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Lowering the cost of capital, may not be the answer.

The last week has been full of chatter about the First Angel Network and the way they operate.  In our society, everyone should have the right to be able to charge what they want, for the services or products they offer.

The problem I have with FAN is the lack of disclosure about the 8% of the total proceeds of the transaction going to the organizers.  This is obviously a direct conflict.   Are the organizers incentivized to bring the cream of the crop in front of the group?  Or are the incentivized to prey on a company that they know will take the deal, knowing they will get their 8%?

I would suspect that demand for capital is rising in the region.  Supply is also growing with the recent exits.  There is more supply directly (from these exits) and indirectly from national groups that have never considered this region investment worthy.  This should naturally drive down the cost of capital and provide entrepreneurs with more choices for their capital needs.

If FAN continues to operate in the way they feel is sustainable and more supply is available in the region at better terms, eventually the model will fail (unless they truly are adding lots of value beyond the investment).  It’s natural selection, baby!

If this natural selection process works and we successfully bring more capital to the region at better terms, will it be the change the community needs?  I actually don’t think so, and maybe too much focus on FAN’s model isn’t where we should be focusing our energy…  According to the Kaufmann Foundation “less than 20% of the fastest growing companies in the U.S. took venture money.”

If cheap capital were an indication of direct success, we’d see more and more successful companies being spawned directly from the funding of all the local government agencies.

If the supply grows too quickly, demand will surely rise.  This is where cheap capital will backfire, because talent will be locked up in pockets of startups and the quality of startups will remain constant, making it harder for them to raise follow-on capital.

As a community we need to work together with new and existing startups to help them grow in customers, talent, exposure, finances and raising capital.  We can’t just simply focus on the raising capital component, when there are so many other variables that can increase the likelihood of success!

Compounding Effects of External Capital

In real estate, you often hear investors talk about leverage.  Use the bank’s money to get bigger returns.  Instead of using your own capital, put 20% down and get the bank to fund the other 80%.  In a perfect market you actually do get larger returns by using other people’s money, by following this strategy.

The problem with our addiction to cheap capital, is we rarely look at the flip side. What happens in a downturn?  When you are heavily leveraged, your losses are amplified.  Let’s look at an an example.  Let’s say you have a property that’s worth $100,000, which you put $20,000 as a downpayment and you owe the bank the other $80,000.  The market drops 10% so you’re property is now worth $90,000, your equity drops to $10,000 and you still owe $80,000 to the bank.  The 10% drop in the market amplified your losses to 50% loss because of leverage.

What about using this model in venture capital and with angel investors from a purely financial perspective?  The examples are two different types of capital groups, debt vs. equity, but they still can have compounding effects on your return-on-investment.

Let’s say you round up a team of three founders, who own 33.33% each, and build a company worth about $5 million with no outside investment.   The business has started to generate significant revenue.  This year the company will have operating expenses of $1 million and generate $2 million in revenue leaving $1 million in profit.

Operating expenses and revenue  is on track to grow 50% each year for the next 5 years, so by year 5 they would be generating $5 million in profit.  In 5 years, the founders would have pocketed $4.3 million each (if they distributed profits as dividends or did some share repurchase), not to mention the equity that is now built up in the business.

A team of identical founders in the exact same scenario, feel that 50% is not good enough.  They feel if they raised capital they could accelerate beyond 50% growth each year.   They go shop the deal and end up raising $1.5 million at a $5 million pre-money valuation or $6.5 million post-money valuation.  The investors negotiate a 15% option pool.  The company is now structured as the following:

  • Founders: 61.92% (each founder has 20.64%)
  • Investors: 23.08%
  • Option Pool: 15.00%

The founder’s equity gets diluted to an effective pre-money valuation of $4 million because of the option pool.  Not only this, the business immediately puts that $1.5 million to work increasing their operating expenses to $2.5 million in the first year.  Similar to the entrepreneurs in the first group, their revenue is still $2 million which means the business loses $500,000 in the first year.  The operating expenses grow constant at 50% each year.

For this group of founders to get the same type of return as the first set of founders, they would literally need to grow at 92% in revenue each year.  This group of entrepreneurs needs to increase their revenue output an extra 84%, just to walk away this the same amount of capital.

A great post I just came across looked at a few real life examples: http://saastr.wordpress.com/2012/10/12/a-real-life-saas-case-study-eloqua-marketo-pardot-there-are-3-different-paths-to-success-my-young-paduan/

This blog post isn’t meant to stop you from raising capital, but to show you the compounding effects external capital can have on your business.  I want to make sure as an entrepreneur you understand that the capital you raise is truly going to accelerate your business and provide the return you want to your founders and employees.

Thoughts on Parallel Entrepreneurship

“I’ve made countless mistakes in my entrepreneurial career.

My biggest was attempting to be a parallel entrepreneur whereby I was foolishly trying to run two companies at the same time.

Startups are an all-consuming thing.  It’s hard to split time and passion across multiple ones.  Startups are hard enough as it is, but balancing two at the same time is almost always a bad idea.”

– Dharmesh Shah Cofounder of HubSpot

When I started my business, years ago, my vision was to build a company that spun off multiple companies that would be run in parallel.  The idea was simple; most businesses will fail, so build a couple and focus on the money-makers.

As time progressed it became clear that this is difficult in practice.  As a small entity, the pain points became very clear, very quickly.

One winner syndrome

No matter how many businesses you are able to successfully spin off, there will always be one winner.  One company will be growing faster than another.  One will generate more profit than another. In the case where you have one business that is in high growth and another that is in mediocre growth, how could you possibly justify capital allocation to company that is growing slowly?

Upfront capital

Every single business has some form of capital requirement.  If you decide you want to build three businesses in parallel, you’ve immediately got to divide your human capital and finances into three groups to make it happen.  This means you’re risking three times as much capital.

Returns

By building multiple companies in parallel, it becomes increasingly harder to make larger returns.   Let’s look at two entrepreneurs.

Bob built three companies and was able to achieve 10% month over month with one.  He decides the other two companies are unprofitable and shuts them down.   It cost him roughly $150,000 to start all three companies and another $25,000 to wind down the two other companies.  To get his money back, he needs to invest another $151,744 to keep the company afloat long enough to reap the reward.  His total capital invested is $301,769. By the end of year 5 his investment returned $2.5 million.  That’s about an 8.3x return.

Jill built one company that achieved a 5% month over month growth at a cost of $50,000.   Instead of being busy winding down two other companies and laying off staff, Jill was able to keep tweaking her company that by month 3 they achieved a 10% month over month growth.   To get her company to break even she needs to invest an additional $160,487 for a grand total of $210,487. By the end of year 5, her investment returned $2.3 million.  That’s almost an 11x return.

Lack of Resources

The biggest challenge any startup has is a lack of resources, whether it is time, focus, finances or human capital.  By splitting those limited resources across multiple companies, you are effectively reducing its power.There are a million little things to do in a startup that start compounding over time.  If your time and focus is split it’s hard to measure your impact.  If your finances are split it’s hard to know if a dollar is better served in one company or another.

Conclusion

With all that being said, I do believe there does come a point, where running businesses in parallel makes sense.  When a company has effectively hit a ceiling with it’s own core offerings, should it consider expanding into new ventures or product offerings.

Let’s get back to basics and build a product that has a large target audience, maximize that product’s economics, scalability and marketability.  If you’ve tried everything and can’t make the product work, start over.  Eventually you’ll find a product that does work and you’ll hit a ceiling, at that point you’ll have an abundance of resources to run in parallel.

How do you compare to the competition?

Competition is inevitable with any company. It begs the question, how does one company compare itself to the competition?  This is an interesting question and depending on your operating philosophy (whether your business is for social good or for profit) you may have different answers.

As you start to research your market you will come across a lot of metrics around your competitors.  The data may feel like you’re losing ground on the total market share.

You’ll see that your competitors:

  • May have raised more capital than you.
  • May have attracted a larger audience and are growing faster than you.

In each one of these scenarios, it’s completely possible that you are the dominant player.  Consider for a minute the following scenario:

  • Company A, has 500,000 users, is growing at 30,000 users per month and raised a Series A round of $10 million.
  • Company B, has 200,000 users and is growing at 10,000 user per month and $500,000 in seed capital.

It’s hard gathering anything truly meaningful when you’re trying to compare your company to this type of data. You may think Company A is the dominant player because it has the most money in the bank and is growing faster than Company B. 

It is truly possible Company B could be generating more revenue.  If Company A is only generating $50 per user and has a 1% paid conversion on 30,000 visitors a month they would be generating $15,000 per month.   Company B on the other hand could be generating $100 per user and has a 2.5% paid conversion on 10,000 visitors generating $25,000 per month.  Company B is generating 66% more revenue.

Beside revenue, Company B’s founders may still own 80% of the company where Company A’s founders own less than 5%.

In both cases, on the surface Company B looks like the worse performing business, but once you start peeling back all the layers it could potentially be the best performing business. You’ll read your competitors press releases and always think they are doing better than you.  Your competitors will do the exact same, they’ll read your press releases and think you are better than them.

The reality is it’s virtually impossible to know how you compare to your competitors unless you are intimately involved with their corporate structure and revenue details.  As Mark Suster says “Startups are all Naked in the Mirror.”

The only way to maximize your return is to focus on your business, not your competition.  If you truly want to maximize the opportunity of your business focus on:

  • Improving Learning & Development Cycles: How quickly you learn from your various feedback loops and make changes, will greatly affect how much further you can get than your competitors.  If you and a competitor both realize a new feature will add 15% to your bottom-line, the company who builds this feature faster will reap the reward.
  • Capital Efficiency: When investors say “Fail Fast”, they virtually want you to deploy the capital in most efficient way to start generating return.  If you’re burning $10,000 a month on marketing that is adding nothing to the bottom-line, and your competitor is spending $10,000 a month with a 100% return on investment – which company is deploying capital the most efficiently?
  • Optimizations: In the example above, one company is able to outperform other competitors even though the competitors have more traffic, simply because they are able to convert more visitors into paying customers.  Focus on optimizing funnels.
  • Revenue: A product that can attract a premium audience won’t have to work as hard to extract higher revenue per user.
  • Retention: Products with higher retention can work at monetizing their existing audience versus spending time and effort attracting a new audience.
  • Acquisition Growth: While it’s entirely possible for one startup to generate more revenue with a smaller audience, it is highly recommended that you maximize all channels for acquisition.  If you are able to outperform a competitor that has a larger audience, imagine what you could do by attracting their audience.
  • Lifespan: A company that can generate $500,000 a year for its shareholders over 15 years provides a larger return than a company that produces $1 million a year for 5 years.
  • Ownership: Gabriel Weinberg wrote a great article on “Paths to $5M for startup founders”.  If the founders wanted to walk away with $5 million and owned 60% of the company they would need to sell the business for $8.3 million.  If the founders owned 10%, they would need a $50 million exit.

Keep in mind with that last variable on ownership, even if your competitor exits at a higher price point it is entirely possible you walked away with more money and made your investors a higher multiple.

Comparing yourself to the competition is challenging, keep your head down and improve your own product – just continue growing.

Minimum Viable Audience

I’m a big fan of components of the Lean Startup – especially the minimum viable product.  Too many startups are pushing features out the door, without knowing if it’s truly going to add value to the bottom line.

One of the biggest problems, in my opinion, with the whole Lean Startup methodology is related to customer development without considering the scability component.  The problem with “getting out of the building” is scaling.

According to the Startup Genome project, the biggest challenge startups have in every stage is ‘Customer Acquisition’.

Untitled

Source: startupcompass.co

Solve the problem beforehand

What would be the point of building a startup that everyone loves just to eventually find out, it’s challenging to reach your audience or the economics of reaching your audience doesn’t make sense?  You’ll be high on the excitement of talking to customers, getting feedback, and building a product that when you come back to reality you’ll realize you’re on a sinking ship.

Scold me if you must, but I personally think a mediocre product that can attract a large audience has a better chance of survival than a better product that can’t attract a small audience.  That’s why sometimes you’ll come across a website and say “100,000 people pay for this!?!?! I could build a better product in my sleep.”  Better product or not, you won’t always be able to attract that same level of customers.

Typically in the discovery stage of a startup, I like to think about customer segments, repeatable distribution and discovery engines.  This typically means understanding marketing before a product is even built (no mockups, no prototypes).  It’s a fundamentally important step that I believe a lot of startups miss.

An example

With our first startup Tether.com, for the customer development phase we could have easily spent our time talking to any of our friends that owned a BlackBerry smartphone to get their feedback to improve the product.  Our audience size could have been 100 local individuals.  Eventually, we would have launched our product to these 100 individuals and converted some of them.

However, we took a different approach.  Our team spent time looking to see where the BlackBerry enthusiasts hung out and we discovered a site called CrackBerry.com.  One forum post on CrackBerry attracted over 2,000 emails to our waiting list.   We asked the editors, if they would write about us in our pre-launch phase, which in turn generated an additional 8,000 emails on our waiting list.

At this stage, we had attracted 10,000 emails with only a promise of building the product.  Those 10,000 emails enabled us to generate large amounts of revenue on our launch day and it gave us a large audience to do our customer development with.  Interviewing 10,000 users in the customer development phase would have been impossible, so it lead us to take a more data driven approach, which in my opinion is the best type of customer development.

Enter the minimum viable audience

Before you go out and spend time and energy building a product, spend time ensuring there is demand for it.  One advantage that brick and mortar companies have is being in the right location automatically generates an audience.  Online companies can easily get lost in the noise.

To insure demand in your product, build a “coming soon” page showcasing the product you want to build, understand the customer segment and learn how to attract that customer.  Reverse engineer what your expectations of the business are based on your own goals.  If you’re looking to start a business that can do $10,000 a month in sales and the product’s price tag was $100, you’d need to sell 100 copies a month.  If your site converts at 2%, you’d need roughly 5,000 visitors a month or 164 visitors per day.  This becomes your minimum viable audience target.

By understanding what’s required to market to your customer segments, you’ll discover a lot of critical business data such as cost of acquisition and how repeatable your user acquisition method is beforehand.  If your cost of acquisition is too high, your business may fail even if you build the entire product.  If you exhaust all of your user acquisition methods and you’ve hit a ceiling, you may run into issues scaling down the road.

As always there are expectations to this…

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