From the February 2007 issue of Startups

Jessica D. Herrin's first experience presenting a business plan to investors taught her many lessons, including a hard-knocks course in humility. During the dotcom boom, Herrin's plan for an online wedding gift registry called for selling products directly to consumers and also through retailers. Herrin, a business school student at the time, lacked wedding industry experience, so she didn't know retailers would never support a startup that competed with them. "When we presented the plan, people looked at us like we were crazy," Herrin recalls.

But the 34-year-old Burlingame, California, entrepreneur turned out to be crazy like a fox. She revamped the plan to employ a retailer-only distribution system and eventually got funding for her gift business. And before she even began to solicit investors for her latest business, a custom jewelry maker, she spent time with a retailer partner who showed her the industry ropes. As a result, Herrin was able to quickly raise the $350,000 in seed money Luxe Jewels needed to get off the ground in 2004. Today, Luxe has $1.2 million in sales, 10 employees and a CEO with a strong appreciation for the power of avoiding deal-breaking mistakes in a business plan.

Business plan experts, venture capitalists and entrepreneurs say Herrin's experience is common. Many business plans sport fatal errors that virtually guarantee a hostile reception from lenders or anyone else who views them. Unwary entrepreneurs plant red flags throughout their plans, from the executive summary to the financial statements, says Linda Pinson, a Tustin, California, business planner and author of Anatomy of a Business Plan. But the most common mistake, Pinson says, is a broad lack of internal consistency. An entrepreneur will, for instance, describe marketing costs one way in the section on marketing, then give another figure for marketing costs in the financial statement. "That's the kiss of death," Pinson says. "If [the business plan] doesn't work, how is the business going to work?"

Entrepreneurs can, however, make even flawed business plans work-if they are alert for business plan red flags and either remove them before presenting or correct them for a second go-round. Rhonda Kallman, 46, spent years fruitlessly asking angel investors to put $1 million into her Boston beer startup, New Century Brewing Co. Then Kallman realized she was thinking too small. She revamped her plan to request $3 million, on the theory that the larger amount would allow her to describe a faster-growing company with more upside. "The investors want to see huge upside potential," explains Kallman, a veteran entrepreneur who co-founded Boston Beer Co., maker of the Samuel Adams beers. A company founded on $1 million, she reasoned, was seen as a smaller opportunity than one requiring $3 million. Now, equipped with a $3 million plan to bring unique light beers and caffeinated beers to market, Kallman is more optimistic about her chances. "I'm showing them what my needs are," she says, "and how I plan on raising the appropriate amount of capital to execute my plan."

Elements of a Plan
If you're looking for red flags in your own startup's plan, start with the executive summary. The biggest problem with most summaries is that they're too big, says Stephen Dukker, a veteran entrepreneur and startup advisor in San Francisco. "If it takes more than two or three slides to communicate the overall picture of what your company is, you're going to either lose interest or you're going to confuse them."

Similar problems afflict the product and service sections of many plans. "People get too involved with the details," says Bart Greenberg, a Costa Mesa, California, attorney and startup advisor. "They forget investors aren't as interested in the product as they are in the market and how much money they are going to make." He suggests entrepreneurs devote more space to outlining the benefits to customers.

In the section describing the company itself, entrepreneurs often make the opposite mistake by skipping over essential facts, Greenberg says. He sees many plans that don't address the question of how the company will deal with regulators or other critical issues. "For example, if you're in the health-care industry, people want to know if you're private pay or [Medicare]," he says. "Because if you're Medicare, they know it's going to take six months longer to get paid."

Market Faux Pas
One of the best-known business plan red flags pops up in marketing sections that contain the "1 percent fallacy." This mistake involves describing a huge market, then saying, "If we can just get 1 percent of that . . . ." Plans with any variant of that error receive short shrift from the likes of Nat Goldhaber, managing director of Claremont Creek Ventures, a venture fund in Oakland, California. "Anyone who comes in and says the market is X, and we stand to get 10 percent or 20 percent, almost always gets thrown out," Goldhaber fumes. "I want to know why entrepreneurs believe they are able to capture a percentage of the marketplace. Tell me what you're going to do to capture that percentage."

Startups often misstep by scaling their marketing plans either too broadly or too narrowly. Pinson says going too broad is the most common error. "They have an unrealistic target market," she says. "They haven't narrowed their market down to the customers they will be able to reach."

But it can be an equally serious mistake to confine yourself to a niche that isn't big enough to interest investors, says Munjal Shah, 33, CEO and co-founder of 45-person Riya Inc., a San Mateo, California, visual image search startup. Though it's fine to start in a niche, Shah, who has raised $19 million in two rounds of financing for Riya, says investors want to see a way for you to parlay a toehold into a sizable chunk of a bigger market. "You have to have an idea that's really big," he says, "because high-risk investors need high return."

Whatever you do, don't underestimate the competition. Greenberg says entrepreneurs often downplay the power of existing competitors in a market, as well as what it will cost to unseat established brands.

Shah goes further, saying many startups deny the existence of any competition. "As soon as you say that, every person in the room turns off to you," he warns. "You may not have competitors, but you do have substitutions. Analyzing what that substitute is and whether it's good enough is where [entrepreneurs] fall down."

Follow the Leader

Many investors first turn to the section of a business plan that describes the startup's management team. All too often, what they find there is a red flag, says Goldhaber. One way startups screw up is by trying to give the impression that they already have all the talent onboard needed to grow the company past its first stage. Goldhaber finds that less believable and less helpful than an assessment that admits talent weaknesses. "The more they recognize their deficiencies, the happier I am," he says. "It helps me figure out how I may be useful to them."

An equally serious problem is describing a management team that hasn't invested significant money into the business, adds Greenberg. "It doesn't show a lot of confidence in the business if these guys aren't willing to put in their own bucks," he reasons.

When it comes to the company's operations, red-flag plans often make mistakes like Herrin's, displaying the founders' ignorance of the industry and lack of practical experience, Pinson says. Here's where you need to show you know your field and that you have the operational chops to execute your goals. If you don't, expect to be shown the door.

Get the Bucks and Get Out
In the financial data portions of their plans, startups often over-focus on profit and income statements at the expense of cash-flow projections. That's a major stop sign for savvy investors. Entrepreneurs have to forecast how much cash they'll need to reach major milestones and where that cash will come from, stresses Dukker. Otherwise, the people you're pitching may like your business, but dislike you. "That communicates to the investor that, even if it's a great idea, you're going to need help beyond what's available today, and you might not be the guy running the company," Dukker says.

Finally, startups need to describe an exit strategy. Investors want an opportunity to cash out, and now is the time to tell them about it. "Before you even write a plan, you need an exit strategy telling where you want to go, who you want to be and how you want to get there," Pinson says.

And don't toss off a half-baked idea for an IPO. "Naively written business plans say they're just planning to go public," Greenberg says. "But not many companies are going public today. If you're planning to be acquired, say who would acquire you and why they would acquire you."

The Biggest Red Flag of All
Some people see so many potential problems with business plans that they prefer to start without one. "I don't believe in business plans," says Shah. "They can lead you the wrong way." Rather than a written plan of many pages, Shah prefers to assemble a set of PowerPoint slides that sketch his idea at a general level and describe how his business differs from others in the market. Then he offers detailed statistics about customers gained from user surveys and other market research.

For the moment, however, the big-gest red flag with your business plan is not having one. "There's a lot of talk about whether business plans are even relevant anymore," says Greenberg. "But the business plan is still important because it helps you think strategically about your business.

Whatever you do, startup veterans like Herrin advise you to look at your plan with a critical eye, and be ready to revise it the moment a red flag pops up. She says, "A business plan is a living, organic thing, and it continues to change and evolve."

Going Back for More
You've removed your business plan's red flags. Now how can you get people who nixed you to take a second look? Odds are, you can't--unless you have a personal touch. Investors who have rejected a plan generally won't consider reviewing revisions without a recommendation from a friend or colleague. "Unless you have an introduction, you're not going to get a second chance," says San Francisco entrepreneur and startup advisor Stephen Dukker. "If your business plan goes from inbox to trash can, expect your phone calls not to be returned."

But don't quit. Talk to your lawyer, banker and other contacts to see if you can get an in. "Start calling people and have a tough skin," says Dukker. "You will eventually get through to people and have a chance to present your plan."

The Business Plan Test-Drive
To spot red flags before presenting a plan, give it a test run. Accountants, attorneys, bankers, and others can provide informal feedback without the risk of final rejection, suggests Costa Mesa California, attorney and strartup advisor Bart Greenberg. You can also find expert eyes at Small Business Development Centers, SCORE offices and local entrepreneur's groups.

If you package it right, you can even get preview feedback from your ultimate audience, says New Century Bewing Co. startup CEO Jessica Herrin. "We talked to lots of people, and the discussion wasn't about whether they would fund us," she says. "It was, 'What do you think of this ideas?' Never talk to venture capitalists about money. Just ask them what they think. Then maybe they'll get excited and offer you money."

Mark Henricks writes on business and technology for leading publications and is author of Not Just a Living.