting the same kinds of deals.

This is not the case. The venture capital business is just that—a business. The people we call venture capitalists are business people who are charged with investing other people’s money. They have a professional responsibility to reduce risk as much as possible. They should not take more risk than is absolutely necessary to produce the risk/return ratios that the sources of their capital ask of them.

Venture capital shouldn’t be thought of as a source of funding for any but a very few exceptional startup businesses. Venture capital can’t afford to invest in startups unless there is a rare combination of product opportunity, market opportunity, and proven management. A venture capital investment has to have a reasonable chance of producing a tenfold increase in business value within three years. It needs to focus on newer products and markets that can reasonably project increasing sales by huge multiples over a short period of time. It needs to work with proven managers who have dealt with successful start-ups in the past.

If you are a potential venture capital investment, you probably know it already. You have management team members who have been through that already. You can convince yourself and a room full of intelligent people that your company can grow ten times over in three years.

If you have to ask whether your new company is a possible venture capital opportunity, it probably isn’t. People in new growth industries, multimedia communications, biotechnology, or the far reaches of high-technology products, generally know about venture capital and venture capital opportunities.

If you are looking for names and addresses of venture capitalists, start with the internet.

2. “Sort-of” venture capital: Angels and others

Venture capital is not the only source of investment for start-up businesses or small businesses. Many companies are financed by smaller investors in what is called “private placement.” For example, in some areas there are groups of potential investors who meet occasionally to hear proposals. There are also wealthy individuals who occasionally invest in new companies. In the lore of business start-ups, groups of investors are often referred to as “doctors and dentists,” and individual investors are often called “angels.” Many entrepreneurs turn to friends and family for investment.

Post your business plan on sites that bring angel investors together. The two most reputable sites in this area are:

Important: Be careful dealing with anyone who offers to help you find financing as a service for money. These are shark-infested waters. I am aware of some legitimate providers of business plan consulting, but legitimate providers are harder to find than the sharks.

3. Commercial lenders

Banks are even less likely than venture capitalists to invest in, or loan money to, startup businesses. They are, however, the most likely source of financing for most small businesses.

Startup entrepreneurs and small business owners are too quick to criticize banks for failing to finance new businesses. Banks are not supposed to invest in businesses, and are strictly limited in this respect by federal banking laws. The government prevents banks from investment in businesses because society, in general, doesn’t want banks taking savings from depositors and investing in risky business ventures; obviously when (and if) those business ventures fail, bank depositors’ money is at risk. Would you want your bank to invest in new businesses (other than your own, of course)?

Furthermore, banks should not loan money to startup companies either, for many of the same reasons. Federal regulators want banks to keep money safe, in very conservative loans backed by solid collateral. Startup businesses are not safe enough for bank regulators and they don’t have enough collateral.

Why then do I say that banks are the most likely source of small business financing? Because small business owners borrow from banks. A business that has been around for a few years generates enough stability and assets to serve as collateral. Banks commonly make loans to small businesses backed by the company’s inventory or accounts receivable. Normally there are formulas that determine how much can be loaned, depending on how much is in inventory and in accounts receivable.

A great deal of small business financing is accomplished through bank loans based on the business owner’s personal collateral, such as home ownership. Some would say that home equity is the greatest source of small business financing.

4. Other lenders

Aside from standard bank loans, an established small business can also turn to accounts receivable specialists to borrow against its accounts receivables.

The most common accounts receivable financing is used to support cash flow when working capital is hung up in accounts receivable. For example, if your business sells to distributors that take 60 days to pay, and the outstanding invoices waiting for payment (but not late) come to $100,000, your company can probably borrow more than $50,000. Interest rates and fees may be relatively high, but this is still often a good source of small business financing. In most cases, the lender doesn’t take the risk of payment—if your customer doesn’t pay you, you have to pay the money back anyhow. These lenders will often review your debtors, and choose to finance some or all of the invoices outstanding.

Another related business practice is called factoring. So-called factors actually purchase obligations, so if a customer owes you $100,000 you can sell the related paperwork to the factor for some percentage of the total amount. In this case, the factor takes the risk of payment, so discounts are obviously quite steep. Ask your banker for additional information about factoring.

5. Friends and family funding

If I could make only one point with budding entrepreneurs, it would be that you should know what money you need, and understand that it is at risk. Don’t bet money you can’t afford to lose. Know how much you are betting.

I’ll always remember a talk I had with a man who had spent 15 years trying to make his sailboat manufacturing business work, achieving not much more than aging and more debt. “If I can tell you only one thing,” he said, “it is that you should never take money from friends and family. If you do, then you can never get out. Businesses sometimes fail, and you need to be able to close it down and walk away. I wasn’t able to do that.”

If your parents, siblings, good friends, cousins, and in-laws will invest in your business, they have paid you an enormous compliment. Please, in that case, make sure that you understand how easily this money can be lost, and that you make them understand as well.

Although you don’t want to rule out starting your company with investments from friends and family, don’t ignore some of the disadvantages. Go into this relationship with your eyes wide open.

Maybe, your idea and your situation is a better fit for crowdfunding—that is, creating a profile and pitching your business idea or product on a site like Kickstarter. In fact, this method of raising money has become so popular that here are dozens of crowdfunding sites to choose from, all offering different terms and benefits.

Words of warning

Don’t take private placement, angels, friends and family as good sources of investment capital just because they are described here or taken seriously in some other source of information. Some investors are a good source of capital, and some aren’t. These less established sources of investment should be handled with extreme caution.

Never, never spend somebody else’s money without first doing the legal work properly. Have the papers done by professionals, and make sure they’re signed.

Never, never spend money that has been promised but not delivered. Often companies get investment commitments and contract for expenses, and then the investment falls through. Avoid turning to friends and family for investment. The worst possible time to not have the support of friends and family is when your business is in trouble. You risk losing friends, family, and your business at the same time.

Submitting a plan

The information you submit to investors depends a great deal on what your objective is. Sometimes you’ll submit a complete business plan, sometimes a summary memo. In most cases, even if you submit a short summary, you have to have the complete business plan ready to go as soon as the investors or lenders ask for it. If you’re looking for lease financing, receivables, or a bank loan, you’ll want to submit a loan support document to the lender.

When the search has provided you with a list of useful names, you can print your Summary Memo or loan support documents and send a copy to each of the investors, along with a brief cover letter.

Summary

Most businesses are financed by home equity or savings as they start. Only a few can attract outside investment. Venture capital deals are extremely rare. Borrowing will always depend on collateral and guarantees, not on business plans or ideas.

3 Mistakes Entrepreneurs Make Setting Up Their Exit

1. Advisers.

Founders wait too long to assemble the best possible team of advisers. The founder will potentially add 20-30 percent to the value of the exit if they have a strong team of advisers at the earliest possible stage — an experienced and professional team of business intermediaries/brokers, legal, financial strategists and tax planners who can expertly structure the business to accomplish the seller’s goals, inclusive of lifestyle, philanthropy and legacy. The advisers will also be experienced in the industry and open crucial doors for fund raising, business development and strategic partnerships.

2. Managers.

Failing to recruit and secure a management team that possess the knowledge, accomplishment and sophistication required by a buyer post-acquisition. When someone is ready to buy your company, they are going to look at the quality/experience of the managers, as the retention of those people will be part of the deal. Having the right managers empowers the buyer to concentrate on the overall management of the company in the role of CEO, without having to also act as CFO and/or COO.

3. Systems.

Failing to install and provide IT systems to accommodate the growth sought by the new owner. If the company does not have the right business growth and management systems in place, the company will be less attractive.  As information technology has become an increasingly critical aspect of a modern companies’ operations, potential buyers have intensified their scrutiny of the seller’s IT systems. In a “roll up” scenario, the ease of a smooth integration of the IT system will be a key component of the transaction.

If you are are already playing the “big check exit” lottery, then check your advisers, managers and systems and increase your odds.