Startups and angels: Along the way to success

Controlling What You Don't Own

Remember Tom Sawyer getting his buddies to do his Saturday morning whitewashing of Aunt Polly’s fence on his behalf?  And that he got them to pay him for the privilege?

Here’s Prof. Bill Sahlman of Harvard Business School’s definition of entrepreneurship:

“Entrepreneurship is controlling resources the entrepreneur does not own.”

“Isn't’t that a bit like Tom Sawyer?” you say.    “Are you proposing we con people?”

Well, no.  I’m proposing that the idea of obtaining needed resources early in the venture’s life is often the critical success ingredient, and that first timers frequently overlook the idea of creative structuring (i.e., converting fixed to variable expenses) as a way to obtain these resources. 

The sales commission is perhaps the oldest (and in the minds of the best salespeople, the most revered) example.  The company pays a lower fixed cost and a higher variable cost by sharing in revenues achieved. 

As long as the venture can make the connection between results of the work being provided and the economic benefit, it’s often a great idea to do this.  Relatively high variable costs that create revenue or disproportionately reduce risk and facilitate the next investment round are good deals. 

Of course, early in a company’s life, equity is a very expensive currency.  It should be used sparingly and with caution.  It’s especially tricky when the equity is being valued at current value in payment for current work.  (I saw a deal recently in which a $1.5MM  post-valuation company was using equity at current value to pay lawyers for routine contracting work.  In addition, the law firm was getting a discount to the current round price and about 25% of its bills in cash, to boot.  Bad idea.)

Can you convert any of your fixed costs to variable costs, especially for the first twelve months?  It can reduce your cash needs and improve your ability to move forward rapidly. 

Make sure you can reach agreements that give you the required control over the work being produced, and that you establish payment terms and deadlines in advance, of course.  And treat the resources you are obtaining with the care and diligence you’d use to screen people you are going to hire.

Managing Personal Spending

The common secret weapon of successful startup entrepreneurs…manage personal spending to reduce cash pressure. 

In the very early stages of a startup, cash is always in short supply.  And, regardless of how the company is financed – through large customer contracts, friends and family money, angels, venture capital, or all of the above, more cash on hand is always better.  And it is almost never enough.

But, the one consistent finding about entrepreneurs is that they can successfully manage the burn rate at home.  In addition to successfully building a business, they have the ability to limit their personal spending and take salary pressure off the nascent venture.  Until things start to accelerate, this skill provides months of cushion.

Early on this means saving to be able to forego salary for the exploration phase; sometimes it means working on the venture at night and on weekends.  Modest salaries are usually next. 

The result is that the entrepreneur is in a much stronger position from every point of view - customers, employees and investors.

Don’t hire a poodle to do a Great Dane’s Work…or, if you want to catch rats, buy a rat terrier.

Entrepreneurs: Get The Right Advisor

I get asked frequently to be an advisor to entrepreneurs.  I’m gratified to be asked, and usually try to think of ways to make a little more time to say yes.  But that’s the wrong idea.  I really need to ask what it is the entrepreneur needs at this stage in his business evolution, and if I’m the guy to supply it.  

If someone is building a highly technical business about which I know very little, even what I do know about business metrics and the “usual” way things work gets less useful.  Discussions devolve to trying to learn and advise at the same time.  Sometimes the entrepreneur adds another, more technical, advisor.  Then the new advisor gets to teach the old ones, since we are expected to pass judgment on the “best course” for the business.  Everyone feels the need for airtime and meetings drone on.  People die, slide under the table, and aren’t noticed.  This is trying to catch rats with a poodle.  Or, trying to get a rat terrier to teach a poodle to catch rats so as not to hurt the poodle’s feelings.

Horses for Courses. Get the right advisor.

Pizzas, People and Progress

Entrepreneurial companies seem to run on pizzas. 

So, one day, about 11 a.m., I hear a lot of commotion in the parking lot.  A couple of key employees are standing around a pile of metal, plastic and tools arguing about design.

"What'cha doin'?"  I ask innocently. 

"Why," they reply enthusiastically, "We're building a car so we can go pick up a pizza."

OK, so I made it up.

But the point is - be sure you aren't doing this very same thing every day.

We have all spent a lot of time and money working diligently to build capabilities that exist somewhere else.   My rule of thumb is that I'd like a couple - not just one - acknowledged experts to listen to my plan and affirm that the capability that I think is the genesis of a unique idea doesn't yet exist.  Often, entrepreneurial enthusiasm masks a lack of real domain expertise. 

Software companies have a particular affinity for this problem - inventing what exists already - but it can happen to any of us.

Do we know if this capability is something we can find somewhere else?  In another industry?  Or closer to home?  Let's check before reaching for the wrench. 

Pick Your Investor With Care

The great day has arrived.  Tomorrow, you're going to close your first professional investment with "Fred," a wealthy individual you met at a networking event.   Just this morning,  he called to tell you how enthused he was.

"Just a couple of tweaks from those lawyers," he laughs with a wink in his voice.  "They're making me put in some technical stuff.  Nothing to worry about."

When the list arrives, you decipher the changes and seem to find that his investment is now a loan and requires preapproval from him to borrow more, along with a new set of warrants based on performance.  It looks like if you miss your quarterly goals, Fred will own more and more of your company.   He's also requiring that you source your software development through his consulting company at a price "to be negotiated."  Finally, if you fail to agree on a price for the development within 6 months, he gets his money back with 18% interest. 

This wasn't the deal you thought you were getting, and in the meantime, you've turned away several other investors.   It's true, you did talk to Fred about his development capability but you hadn't really expected this. 

And, while you haven't really spent the money, you have certainly got plans.  If you accept this deal, you really can't prudently spend anything for six months while you negotiate a price.

"Well," you think, "we can work this out.  I like this guy."

But ---

1.  Did you get references from people he's done deals with?  From references that you got from the references he introduced you to?  Have you checked him out on the jungle grapevine?

2.  Have you asked him - directly, if politely - what the meaning of these changes are?  If you start using lawyers to talk to each other, each will do what he is paid to do - represent your position and work back and forth, hopefully towards agreement - and as a byproduct, a big bill. 

Does this happen?  Is the sky blue? 

I've seen:

• A business fall into the hands of a minority investor who controlled the offshore manufacturing. 
• Deals that were put together so poorly that the entrepreneur had little room to work. 
• Structures that disproportionately favored one side over the other.

Good deals do none of these things.  Good investors never let their advisors make substantive document changes without discussing them with you.   Good deals are easy to understand and don't motivate one party or the other to work against their mutual best interests.

In all of these cases, the investors were individuals working with the entrepreneur directly.  This is great if you know the person investing or you know their reputation.

But, if neither of these facts apply, be very cautious.  Groups of investors usually cannot afford to try this kind of stuff; their deal flow dries up. 

After all, the investor is thinking of you, the entrepreneur, from a cautious perspective.  Do the same. 

Or, "Err in Haste; Repent at Leisure."

Compensation for Entrepreneurs

What’s a fair compensation plan for an entrepreneur (or CEO) with investors in his company?

I’d like to see an entrepreneur who is committed to the enterprise in more than words.  To me, that may include, based on the particular situation:

1.    Leaving all of the start-up cash in the company as equity, rather than carrying it on the books as debt, or trying to pay it from investment proceeds.  (It’s certainly OK to pay yourself back if you don’t have investors.)

2.    A salary package that is at least 15% to 25% below market for similar positions.  As the venture becomes it is important for the team to receive year-end bonuses from the board if and when cash is prudently available.  These milestones are usually agreed to in advance of the investment decision.

3.    Vesting ownership of stock over several years based on achieving goals.  There should certainly be latitude in the goals (worst - most likely – best) with vesting percentages tied to each.

4.    For CEOs who are not founders and therefore have a smaller equity stake,  a  carry on the upside that pays some sort of bonus based on sale price is a good idea.  I’d calculate these off of the IRR the investors receive.  For instance, after the investors receive a 50% IRR, the CEO would receive 10% to 15% of the profits thereafter with the balance distributed to investors. 

The general idea here is to align the interest of all of  the people in the deal.  The founders and managers have significant upside opportunity and a proactive structure by them makes this part of the investment decision much smoother, especially when this is a first time venture for them. 

As the venture starts to meet milestones, cash compensation issues become much easier.  It is terrific to be part of a success in which everyone succeeds.

Tips for talking to investors

If you find yourself presenting to investors, here are a couple of tips.  These are in addition to market opportunity-competitive matrix-deal issues, which I assume would also be covered.  These are the items I hope will be covered because they present me with a comfort level that will lead to a partner-based relationship with you, the entrepreneur.

1.    Understand the principle of risk reduction and its role in your business.  Explain how, since the beginning of the company, you have identified the critical risks that you face and how you have successfully and quantifiably reduced or eliminated them.  “Reduce the biggest risks with the smallest dollars,” is the underlying idea.  Tell me that the next level of funding will reduce specific, measurable risks quantifiably beyond the value of the investment.  This is your added value.  Identify the next level of funding, if there is one.  Tell me what they would consider to be the biggest risk reducers.  Explain how you will get there.   A lot of “why this is a great product” in place of this kind of thinking makes me nervous.

2.    Understand the testing concept as it relates to reducing risk.   Show me that you have thought about these critical risks and have ways to test them swiftly, accurately and cheaply.  The most probable outcome is that the product will need tailoring or even alterations.  That’s fine when it’s swift, less fine when it’s six months and $100,000 later. 

3.    Explain your valuation in terms of others in your industry/market/stage.  While I suppose there is a place for a breakthrough idea by a first time entrepreneur that’s a good bet at $12MM preval, I have yet to see it.  It’s a shame to see a potentially good idea dragged all over town because the entrepreneur is peeing in the well.  If you have a good grasp of comparables for your industry and stage of business that’s great and will make a more interesting conversation.

4.    Do have reasonable skin in the game expectations.  Don’t show up looking for a $250,000 salary and the repayment of the $100,000 of working capital you’ve put in the company up until now.   If you do ask for this you may as well ask for a ride on the investor’s flying pig, as well.

5.    Know your audience. If your product is a new surgical appliance try not to get into a knowledge debate with the surgeon in the audience.  Work hard to inform yourself of who is in the audience.  Talk to their expertise; engage them in discussion. 

6.    Pass the “Congruity and Integrity” test.  Bet that someone in your audience will know everyone you’re referring to.  If they are interested in your business, they’ll make those calls.  Better to understate.  Modesty isn’t a virtue for nothing.   

Anticipating The Customer's Needs

It's a truism that any company has to understand their customer's need(s) well enough to cause value to be created.

Many development plans proceed from fulfilling customer requirements in a forward-looking way.  The obvious way this is often done is by examining the customer's business process and anticipating where improvements based on the company's product (or service) would create additional value at less than the cost required to produce and market it.

But, how can the entrepreneur get ahead of others trying to improve the same process for the same customer universe? 

1.  Be really good at crunching the numbers.  Where does improvement pay off the most for the customer?   Start by looking at these opportunities. (Don't forget to look past your customer to his customer for opportunites as well.)

We had a customer analysis algorithm that, when applied to our customer's data about his customer, yielded tremendous results.  We worked hard at developing this because our initial analysis suggested that we could generate profits that lowered our months to break even to less than three.  (That is, we helped the custoemr earn enough extra revenue that our total solution was paid for initially in less than three months.  "Raise the price," the board often said.")

2.  Anticipate the behavior of your customer's customer.  Are there opportunities there that will help leapfrog your product? 

3.  Concretely define "the monster."  What would be most threatening to your business prosperity?  What would a new entrant to your market do if not burdened with your cost structure?  What changes in your customer's behavior (aside from buying from someone else, I suppose) would cause you the most grief?

4. Look way outside your industry.  One of our portfolio companies is developing a medical device that came from the automobile industry!  Apparently scientists working on the same general problem from two different points of view discovered substantial synergies.  It has huge market potential and leapffrogs the competition.

5.  Know your place on the Chasm curve and know what the next group will want.  Are you currently selling to early adopters?  What will the early majority want? 

Advisor Capitalists: New and Improved

If you follow this link, you'll find a discussion that's been going on for several months about "advisor capitalists" and their value to the entrepreneur by Stowe Boyd.

Way back in the dark ages, Randy Komisar was doing much the same thing.  Remember The Monk and The Riddle?  Komisar has great instincts and high value, not the least of which is his ability to deliver VCs at the appropriate time and the right value proposition.  If you're thinking about going this way, read the book.

If you accept the premise that the entrepreneur's company may never need capital, but almost certainly needs advice, advisors of one sort or another are the logical choice.

Much of the current discussion seems to revolve around how to choose one.  Implicit in the AC model Stowe proposes is the idea that the "AC" replaces the expertise previously delivered by the "VC."  "VC without the C," is how he introduces himself. 

But antecedent to that choice (one or many; equity in lieu of cash; etc) comes the question of the criteria the entrepreneur ought to use to pick the advisor.

If you're an entrepreneur consider this:

1.  How will you invest yourself in this advice? How will you validate the counsel you're being given and act upon it?    It is critically important that the process of interviewing advisors, way before you get to compensation, is the question of value to you.  What makes you believe this person will really be helpful to you?  As you develop a relationship with an advisor, if they are to be valuable, they must be informed very regularly, and given all of the information required to make substantive recommendations. 

This will take a lot of time.  You will put that most precious commodity at risk - time - as you develop a dialog with your advisor.   If you have the wrong advisor, at best you waste time getting advice you can't use.  At worst, you get led down the wrong path and the implications are more serious. 

We once had a fairly famous advisor from a big name Silicon Valley outfit who wanted us to abandon our customer base (in 1998) and move wholeheartedly and totally toward web-based (read dot.com) customers, citing the startup consulting companies of that period who were making lots of money.  Thank goodness sanity prevailed and we parted company. 

What is interesting about this is that the advisor had no skin in the game.  VC without the "C" is also a "no downside-only upside" proposition.  You just cannot argue that the time invested by the advisor is equal to the money invested by the VC.

And, if you are really invested in the advisor's advice, you should be willing to agree as to the plan and then follow up by detailing the execution in following meetings.  Otherwise you're just wasting time. 

2.  What is the definition of expertise?  "Seek the advice of leading authorities in the market that the product will be competing -- and often, this translates to the leading bloggers, consultants, and authorities writing about the market in question," says Boyd.  Bloggers, consultants and "authorities writing" are hardly an exhaustive list.  One broader source of expertise may be those with direct industry experience in the driver's seat.  Are there VCs in your industry?  Do they use venture partners?  Are any of those partners interested in your company? 

3.  What is the ongoing value?   " A consultant is unlikely to want to part with a strategic concept that could make a client into a $100M player, potentially, in exchange for a per diem and the possibility of some downstream consulting, maybe, if you're lucky," Boyd, again. 

The implication here is that the consultant has the magic idea and that's the game.  I don't buy it.  Ideas are a-plenty; it's the people that are the whole game. 

Really good advisors ought to be capable of having the leadership discussion with the entrepreneur - with you - privately, but clearly.  If you've attracted good advisors, it's because you've passed the "rich or ruler" test.   This is a long term discussion with high value to the enterprise and to the entrepreneur.  It's way more important than the magic bullet.

I wonder what entrepreneurs and their advisors think?

The Useless NDA

"Why," I get asked all the time, "won't you sign an NDA?  Are you going to steal our idea?

This dialog is in full swing in a conversation started by Brad Feld.  Here is Feld on "Why VC's Don't Sign NDAs".

I'd add that in adddition to creating entanglements, they suck up an inordinate amount of time and effort for no benefit.  I can't think of a single good reason to consider one.