Category Archives: Financing

Cheating is Allowed

One of the things I struggle tracingwith as an artist is a constant inferiority complex. While I am a pretty good illustrator, whenever I spend time on any art sites I see the amazing work done by others and feel like I am a complete novice. I’ve spent 20 years learning and perfecting my technique but these others make me feel like I’ve only just gotten started. How did they find an easy button where I still struggle?

If you are a founder of a company, you understand that feeling well. You see your friends and colleagues raise large rounds of funding or get lucrative acquisition offers and you are still struggling to get those first few meetings. Where is the easy button they found?

Often, when you feel this way, you are making some bad assumptions. For example, when I first see a beautiful illustration of a person’s face I always assume that the artist draws the same way I do – from memory or imagination. In reality, many artists trace photos. In fact, there is evidence that even the great Renaissance painters were tracing their subjects with the use of mirrors. Tracing is infinitely easier than drawing free hand, and the result is always significantly better.

However, by assuming they were approaching the problem a certain way I assumed they were simply better than me. In reality, they just found another approach to the problem which is easier and has much better results!

Some artists consider tracing to be cheating, but in reality no one cares. No one looks at a given piece of art and says “Well, they didn’t do this the hard way…”. The same is true for your company! Your goal is to build a successful business, not to build a business the hardest way possible.

What are some short cuts you can take as a founder?

  • Sell to your friends. Every enterprise software company’s first 10 customers are friends of the founder. In fact, many of those customers might buy the product only because they are friends! That is perfectly fine as long as you quickly move on to non-friend customers, since all they gave you was a head start.
  • Leverage existing networks. Every YCombinator enterprise software company launches with 50+ customers – how do they do it? Most of them are other YC companies who want to help out a fellow founder. You can do this as well, by plugging into the network of your investors and advisors.
  • Hire your old team. Many experienced founders initially hire people from the teams at their prior job. Considering how hard it is to hire in the technology market, having the advantage of a trusted relationship and existing work style is a great way to build your initial team. It’s both less risky and easier to close someone who knows you already.

These short cuts won’t build your business for you, but they do give you a head start in a time when you desperately need the help.

The next time you feel like things are really hard perhaps it is worth rethinking your approach to try and find a short cut. Or, maybe it’s just really hard.

Image courtesy of Flickr user Smoobs via the Creative Commons Attribution 2.0 License.

Selling Your Company

It happens to every founder at some point. Fsbo_tabletYou realize building your business is harder than you expected. You’ve been working for a few years without finding breakaway growth. The team is tired and losing some of their passion, overwhelmed by the work that needs to be done. You need to start a new round of fundraising soon and are not sure you want to invest another 3-4 years into building this company. All of a sudden, you find yourself thinking of selling.

Selling your company always seems like an attractive option. Instead of working harder you can get out now for a few millions dollars, pay back your investors and pocket a little extra for the few years of hard work. You read about it happening everyday in Techcrunch so why not you? You have a great team and an awesome product, some large company would surely pay for that.

Unfortunately, that is not how it works.

Companies are bought, not sold (as everyone will tell you). Selling your company when things are not going well requires a number of forces to converge in your favor at the same time:

  • An acquirer must have the need for your team, product or customers at a price you will accept.
  • Your team must be willing to work for the larger company for a few years.
  • Your investors must be willing to sell for a price that is likely a loss for them.

It is surprisingly rare that these three factors converge at the same time. When acquirers come knocking, you and your team might be fresh off a round of financing and flush with your dream of riches. When you and your team decide to sell there may be no acquirers ready to move. And even if your team and an acquirer are on board your investors might not be willing to give up.

That being said, selling while under distress can be done. It takes a lot of work on your part, as a founder, as you need to do a number of things at once:

  1. Focus on maximizing the value (and hence attractiveness) of your business by emphasizing the things acquirers will value. That includes your customers, product, team, etc.
  2. Spend a lot of time networking to find any and all potentially interested acquirers. You need two or more to get a decent deal in negotiations and these will usually come from existing partners who know your business well.
  3. Convince your team to continue to work hard during the search for an acquirer, despite all the uncertainty and unknowns. This can be the hardest part, especially if they are already feeling burned out.

It is a hard balance and few companies successfully navigate it. I have seen teams fall apart right before a deal is closed because of fear and uncertainty. I have seen great teams with great products look high and low never to find any interested acquirers. Even if you find an acquirer, most distressed companies are treated as “acqui-hires” which means the team gets a token bonus in addition to a job offer. A small reward for years of hard work.

The only real chance you have for being rewarded for all your hard work is to build a business that grows. If that looks impossible, maximize the strategic value you can provide through your product, team and customers while pursuing relationships with potential acquirers. In other words, the normal things you do as a founder.

So, time to get back to it.

Image made available By Prokopenya Viktor (my own picture collection) [Public domain], via Wikimedia Commons

The Myth of “SaaS”

Software-as-a-Service (SaaS) has taken the technology world by storm. These days, all new software companies are SaaS which simply means they are based in the cloud and have subscription pricing. With the exception of mobile applications and e-commerce, almost all new companies are following this model.

It’s not surprising. The benefits of SaaS over older models of software delivery are clear. Cloud based software can be updated and improved much more rapidly than on-premise software, with a fraction of the cost of maintenance. Subscription pricing means that revenue continues to roll in month after month for the entire life of a customer. What is not to like?

However, many founders of SaaS companies have unusual levels of stress, even more so than typical founders. Your typical SaaS startup founder will:

  • Spend a few days every month trying to follow the latest SaaS metrics fad, based on blog posts like this*. They are searching for the perfect metric to compare themselves against other SaaS businesses.
  • Try desperately to reach a mythical MRR milestone that will magically open the door to raise their Series A.
  • They spend time meeting the best “SaaS” investors, even if those investors are completely unfamiliar with their space.

The ironic reality is that there is no such thing as SaaS anymore. SaaS has become so pervasive that the term is the equivalent of “Internet” or “Web” or “Software”. There are SaaS companies across every vertical, every market. Some charge millions of dollars a year and others charge $5 per month. Some are profitable with only 5 customers, others have 500,000 customers and still are in the red.

SaaS no longer means anything because the world of SaaS has become too large.

Those SaaS founders I mentioned earlier are under abnormal stress because they are chasing the myth of a “typical” SaaS business. There is no such thing as a “typical” SaaS business and all of the fancy metrics and analytics you hear about are attempts to normalize and compare SaaS businesses that are completely different. The only ones who benefit from such normalization are investors, who want help in picking and choosing which companies to support. As a founder, you only care about one business: yours.

The good news is that the world is much simpler when you abandon this myth of the “SaaS Business”. Your business, while it might be SaaS, is not governed by complex new metrics but by the The Most Important Equation for Your Business. Your MRR does not matter, there are businesses raising Series A rounds with $0 MRR everyday. What matters most is The Only Thing That Matters, just like with any other business. Investors will look at your rate of growth first and your MRR second.

In short, you are building a business. Just because it is SaaS does not mean the rules are different, only that there might be more distractions. Do whatever is right for your business.

Then, when you are successful, don’t be surprised when another founder tries to model themselves after you. It is SaaS, after all.

* This blog post is actually very good. I only point it out since every founder I meet that reads it finds it more confusing and intimidating than helpful. 

How to Get What You Need

I have many conversations with founders that start with “I need…”. “I need to raise money.” “I need to hire more people.” “I need to find some more customers.”

It is very easy to develop tunnel vision when building your company, as you are tackling difficult problems everyday. Your world consists of aggressive (maybe impossible) goals and you evaluate all the things you need to be able to achieve those goals. Those needs become your entire focus.

The problem with focusing on your needs is that no one else cares.

When prospective investors, employees or customers look at your company they don’t care about your needs, they care about what you can do for them. Investors don’t care that you need to raise money, they care about whether you can produce a return on their investment. Employees don’t care that you need to hire more people, they care that you offer unique and valuable opportunities. Customers don’t care that you need their business, they care about whether you help them solve a problem.

When you think about the world this way, you realize why many first time founders struggle. They focus too much on their needs and not on how to create enough value so that people will want to fulfill those needs.

Getting What You Need

In order to get what you need, you need to make the opportunity to give it to you such a great deal that no one would ever pass it by. So, if you need..

  • To Raise Funding: Make your company an amazingly attractive investment. This should be a combination of traction, team and vision (and perhaps revenue). Make the terms of investment friendly to both you and the investors so they don’t feel you are trying to take advantage of them.
  • To Hire People: Make your company an amazingly attractive place to work. Empower new hires to learn and expand their roles, giving them the freedom to be creative while holding the responsibility of delivering important parts of your strategy. Hire for passion as much as skills.
  • To Sell Customers: Make your product an amazingly attractive solution to a problem they have. Not only should your product be easy to use, it should be easy to get set up and priced to make it a clear decision for the customer.

Remember, when an investor, candidate or customer is considering whether or not to choose your company they are not deciding if you are a good company. They are deciding if you are better than the hundreds (or thousands) of other companies in the market, some of which may be in entirely different industries or businesses. You are competing with everyone to stand out, not just yourself.

So, next time you find yourself saying “I need” try to rephrase it as “Here is what I can offer”. It will greatly improve the chances that you get what you want.

You can’t always get what you want
But if you try sometimes you just might find
You just might find
You get what you need

– The Rolling Stones

Fundraising Fever

In the past few months, almost every discussion I have with founders who recently started their companies start the same way.

“We are really excited to have you help us, do you know of any investors that might want to invest?”

These are companies that were literally just started, whose product does not yet work and who have no customers. They haven’t even figured out what their business might look like, but they want to immediately jump to raising $1M using a convertible note with a $5M cap (yes, those terms are so common I’m not even making them up).

Why is everyone rushing to raise money? Most of the blame falls to the frothy funding market right now and how easy it is to raise seed funding for new ventures. If you look around and see everyone else doing it, why shouldn’t you? It would be nice to have the money to pay a small salary and remove some of the financial stress that goes along with being a founder. Besides, the market might crash at any time and you should act while the market is hot.

It’s tempting, but dangerous.

Fundraising too early can be very risky for your new company. It will distract you from building your product, recruiting customers and learning about how your business will change from your initial vision (and it will change). In fact, you might not end know what kind of financing is right for your business since it is too early to tell.

Let us look at the difference between two example companies, Company A and Company B, in their first six months of existence. Company A decides to focus on product and customers, delaying fundraising until after their Beta. Company B decides to raise money right away to remove some of the financial stress from the founders. We can give both companies the benefit of the doubt and assume they did sufficient customer development ahead of time so they are working on business concepts that have potential.

Below is how the first six months play out for both companies:

First Six Months

 

As you can see, after the first six months Company A is already in their Beta and has started fundraising, while Company B is still working on their product because they took three months out for fundraising. This is being conservative, since it’s quite likely that fundraising takes Company B more than 3 months.

But wait! Why didn’t Company B just continue their product development while fundraising? Because there just isn’t enough time in the day. Raising funding is incredibly time intensive, requiring meetings and discussions with many investors, only a few of whom will invest in your company. Assuming both companies had co-founders, there are 2 people on the team and at least 1.5 of them would be working on raising money.

Not only that, but when Company A is fundraising they can speak to investors with confidence about their product and business since they have tested it in the market with customers in their Beta. Company B was pitching investors on an idea that may or may not need to change. This means that Company A will likely be able to raise more money on more favorable terms than Company B.

Well, so what? Company B raised money, right? They have plenty of time to figure it out.

Maybe and maybe not. Again, they have yet to understand what their business might look like as they learn from the market. It is possible that the market completely rejects their business model, or perhaps their product is significantly harder to build than they thought. If they cannot get to market with the financing they raised it is very unlikely they will be able to raise more.

Just in case you don’t believe me, there are countless cases of companies that raised money too early and ended up failing because of it. Color burned through $41M in premature financing before failing. Clinkle is in the process of failing after raising $30M too early.

I know it’s hard to work for free and watch your bank account dwindle. I know that it’s hard not being able to hire a few more people to help build your business and make it move faster. I know that you worry about the market turning and financing getting harder to raise. These are things you will worry about for most of the life of your company. Paying a long term price to address them in the short term is only hurting yourself in the long term.

Raising your first capital is an important event in the history of any company. Be sure it is the right time for yours.

 

The Profitability Challenge

Here’s a fun weekend experiment for you, something I call the $20 Weekend Challenge: Take a $20 bill out of your wallet on Friday. You task for the weekend is to turn that $20 into $40 by Monday, doubling your money. You are welcome to use any legal means at your disposal, but heading into a casino or buying lottery tickets doesn’t count. You have to turn that $20 into $40 without gambling. It sounds hard, but it is worth it, I promise.

640px-US_$20_Series_2006_Obverse

So, what does this have to do with building a business?

Cash and Business

A common refrain in business is that “cash is king”. Most people say that to mean your company does not exist if you don’t have enough cash to pay your bills, but it is also true that your business is designed to take in some cash and output more cash. You are trying to build something impossible in the world of physics: something that produces more than it consumes.

This is much harder than it sounds, as you likely know if you tried the $20 Weekend Challenge. If you are accustomed to working for a salary, you are used to exchanging your time for money which is very different from building a business. Having a job requires little thought on your part since your salary is (usually) guaranteed and your time has flexible value. Building a business, however, requires a lot of thought.

Let’s do a simple thought experiment to prove that point. Your typical employee at a high tech start up company costs between $100,000 and $150,000 depending on your location so let us assume $125,000. No, that’s not all salary, it includes benefits, payroll taxes, accounting costs, etc. (as a business, the salary can be only half the cost of an employee).

Depending on your business model, let’s see how many customers you would need to pay for that employee.

Business Model: Advertising

In advertising you are paid per every 1,000 ad impressions you show (CPM). CPMs vary wildly so let’s assume you make a $2 CPM (which is not bad). Assuming that 20% of your users are active on any given day and those active users generate 2 ad impressions, you would need 286,200 active users every day to support the cost of one employee.

Business Model: Subscription

In a subscription model, you make money through the monthly fee you can charge active customers. Let’s assume, your product costs $50/month to maintain a subscription. That means you need 210 paying customers every month to support the cost of one employee.

Business Model: Selling Products

When you are selling products, you get a one-time fee for the cost of the product. Let’s assume you sell your product for $100 and it costs you $90 to make it, leaving $10 in net profit per sale. You would need to sell 240 units every week to support the cost of one employee.

And remember, all of that only covers one employee.

The $20 Weekend Challenge

When thinking in these terms, I hope the value of the $20 Weekend Challenge becomes clear. In order to pay for a single employee, you have to have a lot of customers. To pay for your entire team, you need a large number of customers. To pay for your team, your offices, your lawyers and eventually make a profit? You need to have all the customers.

You need to take your money and almost double it to simply pay your bills.

Building a profitable business is hard because the cost structure that goes along with companies is high. Some companies claim they are profitable when they achieve Ramen Profitability, but that is really a false milestone. If you can’t afford to pay yourself a living wage, you are not really profitable.

If this makes starting a business intimidating, good. It should be intimidating. It should seem almost impossible. However, I bet when you first started thinking about the $20 Weekend Challenge it seemed pretty hard too. The only way to see if you can do it is to give it a try.

What Investors See When They Look At You

If you’ve gotten far enough in building your mirror business to think about raising investment, then you’ve worked very hard and survived some near-death experiences. It’s been a tough road and you should be proud of the progress you have made. Well done!

However, when you sit down to talk to a venture investor about your business you need to put all of that aside. When a venture investor looks at your company they don’t see it as it is today, they are trying to envision what it might look like in 5-10 years.

Wait, let’s take a step back: How do VCs work?

If you’re not familiar with how venture capital funds work, they are easy to explain. A group of partners (known as the general partners) form an LLC to act as an investment fund. They then raise capital for the fund from large institutions like pension funds, endowments and other funds (known as limited partners).  The size of venture funds varies wildly from $20M to $1B, but almost all venture funds have a 10 year lifespan. For the first 3-4 years of the fund, the general partners are making investments in new companies and the remaining 6-7 years is spent managing those investments and making follow-on investments in the same companies. At the end of 10 years, the fund is closed and, assuming there was a positive return, the limited partners get their rewards. (For a much deeper explanation of venture funds, read Venture Deals).

Keeping that in mind, the primary motivation of a venture investor is to produce returns on their fund in 10 years. Considering the high failure rate of start up companies, out of a portfolio of investments in 10 companies they can expect 7 to go out of business, 2 to be moderately successful and one to be hugely successful. In order to produce a return on the entire fund, they need those successes to be huge (return 20+ times the money invested).

Okay, so how does that affect how they see me?

Venture investors, because of how their funds are set up, are constantly looking for companies who have the potential to produce a 20x return on investment. That is very difficult to achieve and not many companies will have that kind of potential. A neighborhood grocery store will never produce that kind of return, nor will your local bookstore.

Not only do venture investors need a 20x return, they need it within 10 years. There are businesses you can grow slowly over 20 or 30 years to produce those returns, but to do it in less than 10 years means that your business needs to grow extremely quickly. To grow that quickly, you need a quickly growing market, a well thought out plan, some critical strategic advantage and the right team to execute your plan.

So, when you sit down with a venture investor, they are looking for signs that your business can produce 20x returns within 10 years.

Ah, that makes sense. So what does that mean for me?

The most important thing for you to convey to venture investors is the potential of the problem you are solving and how large the market is that has that problem. You cannot produce a 20x return on $10M of investment if your market size is only $50M, but you can if your market size is $1B. If the venture investor can envision your company in 10 years operating at that scale, you will get their attention.

After you convince them that your problem/market is big enough, it is time to convince them that you can make that happen. It is very hard to convince anyone what will happen in 10 years, especially investors that hear similar things everyday, but there are some keys to doing it well:

  • Present a plan. Your plan might change, but you need to have a credible long-term plan for getting to the large outcome. If you can’t build a credible plan at the beginning, it’s unlikely you will be able to come up with a new one as the market changes. The plan you present will also serve to identify the key risk factors that your business will face as it grows.
  • Show you mean it. You have already been following your plan in building your business, so show off how well you have executed. Remember, your progress so far is not why they will invest in you, but your progress so far is proof that your plan is credible and that you can execute against plans you create.
  • Sell the team. 10 years is a long time. If your company is going to be very successful, it will be a long and difficult road. Your team is critical because it is those people who will steer the company through those hard times and the venture investor needs faith that you can do it. In the end they are investing in you.
  • Don’t play fair. If you really have found a big opportunity that can product 20x returns, it is likely that many others have as well. You need to show a distinct competitive advantage that will allow you to win when faced with dozens of competitors going after the same goal.

Hopefully, at this point you are starting to realize why many companies struggle to ever raise venture funding at all. It is great that you have 5 paying customers today, but can you convince an investor that you will get to 5,000? You have 2 brilliant developers writing code, but who is going to sell your product to Fortune 500 companies? You have a great plan and team, but without any customers how can you be sure your product will work in the market?

Time to Focus

The good news is that, assuming you’ve followed at least some of the advice on this blog, you have already built the foundation for a great company that can produce the kinds of returns that venture investors want. In order to successfully raise investment, you just need to make sure to present your company in the way the potential investors need to see it. Focusing on where you can go, and not on where you’ve been, will go a long way towards that goal.

Besides, after all the hard work you’ve put in, it’s fun to think about how successful you can be in 10 years.

Thanks to Leo and Beth for reading a draft of this post. Image copyright Graham Hogg and made available via Creative Commons.