Category Archives: Business

Financing: A Tale of Three Companies

Image licensed under creative commons by Fornax, 2010.

If you want to start a company you might wonder where you will get the money your new business requires. The good news is that you have many options, as long as your business plan is sound and the market opportunity is big.

But, before we get to that, don’t confuse the money your business requires with the money you require to maintain your lifestyle – investors will not invest in you so you can pay your mortgage or make your car payments. Investors invest in your company to get a return so if you want to raise some capital you need to present them with a good investment opportunity that is likely to provide a return. It’s up to you to figure out how to cover your lifestyle expenses until you can pay yourself a decent salary, either through your savings or secondary income.

Assuming you have your personal expenses covered, a good business plan and your investment has a potential of return, there are many ways to raise capital for a business and we will cover three of them here. For these examples, let’s assume that you think that the market for umbrellas is going to expand quickly over the next few years due to global warming. Here, then, are the tales of three businesses started to take advantage of the upcoming umbrella explosion and how they might finance themselves:

1. Cash Flow Financing: The Umbrella Store

You decide to start an umbrella store, where people can choose from dozens of different models of umbrellas (either a physical store or online or both). The start up costs only include purchasing some initial inventory and setting up your store, but you are confident that sales can cover that cost. If you do well you might open up other stores, but you will wait for the market to demonstrate demand.

The best option is to finance the company yourself via cash generated from sales at your store. You will put up the initial money from your savings and the more umbrellas you sell, the more you will buy to increase your inventory. It might take a while but you think you can build up a healthy store that can support you and potentially a few employees.

Quick summary of your umbrella store:
Start up costs: $10,000
Estimated Annual Revenue: $150,000
Investors: You

In general, cash flow financing is a good idea if:

  • Your business will start generating revenue on day one.
  • Your start up costs are low.
  • You want to maintain complete control of your business.
  • You are not sure what form your business will take.

Cash flow financing is a bad idea if:

  • You can’t afford to provide the initial capital for the company yourself.
  • Your business needs to grow quickly to take advantage of a market opportunity.

Examples of the kinds of businesses funded via cash flows are consulting businesses, services businesses and small stores.

2. Crowd-sourced Financing: Umbrella 2.0

You design a new kind of umbrella, something the world has never seen before but is definitely better than all of the other umbrellas on the market. The cost of manufacturing the first batch will be significant because of the cost of setting up manufacturing, but after that you can easily grow the business based on sales revenue.

The best option is to crowd-fund your company by raising a little money from a large number of people. Using platforms like Kickstarter or AngelList, you can quickly find a large number of people who believe in your vision for a new umbrella and are willing to back you. In some cases, like with Kickstarter, you are pre-selling the product while in other cases, like with AngelList, you are giving them a small ownership in your company. If your start up costs are not very large, you can just raise funding from just your friends and family without needing to recruit investors that you don’t know.

Quick summary of your new umbrella product business:
Start up costs: $100,000
Estimated Annual Revenue: $1,500,000
Investors: Friends, family and/or strangers on crowd funding platforms

In general, crowd funding is a good idea if:

  • You require a large amount of startup cash but will be cash flow positive afterwards.
  • Your product will appeal to a wide range of people.
  • Your business will grow slowly.

Crowd funding is a bad idea if:

  • The amount of start up cash you need is very small or very, very large.
  • Your product is complex and will take many years to create.
  • Your business needs to grow very fast to take advantage of a market opportunity.

Examples of the kinds of businesses funded via crowd funding are new consumer products and non-profits (charities).

3. Venture Capital Financing: Build Your Own Umbrella

You want to build an online marketplace for people to design their own umbrellas and then have manufacturers build them on their behalf. The potential of the business is huge, but it will take a few years to grow the marketplace to break even and you don’t have a large window of opportunity so you need to move fast.

The best option is to raise venture financing. Venture capitalists and angel investors invest large amounts of money in high-growth companies with the expectation of a 10x return in under 10 years. The risk is high since your company needs to be extremely successful, but the reward is very high as well.

Quick summary of your umbrella marketplace business:
Start up costs: $1,000,000
Estimated Annual Revenue: $150,000,000
Investors: Venture capitalists and Angel investors

In general, venture capital financing is a good idea if:

  • You require a large amount of time and cash to build your business.
  • You expect your business to grow very fast (double every 3 months).
  • You need to spend ahead of revenue to fund your growth.
  • Your market opportunity is vast.

Venture capital financing is a bad idea if:

  • Your business will grow slowly.
  • Your market is small.
  • Your capital needs are small.

Examples of the kinds of businesses funded via venture capital are software-as-a-service companies, new drug manufacturers and new chip design companies.

So, what’s your best option?

Hopefully it is clear at this point that the best option for your business depends a lot on what your business is, how fast it will grow and how big it might become. Choosing the right option can be critical to your success or instrumental in your failure. Trying to fund a high-growth company on cash flows can starve your business since you will move too slowly and miss the market opportunity, but raising venture capital for a slow growth company can lead to unhappy investors and poor results for founders.

In many cases companies will combine strategies for the best outcome. For example, you might crowd fund your company to get started only to later raise venture capital financing when you start growing quickly. Or, you might grow using cash flow until you have a big opportunity for expansion and use crowd funding to take advantage of that opportunity.

There are, of course, other options than those listed here, including bank loans, and depending on where you are based those options may be most accessible. Network within your local community to understand the most common options.

Think about your business and what makes the most sense for financing options. But remember that investors are investing in your business, not your mortgage, so be sure to show them why their money will result in a big return.

The Entrepreneur’s Creed

“My product is great. My vision is sound. My team is amazing.”
– The Entrepreneur’s Creed

Reality is a harsh place. Almost everything that is worthwhile doing is very hard and, despite what  you might learn in school, there is no credit for hard work. There is very little recognition for your success and plenty of recognition for your failures. To be frank, the world is out to get you.

The good news is that there are no rules. You can do whatever it is you like, pursue whatever goals you desire and set your own definition of success. Other people will try to do this for you but there is nothing forcing you to listen to them. You set your own rules and choose your own path.

Starting a business is a great case study of these two characteristics of life. Anyone can start any kind of business whenever they want, setting whatever goal they desire. Unfortunately, most people who start a business run out of money, fail to acquire customers or simply not be able to get started in the first place. Reality kicks in and shows you that starting is easier than finishing and money does not come as easily as your dreams. Being an entrepreneur is a lonely pursuit because, in many ways, it is you against the world.

When you are starting a business you will inevitably talk to other people, most of whom will tell you that you will not succeed. They are almost always correct because  it is very unlikely you will succeed. However, success cannot be impossible or else there would be no companies in business today. So the question is not if you can succeed, but will you succeed or will it be the next person. Everyone will tell you it’s the next person.

The best defense against the harshness of reality is perseverance. Since the world is telling you that you will not succeed, you have to believe in your heart that you will. This is not denial because the belief in your heart is based in facts. You don’t just believe, you know. You have done your homework and designed a great product. You have studied your market and have a clear vision for the future. You have surrounded yourself with a great team that works well together.

Does that guarantee success? Of course not, but it ensures that you play the game as best you can. Even the best baseball players will only get a hit at 1 out of every 3 at bats but they approach the plate every time convinced that they can get a hit. That inner strength, born from perseverance and knowledge, is what gives you a chance to succeed. That chance is the most life will offer, so take it and use it as best you can.

So every morning, with complete conviction, repeat after me:

My product is great. My vision is sound. My team is amazing. 

———–

Note: This post was originally on my personal blog

The Most Important Equation For Your Business

Business is a very human activity. Despite the existence of high frequency trading, supply chain optimization and manufacturing automation all business boils down to one person selling something to another person. A product is worth what someone else is willing to pay for it, and business is the act of making that transaction happen. So, you would assume that you cannot describe business using mathematics.

But you can, and the formula that does is as follows:

LTV – CAC > 0

This equation describes the viability of your business. LTV (Lifetime Value) is the total amount of money you can expect to make from a customer over the entire period of time they are your customer. CAC (Customer acquisition cost) is how much it costs to acquire the customers that will then make you money. If the lifetime value of your customers is higher than your customer acquisition cost, then you have a profitable business because you make more from customers than it costs you to find them. If not, then it costs more to operate your company than it makes and the business will fail.

This equation maps into every kind of business precisely because all business is the act of one party selling something to another party. Below are some examples of how this equation applies to various types of business:

1. Physical Product

When you build and sell a physical product, both your LTV and CAC have many factors. Your LTV is not just the sale price of the product, as you have to remove the cost of producing the product in the first place. The CAC is a combination of both your marketing spend as well as the sales commissions you pay to either your sales people or the retail stores that sell your product. Hence, your equation looks like the following:

(Sales price - Cost of good) - (Marketing Spend + Sales Commissions) / Units sold > 0

As you can see, you calculate the net profit for the sale of a given item (Sales price – Cost of producing it) and remove the amount of marketing and sales commission that went into that item. In some cases, simply dividing the overall marketing and sales commissions by the unit price is misleading since different distribution channels have different costs. In those cases you would measure the viability of each channel independently and use the actual per item marketing and sales commission numbers.

2. Software as a Service

Most software as a service businesses are based on monthly subscriptions. Here, the LTV is the amount of the monthly subscription (often called the Monthly Recurring Revenue or MRR) times the average number of months a customer is active (paying for your service). The CAC depends a lot on your user acquisition strategy but is typically either sales commission based or performance marketing.

(MRR * Avg Months  Active) - (Marketing + Sales) / Number of customers > 0

The most challenging factor here is estimating the average active months for a customer, especially for new services which might not have a long history of data to use. Because of that difficulty, it is often easier to measure monthly churn rates which are simply the percentage of customers you lose every month. You can then use the MRR and monthly churn to estimate the LTV and use the following equation:

(MRR / Monthly Churn Rate) - (Marketing + Sales) / Number of customers > 0

By dividing the MRR by the monthly churn rate you are calculating retained revenue (the value of customers that stuck around). By subtracting out the cost of marketing and sales you are measuring how much it costs you to retain that revenue. You can see that if your churn rate is high (and hence your average active months per customer is low) then your business is not viable unless your marketing and sales costs are extremely low.

If you measure your MRR in aggregate instead of per customer, you do not need to divide the cost by the number of customers as you are calculating everything in aggregate.

3. Consulting 

In consulting, both your revenue and costs are measured in time. Every hour you spend working for a customer is revenue and every hour you spend recruiting new customers is the cost of acquiring those users. Assuming your hourly rate is fairly consistent then you can measure your viability the following way:

Average # hours per contract - Average # hours recruiting contract > 0

The great thing here is that you don’t need to estimate your CAC cost per unit since you are measuring your business in a universal unit of time (instead of money). This works even for large consulting firms who have many employees, assuming a fairly even hourly billing rate. If it is difficult to track the recruiting hours specific to each contract, you can generalize this and just use the total billable hours and the total recruiting hours across all contracts.

Note that this requires you to track your business development time in the same way you track your customer billable time, which I always recommend anyway. It is common for consultants to consider only the time that they bill in determining their cost structure, which is a mistake.

Viability vs Profitability

Most companies have a goal of being profitable, not just being viable. In those cases, the fact that your LTV is greater than your CAC is not as important as how much greater. One rule of thumb for high growth companies is for your LTV to be 3 times your CAC because that gives you room to make mistakes and still be profitable. Keep in mind that the cost of your operations is likely not zero so your ratio needs to cover that cost as well. The best person to judge the right ratio for your business will always be you.

If you don’t already watch this viability equation as one of the key metrics of your business, you should start. It will provide a simple way to understand the fundamentals of your business.

The Journey

After almost nine years, today is my last day as an employee of Flurry. I will remain involved and on the board, but it is the end of a significant chapter of my life and the beginning of a new one. It is a bittersweet day for me.

I have been lucky over these nine years. Most start up companies fail in the first few months, many others in their first year. Not only has Flurry survived, it has thrived and now employs 150 people with a large and growing business. Today, Flurry is recognized as a central part of the mobile world and provides a clear voice for this new industry.

Along the way, I have been lucky enough to enjoy front row seats for the mobile revolution as it has changed the world. Starting in 2005, back when everyone believed the carriers controlled the world, Flurry has been at the center of mobile applications. Flurry grew up with the industry and as it changed so did we. When the Motorola RAZR became the hottest phone on the market, we were there. When the iPhone changed the definition of a phone forever, we were there. When Android was released as the first free mobile OS, we were there. When the iPad, Kindle and Nexus devices introduced us to the idea of a tablet, we were there. These important moments in the history of business were also moments in the life of Flurry, woven together like a tapestry to tell the story of this amazing revolution.

I am proud of Flurry and what we have been able to accomplish. I am proud of how many mobile developers we have helped to succeed, some of them beyond our wildest dreams. I am proud of the team we assembled and how we were able to do so much while still having so much fun. I am proud of the moments when we were faced with impossible odds and found a way to succeed.

My journey with Flurry has been amazing, but now our paths diverge. I leave the company in great hands with a promising future and will enjoy watching it grow from the sidelines. For the first time in nine years I will have a chance to catch my breadth, relax, and recharge my batteries. There are many adventures left to be had and I am eager to discover them.

So, what’s next?

Why no one will invest in you

I often have discussions with people who have a great idea and are thinking of quitting their job to pursue it. However, they have fixed costs (rent, car payments, etc.) and can’t afford to work for free. Instead, they want to raise some venture investment to fund their new company and pay them a salary. Inevitably, they are surprised at how hard it is and rarely succeed.

The problem that these potential entrepreneurs fail to see is that investors are looking for investments to make a return, not to fund your lifestyle. If an investor is going to invest in you it will be for one of three reasons:

  • Investing in people (you). An investor might invest in you because of who you are and your track record of success. However, unless you have started and sold companies for tens or hundreds of millions of dollars, it is unlikely that investors will invest in you for who you are. The risk for new companies is too high for someone inexperienced who doesn’t have a product or a plan.
  • Investing in your product. Investors will invest in products that have no plan (or revenue) but are growing like wildfire (Snapchat is a good example). The investor might not know you and you might not have a plan in place, but they see the product succeeding in the market and have faith that you can come up with a plan when necessary. This is exceedingly rare because the product needs to be so amazingly successful as to forgive the higher risk of not having a plan.
  • Investing in a plan. The vast majority of venture investment is in a plan. A plan includes all of the other elements including people, products, marketing/growth, financials, etc. When an investor invests in your plan, it is because they see how their investment will help you achieve your plan and in doing so produce a return on their investment.

Now, before you spend weeks writing a 50 page business plan, it is important to understand what an investor looks for in a plan. The best plans are not determined by length, but whether you can answer the following questions:

  1. What problem are you solving? Explain who your customers are, what problem they have and how much money can be made by solving it. The bigger the problem the bigger the market opportunity.
  2. How do you solve the problem? There are many ways to solve the same problem, what is your solution and how is it unique? In many cases this is a demonstration of your product.
  3. Why hasn’t the problem been solved before? There are reasons this problem exists and one of them is that no one else has solved it. Why not? Are there difficulties that you have overcome?
  4. Why are you (and your team) the ones to solve it? While this is your plan, you need to give investors confidence that you can execute the plan.
  5. How will you beat the competition? Even if you don’t have competition today, you will at some point. How will you win when the competition attacks?
  6. How much money will you make if everything goes well? This is the most important question. Investors want to see a business that will become very valuable, very quickly based on the money it can make.
  7. How much money do you need? The final question is how much it will cost for you to build the business to a point where you’ve removed a significant amount of risk. Your plan, no matter how well formulated, has a lot of risk. Instead of giving you $20M now, they would rather give you $1M and see if you can eliminate some of the risk in the plan and then give you more. It is up to you to set realistic goals and estimate costs accordingly, and the investors will evaluate the risk profile from there.

Note that these are the questions for a seed level company, one that is just getting started. As your company grows, the questions you need to answer in your plan will change. Even public companies need to have a plan for their shareholders, who are their investors.

So, if you are looking to raise money for your company be sure you have a plan that justifies the investment. And quit your job first, no one wants to invest in your plan if you don’t believe in it enough to go all in.

Never Play Fair

When you are starting a new company you are, by definition, the underdog. Your market may have established competitors with massive resources, or maybe the market is new and unproven. As the underdog you are at a disadvantage in the game of business and if you play the game by the rules you will lose.

So, in order to win you have to cheat.

Cheating in business means having an unfair competitive advantage, something that competitors (and the market) can’t easily replicate. There are many kinds of competitive advantages and I’ve listed a few of them below.

  • Technology. A technology advantage allows you to do something no one else can do. The technology could be some new kind of software, new production process or new mathematical model. Any technology advantage is really a head start because someone else will find a way to replicate your technology in 6-9 months. Yes, even if you have a patent. However, that 6-9 month head start is a lot of time to make use of your technology to build other advantages, or continue to improve the technology to extend the head start. Examples: Google, New Relic.
  • Cost Structure. A cost structure advantage means that it costs you less to provide the same or better service than existing competitors (sometimes this is called a “new business model”). Maybe you outsource labor overseas, have volume discounts or have a better process that requires fewer people. Cost structure advantages can last longer than technology since established competitors often have trouble making fundamental changes to their business. New entrants won’t have that problem so you can expect other start up companies to copy your model quickly if it works. Example companies: Amazon, Walmart.
  • Happy Customers. An existing base of happy customers is a huge advantage. Customer acquisition is one of the biggest costs for any business (especially marketplaces) so if you have already acquired customers it becomes that much more expensive for competitors to take them from you. However, they need to be HAPPY customers so you need to continue to invest in customer satisfaction to maintain this advantage. If your customers become unhappy then this becomes a liability quickly. Example companies: Uber, Etsy, Airbnb.
  • Data. If you know something that no one else knows you have an advantage. The trend of Big Data is really just a translation of the data companies already had into a competitive advantage. This is the most maintainable of the competitive advantages since it is a lot like a trade secret – managed correctly your competitors will never know what you know. However, it’s also the hardest advantage to translate into revenue since you need to use it to create new technology, make your customers happy or improve your cost structure. In the best case scenario you can get customers to pay you for your data. Example companies: Facebook, Twitter.

There are, of course, many more possible advantages. The best companies have more than one of these and the struggling companies might not have any. I recommend picking out some companies you respect and thinking deeply about their competitive advantage; it is not always what you think.

When you are getting started it is important to know what your competitive advantage is or what you want it to be. Everything you do should make use of your advantage or help strengthen it. That is how you cheat, you use your advantage to compete and win.

This makes prioritization for your company easier because you stop asking the questions “What can we create?” and “What can we sell?” to “Where do we know we can win?“. Playing an unfair game is how you win and you make the game unfair by maximizing your advantage.