Startups and angels: Along the way to success

Bet on the Stubborn Ones

“Entrepreneur and stubborn are synonymous,” the speaker at an angel meeting I was at said yesterday.  “Perhaps, ‘single-minded’ would be a more polite term,” he added.

Or, I thought, naïve, or ignorant might work too.  Well, I added, perhaps that’s strategically naïve or strategically ignorant.  I think I might really like strategic stubbornness, ignorance, single-mindedness, or, yes, even naïveté. (SISN)

Seems to me that the task facing an entrepreneur is really daunting.  I recently heard Alan Patricof tell the story of an entrepreneur who started out as an iron scrap monger and today owns smelting operations around the world that he visits with his G4.  Imagine that guy and the challenges he faced – one after another.  Not much different from the path a really great entrepreneur will unerringly follow through her own field of challenges.

But what’s that got to do with SISN?  (Don’t you just hate instant acronyms?)

Well, our prototypical entrepreneur (a great, world class person!) clearly can map her competition.  Knows who the potential partners are, and what other players are out there in various roles. 

But more than anything else, she has an unerring sense of what the customer wants today and will want tomorrow. And will need the day after that.

The problem is, of course, getting there.  And that’s where SISN comes in.  If she accepts that new challenges can’t be overcome because of (one of my favorites!) “the laws of physics don’t allow it,” or “there’s no way to accomplish x,y, or z” nothing much will happen.

But, of course, the stubborn entrepreneur simply finds a way.  Now that doesn’t sound like a big thought.  But I think it might be.

We were once told by great software engineers back in the 386 days of early 1989 that we couldn’t construct a reliable database that would query hundreds of millions of individual transactions on a pc in anything under tens of hours.  But, being able to do it would carve out an ability to deliver value to our retail customers well beyond any other way then available.

We were fortunate to have a couple of outside the box thinkers who figured it out, on paper, and were confident we could do it.  So, we announced it.  While I don’t recommend that as a strategy, it sure did focus our minds.  And V1.0 came out of the lab on time and working. 

So, if your challenge is finding a way when you here “it can’t be done,” put on your SISN hat and do it anyway.  In fact, send me an email and I’ll send you a SISN t-shirt for that next important meeting. 

What’s Wrong with “Friends and Family” Money?

Not a thing. 

Most startups will never have professional investors.   Friends and family money, especially in quantities appropriate for the investor, is usually very patient and unconcerned about the valuations, structures, and so forth that are part and parcel of professional investing.   

It provides a patient environment to the entrepreneur that allows her to grow and develop that first time business.  It may be the difference between starting or not. 

For most entrepreneurs, in one form or another, it’s the way the business is going to be funded.  Next will be revenue, and then, hopefully, positive cash flow. 

The only thing that’s lacking is an independent source of oversight that comes with professional investors. 

In many businesses, it’s arguable that the entrepreneur doesn’t need it.   I’m acquainted with a consulting company that’s now three people.  They bootstrapped themselves on credit cards and a bit of savings.  (Mostly they spent that money to find customers and eat.  Their product was pretty well invented before they began.)  Now, they’re billing enough that the business is very profitable, and, like a good surgeon, they’re happy as long as they stay at it.

Their consulting practice is highly technical and very solid.  They have a model that they are executing and have contingencies in place as things change.  Probably not much need for outside oversight here.

For those businesses that do need it, the canny entrepreneur will find a way to impose that oversight on herself and her company without professional investors.  With the right business model and the right oversight, this can work just fine.   This takes the form of advisors of some sort.  What’s important, though, is how disciplined the process is made to be. 

This oversight ought to include not just decision review, but also adherence to financial performance, performance reviews for the entrepreneur with time devoted to developmental plans and actions, an external view of the competition and the market, and regular reviews of key people in the company, their goals, and the company’s plan to fulfill them. 

I once had a board member, Len Vickers, who worked for Jack Welch and invented “We Bring Good Things To Life,” tell me that he’d gladly be an advisor, as long as the agreed upon actions were being implemented on a regular basis.  That arrangement worked just fine until we sold the company. 

The Equality Conundrum: Where 50-50 equals Zero

A lot of entrepreneurs thinking about start-ups prefer to have a partner or partners.  After all, there's lot of talk about "building teams" and "hiring up," so it makes sense to have a partner with whom you can talk, right from the start.

Partners bring critical skills that deepen the young company's capability.  They share a dedication to the idea, the customer, and the (growing group of) early employees.

And, it is true, the CEO's job, especially in a small, expanding company, can be both lonely and harrowing.  Decision making with imperfect data is almost axiomatic in that position.  So, once again, having a partner to share those decisions with should make a lot of sense.

Right?

Well, yes.

But, the one of the worst decisions the entrepreneur can make is the quick, founding handshake with the comment, "Let's just each be 50-50 owners." 

What's wrong with that?  Isn't 50-50 a time-honored American tradition? 

Here are some examples of what goes wrong:

1.  One partner backs out, but expects to retain his ownership. 

In a lot of early stage companies, documentation of "the deal," and especially the "buy-sell" isn't done, or is done poorly.  Then, for any number of reasons, one of the founders decides to leave.  In the absence of a stated arrangement that really can be implemented, this gets contentious.  I have seen this many times.  In one case, a buy-sell was in place, but the burden was so onerous on the company that it made no economic sense.  In another, the departing partner's issue weren't settled for several years, during which time the calls and inquiries are never ending.

2.   One partner has different economic "requirements" than the other.

After the initial enthusiasm starts to fade, one partner with half the equity but a higher compensation package than the other  will be a thorn in the side.  The usual solution, more for the 2nd partner, often begins to put a strain on the cash.  I once saw a company, one of whose owners had, I think, three or four "company" cars.  Needless to say the levels of cash compensation for the other partner were too high for the company to support.  (Wyoming: "Lotta pigs in that trough.")

3.  The contributions that one partner makes over time far outweigh the other and this becomes a problem for the other partner.

It is hard enough in early companies to have to deal with the reality of company growth outstripping the capabilities of early employees.  It is even harder if this early employee is your 50% partner.    This issue is virtually guaranteed in a 50-50 deal.  (Investors will often have a CEO/founder's shares "vest" over several years so that if something doesn't work out, the shares can be re-allocated.)

4.  As time passes and the company grows, time spent in meetings is less and less useful, and more focused on partnership issues rather than business opportunities.

The flip side of having a trusted colleague is that if positions diverge, stalemates can - and will - create endless discussions.  Employees see it; customers will feel the effects.  Opportunities get lost. 

So, what's the answer?

Underlying each of these examples is the idea of stalemate - neither party can make a unilateral decision.  Because of that, each of these problems that could have been resolved, (hopefully with sensitivity and good will) become insurmountable and can jeopardize the basis of the business itself.

I never do 50-50 deals anymore.  (Yes, I did. Future essay:  Whoppers I've made.)  If the economics of the deal dictate ownership, fine.  More often they don't.  It's a hard discussion, but better on the first day than later. 

Can 50-50 deals succeed?  Sure they can.  In effect, partners can agree on tie-breaker mechanisms and buy out agreements and cover all of the bases.  But, if the end goal is to share equally in the reward, that can be done by agreement.  Maybe that is the way to a solution, rather than through 50-50 equity. 

In truth, partner turnover, whether 50-50 or not, is a gut wrenching experience.  Leadership in a start-up is an evolving process, and turnover is going to happen.  Management of the process, in the end, is easier with clear authority. 

Lessons Learned: A Successful VC Reflects on his Experience

Last night, Bob Zieserl, Venture Capitalist, and general partner at Stratus Ventures, was the keynote speaker at the Marquette University Business Plan Competition.

Here is a summary of his remarks, “Things I’ve learned about Investing in Companies.”

"Over the last twenty years, 11,000 companies have had Venture Capital investments.  Of those, 58% did not return their principal. They were unsuccessful.

"However, as a group these 11,000 companies returned 3 times the money invested.  This means that while venture investing produces good returns, more than half the companies were unsuccessful.  Here are 8 points for you to consider that might help avoid the 58%!"

1.    Use the investment thesis to make and monitor the investment.

We always ask ourselves, “What is the investment thesis of this business?”  I’d define this as the key things you need to get right.  (A clear point of view on how the business will achieve significant increases in value.) Then, quickly validate the thesis.  If it does not work, get out. 

As an example, we had an advanced manufacturing business that achieved excellent early results.  The product development cycle was excellent.  However, the distribution channel we had planned to use lacked the sophistication ultimately required by the product design, and the manufacturers adoption cycle was insufficient.  We realized the ramp rate was not going to be what we needed.  We sold the business and it subsequently performed about as we expected.

2.    Reduce the duration of the “S” Curve.   

In many startups, early adopters buy first, and then the early majority follows.  The period of flat revenues in between has killed many companies waiting for the early adopters to begin buying.   Planning for this period is critical.

You might try and plan for how long those early majority buyers will take to begin to buy.  Better be right.

You can reduce the “acceptance difficulty” between the early adopters and the early majority in your product design.  As an example, we are involved with a monitoring company that produces critical patient data in a very new way.  But, and this is the key, the measurements they produce are familiar to every physician who has made an ICU  rotation in medical school.  So, while the company’s product is revolutionary, its use will be easy to adopt because its output is simple, well understood and the physician can alter treatment based on the information.

3.     Technology  doesn’t win; products win.

Create a culture in your company that is focused on the customer, rather than on the technology. 

4.    A Business Needs Sustainable Intellectual Capital to sustain the business.

Make sure that as you grow, you guard your intellectual capital.  You cannot afford to lose the people who can advance your products and create new products.

5.    I am struck by how little understanding there is of the competition in young companies. 

They get frozen looking at the competition through the lens of their own offering.  Build into your culture and your company a deepening understanding of what the competition is doing.

6.    Assess risk and reward when making investment decisions.

Reducing risk for the next round of financing yields a higher investment value.  So, look at every expense, plan and project from the point of view of reducing the risk in the company and making the valuation that much higher in the next round.  In other words, ask “Will you be rewarded for taking this risk?”

7.    Cash is important, but relative momentum is more important.

If your company is growing rapidly, what I am interested in is the pace of growth, more than the absolute number.  We had a business at $2MM in sales look like it could go to $8MM.  The CEO wanted to plan for $12MM, but would pinch the cash hard, especially if he missed.  The ultimate goal (part two of the investment thesis) is to grow to $50MM.  The $8MM year is as good as $12MM, especially if the cash is well managed.

8.    People make all the difference. 

Really good, hard working, dedicated, focused coachable people are in short supply.  We haven’t had a successful experience without good management.   We want a team we can build upon.  And, it goes without saying, integrity is an absolute requirement. I assume everything the entrepreneur says is honest.  And, this is a two way street.  Investors have to be the same way. 

When I invest in your company, I want to share your dream.

Thanks for listening.

Questions for Entrepreneurs

I'd be interested to know what those of you who are entrepreneurs think about these questions.  They can be the start of an informative discussion for all of us:

1.  What do you think the highest risk is that you face(d) in your start-up phase?  How did you deal with it?

2.  What are your best tips about raising money for new ventures, including bootstrapping ideas?

3.  Should angel networks charge entrepreneurs for reviewing their plans, and if so, what's a fair price?

4.  If you were to pay to have your plan reviewed, what would you expect to get, aside from "yes" or "no" ?

Who is your competition?

One of the most useful competitive analyses I've seen for planning entries to new markets is Michael Porter's "Five Forces Analysis" work, first done by him in 1980.
 

(I'd also recommend reading Crossing The Chasm by Geoffry Moore. See "Books I like in the right column.)

Porter suggests that a market for a product or service tends to stabilize.   But, forces are at work to destabilize the market.  So, as the entrepreneur begins to try to figure out the competitive possibilities, think about from which of these forces the greatest threat comes.

Those forces are:

1. Threat of New Entrants.
2. Threat of bargaining power of suppliers.
3. Threat of bargaining power of customers.
4. Threat of substitutes.
5. Rivalry among existing competitors.

Threat of New Entrants. 

• Do you have the ability to enter this market with cost advantages that give you a competitive edge over existing participants?
• Does your offering cross the chasm - provide a leap in capabilities that make existing products less viable or too highly priced?
• Can you get adequate distribution or do the existing competitors have the existing channel all sewn up?

Threat of bargaining power of suppliers. 

• Do you rely upon a few large suppliers who can demand a disproportionate share of your profits, making you less competitive?  One obvious, well worn example is the relationship between newspapers and paper mills.  (Old media jokes notwithstanding.)

Threat of bargaining power of customers.

• Are you selling to elephants?  Our software company sold to very large customers.  As competitors entered the market, switching costs were insufficient to prevent the elephant from sitting where he chose.  They exerted a lot of pressure on price.  This pressure again makes the company less competitive.  The best response is continuing differentiation in product evolution and pricing strategies.  We were doing ASP style pricing in 1989, as one example. 

Threat of substitutes. 

• Are you entering with a product that is an alternative to the way the market is serviced today?  I recall the early fax machines at GE that cost thousands of dollars to purchase, and dollars per minute to use.  This was the market that FedEx entered with FedFax.  (We pick up your document with our truck, fax it to our office in the city it is destined for, and then deliver it within four hours with another truck.)  Both products were promptly crushed by the much less expensive fax soon thereafter.  And now, for most of us, email has replaced the fax.  Are you the new email or just FedFax?
• Are you competing for dollars that the customer may choose to spend with you and not in some entirely different category? 

If you're offering something quite different from the status quo, an important consideration is the relative power of rivals as you enter this market.  There are plenty of examples of large, established competitors who were threatened by upstarts with better, unique offerings.  Even with plenty of intellectual property protection, in a market of large, powerful competitors, there is danger.

Of course, if your rivals are largely new entrants and your product is strongly protected, and you can execute, my bet is you win.

Board Seats for Angels in Startups

Should Angels be compensated for work as directors of the companies in their portfolios?

I am not sure about this, but here is one view that ought to be worth discussing.  I'd be interested in comments from angels and entrepreneurs about this one.  Follow this link to an interview with George McQuilken of eCoast Angels in Portsmouth, NH on this topic.  And then please post your comments here and let's see what develops.

Entrepreneurial Outsourcing

Here's a terrific suggestion for a topic from Paul Leblang, a legend in American Retail.  Paul was the longtime VP of Marketing at Saks Fifth Avenue at the time when it was a great icon in retail.  He's a consummate direct marketer. (Find one of his presentations here.  [PDF 1MB])

"When should the entrepreneur outsource functions on his team, and when should he bring these tasks in by hiring?"

1.  The cost of the test is less important than the result.   

One instance of outsourcing is where the company is testing a new concept.  For instance, we had a retail company in our portfolio that was going to test a new idea at campgrounds.  This was a successful product at resorts, but there was some risk in this new group of customer.   Rather than staff up to hire people to sell at each venue, (kind of a summer student kind of job) they used a temporary help agency.  It doesn't matter much that by using the agency they paid more.  When the test proved successful, they had acquired knowledge of sales per venue and so forth.  This allowed them to calculate their "rollout" costs on the basis of real facts rather than conjectures.

2.  The cost of the activity on an outsourced basis should be twice as expensive as in-house per employee when the entrepreneur hires to bring it in-house. 

OK, so it's a rule of thumb.  But, in general, if the company needs to hire 15 people, there ought to be deep knowledge that the function is going to continue to grow and cannot be bid competitively to transfer fixed versus variable risk to a vendor better equipped to handle it.

3. For activities that are highly skilled and would require many variable skills, outsourcing is probably better for a long time.

The growth of high quality programming skill at very competitive prices in many places is just one obvious example.  If the entrepreneur can hire a company that will code "to spec" or even add project maangement skill, it is almost always true that they will have more ability than is easy to hire and manage at anywhere near the same price. 

4. Skill in managing outsourced relationships is primarily specification and project management based.   

The discipline imposed by managing the process of outsourcing reduces business costs and increases efficiency.   This doesn't simply mean software development. We have a company with a distribution component.  By streamlining the pick-pack sequence we have the perfect opportunity to hand if off with full knowledge of how it works and what capacity it can handle. 

5.  If you think that you must in-source an activity for strategic reasons, but it is not knowledge based, think again.

If you are neither designing the product nor executing the secret recipe, nor building proprietary knowledge based on results,  you should consider an outsourcing strategy.  We are looking at a business with parts from a contract manufacturer, a proprietary design, and a clever distribution plan based on tested results.  (We know what each sale costs, what the repeat rate is, and so forth.)  It's several million dollars in sales. Except for a couple of people (product design and sales), all the rest is contracted. 

How Does An Angel Do Valuation?

(With thanks to Mark Witt for the question!)

Well, in truth, it is often a guess.  Along the way both of us gain an understanding of the way this potential relationship might evolve. 

Most often the discussion begins with two simple ideas - how much money the business needs right now to achieve planned growth to the next step, and what percentage of the equity the entrepreneur is willing to "sell" for that cash.

(In general this is not a discussion about technicalities, but this one bears mentioning.  The cash goes into the company and the stock "sold" is created by the company for the event.  It is not cash that goes to the entrepreneur, of course.)

There are then two sets of discussions here.  The entrepreneur is trying to value the current enterprise and the angel is trying to determine if the business can successfully meet his expectation of return. 

On the entrepreneur's side, especially if this is a first valuation, there are sometimes issues of the value of the startup cost and the "sweat equity" in the company.  If the entrepreneur is proposing $500,000 for 15% of the company, the implication is that the company is worth $3.3MM.  How either party really figures out what the value is today is a difficult question.

The more important question is one of total value. 

Let me start with a method to "ballpark" the outcome and see where it takes us.

Suppose in the above example that the entrepreneur feels that in three years he will generate EBIT (Earnings before Interest and Tax) of $1MM, and that companies in his industry seem to be selling for 12 times EBIT.

That would make the company worth $12MM in three years.

Fifteen percent of that is $1.8MM, which, under the investment terms above, would be the investor's share if the company were sold as described. 

Now let's consider the investor.  She feels that a 50% internal rate of return is a good benchmark.  At the end of year one following the investment, that would be 1.5 times her investment; 2.25 times at end of year two, and 3.38 times at end of year three.

So the ballpark return the investor expects is 3.38 x $500,000 or about $1.68MM.  If the investor agrees the projections make sense and are achievable (and especially if she can add value and help make them come true,) we have a deal.

Let's also suppose that the entrepreneur invested $200,000 in starting this company in cash, and feels emotionally that the idea and the early execution is worth a lot.  He has foregone a job and taken a lower salary, perhaps even guaranteed some debt.  How did he do on his $200,000?  Well, it returned him a bit better than $10MM on his $200,000.  (This assumes when the company is sold there is no debt owed to anyone that would come out of the proceeds.)

That works out to $3MM per year.

Were life only so easy, of course.  There's a lot of execution required between here and there and a thousand variables. 

Also, in negotiating this agreement, both parties are going to have to talk about the kind of investment instrument to use (common, preferred, debt with warrants) etc.

However, those are probably subjects for another time.  Thanks for the question, Mark!

 

Bootstrapping Startups

First time entrepreneurs faced with a good idea, some opportunity, and little else find themselves candidates for bootstrapping.

In 1989, faced with the opportunity to build a company around one customer and a new idea for CRM, I bootstrapped a company that grew nicely for better than 12 years and is today part of a much larger organization.

Here are some of the keys that I learned along the way:

1.  Plan from the bottom up.

Few companies really have the luxury of planning their revenues and then working up their expenses.  Too many try to do this.  Inevitably this results in expenses that are both too high and fixed (leases signed, employees hired, etc) and hard to adjust when the reality of early revenue doesn't really work.

If the business idea is really a good one, the resulting investment by outsiders in this situation is very expensive money. 

Instead, plan your minimum expenses.  Figure out ways to outsource as much as you can - on a variable basis.  Yes, this is short term more expensive but it will not be a burden early on.  As revenues grow predictable you can always trade higher variable for lower fixed costs.

2. Manage the business to make the customer insanely happy.

The best customer is the early adopter, of course.  (See Crossing The Chasm.)  We kept the customer well informed about our plans and ideas, often offering up ways for them to try new features quickly.  We wired together a lot of things to achieve this.  (Sometimes it felt like the back room at the the Automat. ) 

We underpromsied and overdelivered.  We "invented" automated results reporting at a time when that was a new idea.  We solicited new applications and kept them informed of our thinking and our progress,

Sometimes we took the chance of building what we were sure the customer would want, if only they knew it.  (This is great if you have the deep business application knowledge to pull it off.)   

And they paid us, every month, 3 days after invoice.  Which made the payroll, the rent, and whatever few expenses we had.  Which brings me to:

3.  Manage the business for cash flow.

We (there were four of us) were pretty good at this.  If we got invited to speak at a conference we booked sales calls and meeting opportunities before, during and after. 

We outsourced all of the CPU (mainframe "in those days") time and programming on a per job basis. 

We rented space in an old factory. (Today, I suppose this is cool loft space!) It had been a shop foreman's area off the factory floor. 

Expense growth plans were predicated upon finding more customers.  You get the idea.

4.  Round up great advisers.

I think what I learned most here was "don't ask, don't get."  I called up the Sr. VP of Marketing at Saks Fifth Avenue, Paul Leblang, who joined the board.  Next, I went after Len Vickers, senior marketing guru to Jack Welch at GE. Len invented "We Bring Good Things To Life."  I had to go see him (on my way to somewhere else) - and he joined.  I added Dick Sim of APW, Dave Drury, who had been Managing Director of Price Waterhouse, a local legend in M&A, and now a successful entrepreneur, and a scientist in database research, Jeff Naughton of UW. 

The deal was that the company's leadership team would create an agenda and provide background info in advance.  They'd come prepared to talk and we listened.  (or tried to.)  Next time we'd report back on what we'd done. 

5.  Sell Services.

We wanted to be a software company.  However, by selling service to our growing customer base we could generate current revenue.   We also priced our software on the "monthly rental" model for the same reason. 

Bootstrapping is probably the best way to build yourself into a company positioned to grow.  Your positive results and customer successes make you much  more interesting to investors.  Here's a great case example of Steve Belkin who bootstrapped his first travel company.

Let me know your thoughts.