Category Archives: Business Strategy

Which Comes First: The Product or Target Market?

Chicken
Egg
Determining which comes first, the product or the market is challenging even for companies with an established brand and existing products consistently generating revenue.  It’s exponentially more difficult for startups to separate the two which is why it may be a relief to hear that the two are actually inseparable.

Startups are born in a variety of ways but two of the most common are these.

  1. When a recurring or consistent need is identified. The founders decide to build a solution and sell it to people with that need. The emphasis is more on the needs of the market but is still ultimately inseparable from the product.
  2. When founders develop something “really cool.” It is often for their own specific use, and realize somewhere along the way that if they can identify a group of people with the same need, they could sell it. Sometimes that requires some adaptations to make it more appealing. In this case, the process starts with the product and evolves to identifying a target market, again making them inseparable.

In the case of the chicken and the egg, both need each other. The same is true of the product and target market. One can’t thrive without the other – at least not as successfully.

If startups don’t know who their customers (i.e., their market) are, how can they determine their needs? And if they don’t know their needs, how can they determine what products to sell them? Alternatively, if they don’t know what products to sell, how can they determine who might want to buy them?

Investing the time to identify and understand their target market drives financial success for startups.

How to Define Your Target Market?

Here are some ideas on how startups can define their markets:

  • By consumer type. Startups that are planning to sell to consumers and businesses might find it helpful to distinguish their markets as B2C and B2B. Businesses can be further defined by size – small, medium, enterprise, global, etc.
  • By geography. Startups that are planning to sell only in one or more geographic regions (they could be cities, states or countries), and then later expand to other regions, might find it helpful to define their markets as names of those regions.
  • By distribution or sales channel. Startups that are planning to sell some products using in-house sales, and some products using a reseller or distributor or wholesaler, might find it helpful to define markets as names of those channels.
  • By marketing technique. Startups that are planning to make customers aware of products using a variety of techniques such as website, direct mail, telesales, pay-per-click web advertising, and so on, might find it helpful to define markets by the names of those techniques.
  • By demographic. Startups might find it helpful to define markets as children, double income no kids (aka DINKs), single income no kids (SINKs), zero income no kids (OINKs), retired, and so on.
  • By size of purchase. Startups may find it helpful to define markets as small purchasers, medium purchasers, and large purchasers.
  • By category of user. In some businesses, a product may produce multiple income streams from multiple classes of users. For example, a company with a product that helps high school athletes find the perfect college to attend might find it useful to define its markets as students, parents, coaches, and college recruiters.

There is no limit to how many ways markets can be defined. As a guideline for the sake of planning and to avoid unnecessary complexity, startups are best served by defining something as a unique market only if

(a) Pricing will be different than for other markets,

(b) Different products will be sold to this market than to other markets,

(c) A different commission structure will be used for this market than for other markets,

(d) Entry into this market will be in a different timeframe than other markets, or

(e) It makes sense to track the financial performance of this market independently from other markets.

The bottom line is there is nothing magical about defining a market. Startups can define it any way that makes good business sense. .

Is it better to define a market broadly or targeted?

To answer this question, let’s look at an example. Let’s say a startup has an innovative, but exclusive, approach to wedding photography.

  1. It could define its market to be the number of marriages in the United States every year, which is 2,000,000+. As a starting point, that might be okay, but where a lot of startups tend to come unstuck is in assuming that “we only need to capture 1% of that business and we’ll achieve our financial goals!”One percent of anything sounds so easily achievable but depending on the product, price, competition, and many other factors, it may be totally unreasonable. Broad market identification tends to lead to a false sense of security.
  2. Another possibility is to define its market as the number of actual wedding ceremonies in the United States that spend over $50,000 for the event. Now the target market is smaller but with a much higher likelihood of being the audience that will purchase from the startup.Although market penetration numbers are going to be higher, the resulting financial projections will be far more believable.
  3. Yet another possibility is for the startup to plan to grow its business regionally. Let’s say it is physically located in Denver. It can define its first market to be the number of actual wedding ceremonies in the greater Denver metropolitan area that spend over $50,000.Now penetration numbers could be even higher as the result of a more targeted marketing effort. Then it defines its second market to be Colorado, and then the third to be the Rocky Mountain region, always targeting the high-end only.

Bottom Line Advice

The narrower and more targeted the market is, the more focused the marketing message can be, resulting in a greater quantity of qualified leads and a higher conversion rate. This also allows startups to have a lower customer acquisition cost. All of that means a higher probability of being financially successful.

About the Author

Alan DavisDr. Al Davis has published 100+ articles in journals, conferences and trade press. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He was a founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003. He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting and optimizing their business strategies. Click on the following to see a short video on Offtoa:

Photo credits:

4 Things You Must Do When Starting a Company

BXP135658The lean startup movement (of which I am a big proponent) has thankfully eliminated the “build it and they will come” attitude among aspiring entrepreneurs.

In its place, most new entrepreneurs build minimally viable products (MVP), test them with real customers, receive feedback, adapt and refine, and continually repeat until they find a product that customers like (at a minimum) or ideally, crave.

This new process reduces risk, minimizes cash burn, allows companies to fail early, and allows investors to put their larger investments into only those companies that look like potentially big winners.

However, it also puts a very heavy emphasis on the product – an emphasis that can result in distracting startups away from other essential activities that when initiated at the start of a business can help to identify and reduce other risks just as enormous.

The Biggest Risks

Those risks will vary from company to company and industry to industry, but some risks are common to all startups:

  1. Will customers crave your product?
  2. What will customers pay for your product?
  3. Are their sufficient numbers of customers?
  4. How will you make customers aware of your product?
  5. What will it cost to produce your product?
  6. What will it cost to run your company?
  7. How much cash do you need?

So how does a startup manage these risks from their inception and consistently?

Reducing Those Risks

The popular iterative process described in the second paragraph of this article addresses risk #1 very well. If pricing experiments are included, it can also address risk #2.

Addressing risk #3 requires some level of market and industry research. I’m not suggesting a major effort here, but I am suggesting that you spend at least some time understanding market segmentation, the competition and which segments each competitor aims for. Make sure you include substitute (indirect) competitors.

Failure to address risk #4 early is perhaps the most common mistake of newbie tech entrepreneurs. Often, they’ll think “once we figure out what the product is, then we’ll figure out how to sell it.” This is just a few steps away from “make it and they will come.”

Another common attitude among newbie tech entrepreneurs is “oh, the internet will take care of sales.” The fact is making sales takes work for 99% of companies. Internet sales are not easy! And margins when selling through Amazon are close to nil.

Iterate on your sales model just like you iterate on product features. Start with an initial proposal (based on serious thought!). Then iterate as you learn more. Some of your basic options include inside sales force, outside direct sales force, sales channels/distributors (e.g., Amazon), and internet sales from your own website along with a major SEO effort. Each choice has major impact on your costs and thus your viability as a company.

The easiest way to address risks #5-#7 is to create a quick financial model.

  1. First, make a list of all your business assumptions; this is a good idea to keep you organized in your experiments anyway; after all, it is these very assumptions that serve as the hypotheses that you are testing in your lean startup experiments.
  2. Use a tool to automatically transform the assumptions into pro forma financial statements. These financial statements will then tell you (a) when you will be profitable, (b) when you will break even, (c) how much cash you will need, and (d) what your company’s valuation will be based on industry averages, and (e) what kind of return your investors are likely to receive.

The actual process of entering data for business assumptions should take you no more than 30 minutes. But the real value of using a tool that requires you to write down your business assumptions is the thinking that it inspires you to do. For example, for manufactured products, it asks you questions about what you assume the cost of raw materials will be; for software products, it asks you questions about how many customer support people you plan to hire, and so on.

Remember, these are just assumptions, so you can launch your company with your eyes wide open. You don’t want to start a company that you know will be unprofitable from the start.

I am not advocating for a full business plan. On the other hand, I do not believe that just having the right product is a sufficient first step. Instead you need (from the start!) to be engaged in at least four simultaneous risk-reduction activities:

  1. Building an MVP and then iterating it until customers crave it
  2. Studying the market, segmentation, and competition
  3. Assuming a sales model and iterating as more is learned
  4. Building a financial model based on assumptions and iterating as more is learned

Here are some examples of why just getting the right product is not good enough:

Why the “Right Product” is Not Sufficient: Example 1

Let’s start with a hypothetical case. You have created a product that provides a special nutritional source for pregnant women in Niger, to help reduce the country’s 14% rate of maternal death during childbirth.

You can run a series of experiments to determine if the product is palatable and refine it if necessary. You can also run a series of experiments to determine its efficacy on reducing deaths.

However, the biggest hurdles are not the product’s features. The biggest hurdles are logistics, costs, prices, and everything else that makes up the business.

Why the “Right Product” is Not Sufficient: Example 2

Turning to a simpler example, suppose you are building an app. You can tweak it based on myriad experiments until you have the product that customers love. But if customers expect to download the app for free, you have no business.

 

Why the “Right Product” is Not Sufficient: Example 3

Let’s look at another example, this time from a real company: This company planned to manufacture industrial lubricants with very unique properties and capture a large percentage of the market by (a) marketing unique differentiators that were the result of unique raw materials that were “green,” and (b) price the products well below competition.

That sounded like a great value proposition for all stakeholders. However, a careful early financial analysis revealed that the green raw materials drove the cost of goods sold up to around 85% of the planned price. This left just a 15% gross margin, far too low to support infrastructure costs. A financial analysis at the beginning revealed that this company was a non-starter.

Why the “Right Product” is Not Sufficient: Example 4

Let’s look at one final example, another real company: Adapta Medical. Founded by Dr. Glen House, and based on his numerous patents, Adapta iterated on and perfected an intermittent urinary catheter that an individual with limited dexterity (e.g., a C6-C7 quadriplegic) could use to self-catheterize.

From the beginning, Dr. House experimented with product designs, customer satisfaction experiments, multiple manufacturing sources, and financial models, simultaneously. The tasks that took the longest time and consumed the most energy were working out the manufacturing and cost models. Fortunately for him, he started on these from the beginning, so after about a year product iteration (to arrive at the first commercially viable product), he only had another two or so years to work out the manufacturing and cost model glitches.

Now that he is in production, he continues to perfect the product, iterate on the financials, hone the costs, and adapt the manufacturing processes. Learn more about Adapta at www.adaptamedical.com.

Summary

These days, everybody thinks they can launch a new company. The popular process of “iterate the product until customers like it” provides necessary but not sufficient assistance to the naïve first-time entrepreneur. At a minimum, an entrepreneur must start with these four activities to mitigate the risks of starting a business:

  1. Building an MVP and then iterating it until customers crave it
  2. Studying the market, segmentation, and competition
  3. Assuming a sales model and iterating as more is learned
  4. Building a financial model based on assumptions and iterating as more is learned

Start doing all of them at the beginning; don’t do them sequentially.

About the Author

Alan DavisDr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books. He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money? If you’d like a tool that transforms business assumptions directly into pro forma financial statements, check out www.offtoa.com.

 

 

Starting Line Photo Credit: “Female Track Athletes at Starting Line” by Tableatny (Creative Commons)

Risk Photo Credit: “Los Angeles Graffiti Art” by A Syn (Creative Commons)

Niger Flag Photo Credit: “Niger Flag” by Philippe Verdy (Wikimedia Commons)

Not for Sale Photo Credit: “Onis Not for Sale Sign” by Noblestrawberry (Creative Commons)

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Startups and Ethics

We have all read about high-profile unethical happenings at companies like Enron, Tyco and WorldCom, but unethical people exist at all levels and in companies both large and small.

To avoid having to deal with ethics in your startup, be observant for the following characters who can pop up anywhere.

The Over-Promiser

Many of us have experienced overzealous salespeople promising customers features that are only being considered for implementation by the company. Some salespeople do this as a means to pressure the R&D team to raise the priority of some features that the salesperson considers to be high priority.

The salesperson thinks that, “We must build feature x into the next release; I have already promised it to customer y,” will be a convincing argument.

In one startup company in which I was president, the VP of Sales took this approach to an extreme. We had 2-3 features still in the conceptual stage, all of which required negotiations and signed partnership agreements with third parties. The VP of Sales did not just promise that we would offer those features in the future; in order to get their sales, he lied and told them that we offered those features today.

Not only did he create mistrust internally, potential customers quickly realized that promises were being made that couldn’t be kept.  There’s no way to restore that loss of trust.

After my repeated warnings, he continued his behavior, and we soon “parted ways.”

The Desperate Salesperson

In another startup, we had a team of three salespeople, all on base salary plus commission. They were an inside salesforce making outgoing phone calls to targeted customers.

All of us were in cubicles so we could hear each other’s phone calls fairly easily. One salesman, let’s call him The Desperate Saleperson, was pacing the halls while talking on his phone with a prospective client. I was able to discern quite easily that he was talking to a female executive (I later learned she was a CEO of a $5-$10M company).

She was not buying his usual sales messages, so he asked her out to dinner. Now, there are a few ways he could have asked her out to dinner, and this was definitely not the appropriate way. She turned him down and hung up on him. Then I heard him ordering flowers to be delivered to her office. Arggh.

Professionalism, ethics, and integrity will survive long after sales are won and lost.  When colleagues are willing to compromise their values the outcome not only reflects on them, it reflects on you and your startup. Value and reward integrity above all else.

He was fired the next day.

The Customer Without Integrity (CWI)

I joined my first startup in 1984 and was responsible for the company’s services division. I had worked for 5 months to secure a $500,000 subcontract with a large government contractor to perform configuration management services. Our purpose was to:

  • Be the “keeper” of the official software baseline.
  • Be the “keeper” of the complete list of outstanding bugs and enhancement requests and ensure that the list was consistent with the current software baseline.
  • Ensure that each new proposed baseline was thoroughly tested for correctness relative to any bugs or enhancement requests that it was supposed to address before accepting it.

I had hired a staff of three to work on the contract but not yet hired the project manager, so I was filling that role temporarily. After a few months, the project manager for our client, let’s call him CWI, came to my office and handed me a large magnetic tape.

He said, “here’s the new baseline.” I asked, “which of the 1,200 outstanding bugs does it fix?”

CWI responded, “I have no idea. Nor does the development team. Just take this and make it the new baseline.” I explained that if I did that, we would no longer have any idea which of the 1,200 bugs still existed in the product and which were fixed. I explained that by accepting the new baseline without a trace to the associated bugs violated the basic principles of configuration management.

His answer was, “We have a meeting with our Navy customer tomorrow. And we promised we would have the new baseline approved. If you don’t accept this baseline, we will miss the deadline and we will be in default.”

I had worked very hard to obtain this contract, and losing it would be a major blow to our startup company, especially my division. But to follow CWI’s command meant violating the very purpose for our subcontract. And from a larger perspective, I was also helping my customer swindle the Navy. I just couldn’t do it.

I suspect that my raise, bonus, and stock options that year were less than I would have liked, but at least I was able to sleep at night. No revenue is worth loss of your personal integrity.

The Grade Changer

A few years later I was teaching a monthly course at a US Army base. Each class consisted of about 35 Army officers, mostly captains and majors, with an occasional 1st lieutenant and an occasional lieutenant colonel or colonel.

Each class also included 4-5 “allied officers.” These were guest officers from all branches from countries that were not (at least in my opinion) our most obvious allies, but were mostly from developing nations whom we seemed to be courting to become better allies of the USA.

During my first month of training as an instructor, the officer in charge of the school, let’s call him Colonel Potter (not his real name), explained to me that I may not give a grade lower than a “B” to any of the allied officers. I asked why not.

Colonel Potter told us that a few years ago, an instructor at this school had given a “D” to one of the allied officers, and when that officer returned to his country, he was executed for disgracing his country!

I understood and consented. In retrospect, some may consider such a practice to be unethical, but the policy did not (and still does not) stir up the unethical bits from the bottom of my soup pot.

The Contract Violator

I was teaching a course on entrepreneurship in Jos, Nigeria, a few years ago and we were discussing the fact that in the USA, founders usually must provide personal collateral if they want to obtain a loan. This led to a discussion of “terms and conditions” and “contracts.”

One of the students then asked, “Here in Nigeria, we have no civil courts to enforce violations of contracts. So contracts have no meaning here. What do you recommend we do?”

My response was heavily influenced by a lesson taught to me many years ago by Ben Sparks, attorney at law (if I misquoted you, Ben, it is entirely my fault!): “Contracts should be signed only by people who completely trust each other at the time of signing. And contracts are used as the basis of lawsuits only when that trust is no longer present.”

My recommendation to my Nigerian student was very simple: “only do business with people who you trust entirely.” When trust doesn’t exist in the beginning of a relationship, it definitely won’t exist at the end.

The One-Sided Boss

This story took place in a small company that had been around for 20 years, but it certainly could have occurred in a startup.

The owner of the company wanted to retire and decided to sell it to two of the employees. One of them decided to have one-on-one meetings with each of their former colleagues, who now have become their employees (not a bad idea!).

During one of those meetings, an employee remarked that she might have a difficult time working for his peer because he did not respect her. The new leader’s response was, “He’s the boss. He doesn’t need to respect you. You just need to respect him.”

Respect has to be built and earned over time.  When it doesn’t exist, or worse when it has been eroded, a great deal of honest work must be done to repair it. And above all, respect is always a two-way street.

Summary

If you recognize these people, don’t let them infiltrate your startup.  Only partner with those you trust and who have the qualities you need to make your business successful.

Please write your comments about these stories. Which have you seen yourself? Which are the most common? Which are the worst? Do you have you own stories of unethical people in your startups? Write about them in your comments.

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About the Author

Alan DavisDr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money? If you’d like to verify that your great business idea makes financial sense, sign up for www.offtoa.com.

Botswana Truck

Are YOU a Good Risk to be an Entrepreneur?

During the past 30 years, hundreds of people have asked me, “I’ve got this great idea for a product. All I need is funding. Will you help me?”

As I search through online forums, I see similar pleas over and over again, “I have this great idea for a new app. Will you help me build it?”

Kickstarter and similar venues are full of great ideas that need money.

Let’s assume that you have a great idea. Will adding money be sufficient to create success? Or are there other ingredients that make a business successful? The answer of course is that building a profitable business requires more than a great idea and money!

It includes attributes of the market, the industry, your background and skills, and the rest of the team’s background and skills, to name just a few. But let’s focus right now on just YOU.

Are you a good risk as an entrepreneur? Do you have what it takes? Should others have the confidence in you to bet their money on you and your company? Here is a list of qualities that experienced investors will be looking for from you.

1. Are you 100% committed?

Assuming that you are looking for others to invest their money in your business, they need assurance that you are completely committed. After all, when things get tough (and they will), you should not find it easy or comfortable to simply walk away from the business.

To demonstrate commitment, you need to show you have some kind of skin in the game. This can be done in many ways. For example, quitting your day job. Taking out a second mortgage on your home. Putting your retirement savings into the venture. Using personal credit card debt to partially fund the company. Working 60 hours a week for the new company while working your day job.  All of these demonstrate commitment.

If you don’t show commitment, you don’t have what it takes, and you should not be surprised if others see you as a poor risk.

2. Do you surround yourself with excellence?

Startups require an enormous breadth of skills. As an entrepreneur, you need to be confident enough in yourself to bring on board your team the absolutely very best talent that compliments your skill set. You do not have all the skills necessary to run a company by yourself. Nobody does. Whatever talent you are lacking (e.g., law, accounting, sales, marketing, engineering, product development), you need to hire the absolutely very best!

If you are afraid that hiring somebody “better than you” will somehow erode your position, you probably don’t understand the role of a corporate founder. If you are afraid to hire the best, don’t expect others to invest in you. You don’t have what it takes.

3. Are all the requisite skills covered?

In the previous section, I talked about the fact that no single individual can possibly have all the requisite skills to run every aspect of a company. So what are these requisite skills? Among others, they include:

  • Product development
  • Sales
  • Marketing
  • Accounting
  • Finance
  • Law
  • Leadership
  • Manufacturing
  • Quality control
  • Operations

And each of the above has multiple dimensions that sometimes require multiple individuals (unless you are fortunate to find individuals whose skill sets span the dimensions). For example, within marketing, there is SEO, website development, marcomm creation, lead acquisition, branding, and so on.

Of course, some of these areas are easily outsourced (e.g., law and accounting). And others can easily be deferred until the company grows.

If you are going after serious investor funding (e.g., from angels or VCs), you will need to have all these areas covered, or at least make it clear that you understand that you will need to quickly fill any vacant positions.

4. Have you or your team “been there before?”

Experience running a startup arms you in a way that cannot be replicated by books, mentorship, and research.  These are important too but experience is the best teacher. Regardless of whether that company was ultimately successful and not, certain patterns repeat themselves in every company. Investors do not like seeing their money squandered while first-time entrepreneurs learn lessons.

If you are a first-time entrepreneur, you might think that you have no chance to secure funding. That is not at all true. The solution is to build your team and make sure the team includes individuals who have been there before. Consider “having been there before” as just one of the many diverse set of skills one needs on the team.

Personally, I served key roles in two startups. First I was a non-founding, vice president for a company that eventually had an IPO. Second I was a founding member of the board of directors for a company that was acquired by a publicly traded company. By the time I launched a startup as the CEO, I clearly had “been there before” even though I had not personally been the founder or CEO of either of the two earlier companies.

5. Are you a proven leader?

You may be the perfect founder for a company, but may have none of the skills required of a leader. In such a case, you might want to serve as the chief technical officer (CTO) for the company and allow somebody else to run the company.

You will still be a significant shareholder, but the company will be more attractive to investors and you’ll end up with a smaller piece of much larger pie than a large piece of a very small pie.

6. Are you motivated by the right things?

Outside investors (as well as potential colleagues) are going to be assessing what motivates you to start a company. It has to be for the right reason. Or at least it must be for a reason that is compatible with the investors.

Some of the likely wrong reasons to start a company are power and ego gratification. A good reason to start a company is a sincere desire to satisfy a customer problem. Wealth creation might be okay if it is not the only reason, and it isn’t just for yourself.

I remember asking the founder of my first startup company what his goals were; he responded, “I plan to become very rich, and I hope as many people as possible become very rich along with me as we endeavor to solve the problems that the customers have” I like that!

Summary

Many aspiring entrepreneurs who lack funding blame investors (or lack thereof) for their failure. In many cases, however, these individuals have at least two options:

  1. They can improve their chances of funding by changing their own skills, attributes, and attitudes.
  2. They can figure out how to bootstrap their businesses. By doing this they expend their energies slowly growing their businesses instead of complaining about the lack of funding.

If you have what it takes to be an entrepreneur, the next step is to create your pro forma financial statements. If you want to learn how to generate pro forma financial statements automatically from your business assumptions, check out www.offtoa.com.

About the Author

Alan DavisDr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., a SaaS company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money? If you’d like to verify that your great business idea makes financial sense, sign up for www.offtoa.com.

 

Seven Signs your Startup will Succeed

Banded Snake Eagle, Ubuntu, TanzaniaMatthew Toren wrote a terrific article 7 Myths About Starting a Business That I Used to Believe. In it he debunks 7 myths about startups that could otherwise easily deter those with a great idea that don’t know any better. With these myths debunked, let’s talk about the seven signs that indicate your startup will be among the 50% that survive 5 years.

1. You Know Your Competition

Key to a product being successful in the market is that customers see it as a better solution to their pain than alternatives offered by the competition.

Better can be mean lower priced, or more convenient, faster, cleaner, greener, more exclusive, more reliable, and so on. These qualities are called differentiators.

I use the word competition here in the broadest possible sense, including companies that are directly competing with you (e.g., Avis if you are Hertz), companies that are indirectly competing with your company (e.g., bus companies if you are a rental car company), and the status quo (e.g., people who are not traveling because of the lack of transportation options).

2. You Know Your Financials

Lean is the only way to start most companies today, but prudent does not mean blind. Responsible lean companies document all their business assumption so they can run experiments to validate those assumptions and incrementally lower risk. Those same documented assumptions are also sufficient to create pro forma financial statements.

Those financial statements enable you to determine whether the company could succeed if the assumptions prove to be true.

3. You Have Room for Error

Pilots always have enough fuel to return to an airport, and always use a runway longer than is required for their aircraft type. Having room to navigate the unexpected is also crucial for startups because inevitably one, some or even all of these things will happen:

  • Fewer visitors will come to your website
  • Customer acquisition cost will be higher than planned
  • Revenues will be lower than expected
  • Customers won’t pay on time
  • Materials, raw goods, and services will cost more than budgeted

4. Your Sales Are Planned Bottom Up

If you guess at your projected revenues, you are not setting up your startup for success. Instead, determine how you are going to sell. For example:

  • Are you going to drive traffic to your website and then convert x% of the visitors to paying customers?
  • Are you going to make x outgoing sales calls per day, and convert y% of them to paying customers?

See the article, 5 Steps to Get & Keep Your Startup on Track, to learn how to calibrate your revenue projections.

5. Your Experiments Are Planned

After you state your assumptions, run experiments to validate (or refute) them. Either way, you are making progress. Knowledge is always better than guesswork.

For example, run advertisements and perform SEO and see how many actual visitors you can drive to your website. Run A/B tests on various pricing models to see what price attracts customers.

6. You Have an External Board

If you put your co-founders and/or your officers on your board of directors, you will receive zero benefit from them; after all, you’ll hear the same things from them in the board room that you hear every other day.

Instead, fill your board seats with experienced individuals who (a) can offer you different opinions, (b) can bring skills that your current team does not have, (c) are not afraid to question the decisions you are making, and (d) can serve as a totally independent sounding board for you.

This is what a board of directors can do for you. And then compensate them with stock options.

7. You Are Sharing Ownership

Jerry Kaplan said it best: “Equity is like sh*t. If you pile it up, it just smells bad. But if you spread it around, lots of wonderful things grow.” Incent those who contribute to the success of your startup with stock options (or reverse vesting stock), and the company is more likely to grow and prosper. There is little downside, and lots of upside. See You are Not Your Company for more details on this subject.

Summary

Starting a company has inherent risks. But some risks are easy to reduce by planning, validating, refining, pivoting and then doing it all again!

I recently visited JoJo, a young woman in Kigali, Rwanda who started a Jibu water franchise. During my hour-long visit with her, I asked her a dozen or so questions. I was impressed by the fact that although she had little formal business education, she had tons of business common sense, understood what her biggest risks were, knew how to reduce those risks, and understood which levers influenced the success of her franchise.

I have no doubt that she will be one of the long-term survivors. JoJo knows how to make a startup succeed! In her case, she knows her competition, knows her financials, has room for error, knows exactly how she is going to sell water, and is constantly running marketing experiments. Although she does not have an external board of directors, she has surrounded herself with individuals with lots of experience.

If you want to learn how to generate pro forma financial statements automatically from your lean business assumptions, check out www.offtoa.com.

About the Author:

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

If you’d like to learn if your great business idea will make money, take a look atWill Your New Start Up Make Money? If you’d like to verify that your great business idea makes financial sense, sign up for www.offtoa.com.

Do Founder Investments Dilute Earlier Investors?

ScalesAs president of Offtoa, a company committed to assisting entrepreneurs succeed, I am often asked by first-time entrepreneurs if their “investments” after founding dilute the ownership stakes of their earlier investors. The answer is always “it depends.”

Specifically, it depends on the type of legal entity that the company is; it depends on the terms laid out in the articles for the company; and it depends on what the founder means by an “investment.”

I’d like to explain the various implications of a founder “investing” money in a company subsequent to its creation and acceptance of earlier investments.

First of all, let me explain how the question is usually posed:

The Starting Conditions

“When I started the company a few years ago, I invested $20,000 and owned 100% of the company. Later, two outside investors made cash investments and purchased 10% and 20% of the company, respectively. Now I want to make another investment of $20,000. Will that dilute the ownership positions of the two outside investors?”

The Answer if your Startup is a Corporation:

If your startup is a corporation, then the outside investors did not purchase a percentage ownership stake; instead they purchased a number of shares.

Investment. If you are purchasing additional shares with your new $20,000 investment, these shares always come from the company’s treasury. Thus, the total number of outstanding shares will increase, and the percentage ownership represented by the outside investors’ fixed number of shares will indeed decrease. So, yes, they will be diluted.

Loan. If you are just lending the company $20,000, then this has no effect on the number of outstanding shares, and outside investors will not be diluted. You become a creditor of the company. The company will need to repay you according to the terms of the promissory note, and in the case of company closure, creditors will be paid before shareholders.

Convertible Loan. It is common practice for insiders who lend the company money to convert those notes into equity if a major investment round occurs in the future. That is, the note is retired, and the outstanding principal including accumulated interest becomes part of the next investment round.

The Answer if your Startup is a Partnership:

Capital Account. Typically, if you invest cash in a partnership, it has no effect on ownership distribution; instead, it is recorded in your capital account and in the case of a liquidity event or other cash distribution from the partnership to the partners, you would be eligible to receive that amount from your capital account.

However, because partnerships allow for “special allocations,” both allocation of profit and loss to a capital account and subsequent distributions is negotiable. So, no, the “outside investors” (i.e., partners) will not be diluted.

Increasing Your Stake. Notice that if you did want your investment to dilute the partners, you would pay the other partners to acquire their positions. This would not provide cash to the company to help its operations.

Loan. If you are just lending the company $20,000, then this has no effect on your capital account or ownership distribution. You simply become a creditor of the company. The company will need to repay you according to the terms of the promissory note, and in the case of company closure, creditors will be paid before partners.

The Answer if your Startup is an LLC:

Because most LLCs are treated as partnerships for tax purposes, the manner of priority, allocations, and distributions are negotiable. However, here is how they typically work.

When you as a founding member invest additional capital in the LLC, it could be treated in either of two ways, based on the LLC’s articles of organization:

  1. Capital Account. Like in the case of a partnership, it is recorded in your capital account and in the case of a liquidity event or other cash distribution from the LLC to the members, you would be eligible to receive that amount from your capital account. So, no, the “outside investors” (i.e., members) will not be diluted.
  2. Like in the case of a corporation, the cash could be used to add to your ownership interest, diluting other members (in this case, the “outside investors”), with their approval.

Increasing Your Stake. As in the case of a partnership, most LLCs also allow you to pay other members to acquire their positions. This would not provide cash to the LLC to help its operations.

Loan. If you are just lending the company $20,000, then this has no effect on your capital account or ownership distribution. You simply become a creditor of the LLC. The company will need to repay you according to the terms of the promissory note, and in the case of company closure, creditors will be paid before members.

Summary:

It is extremely common for founders to want to make additional infusions of capital into companies after starting. But notice that the implications of making such an investment are non-trivial. This is one of the many reasons why almost all startup mentors recommend that first-time entrepreneurs consult with an attorney experienced with entrepreneurial matters prior to creating their companies.

The type of legal entity that you decide upon and the terms you include in your incorporation/organization/partnership agreement will have significant effects on many aspects of your business. The above example of re-investing in the company is just one small example.

Please note that I am neither a CPA not an attorney. If you want to understand how investing in your company will affect your earlier investors, please consult with your CPA or attorney.

ABOUT THE AUTHOR:

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.
Photograph of Cover

If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money? If you’d like to verify that your great business idea makes financial sense, sign up for www.offtoa.com,.

7 Steps to Calibrating Your Startup Growth

640px-Mahr_Micromar_40A_0-25mm_MicrometerWhen you start a company you naturally have two immediate and equally pressing priorities.  Those priorities are to solve a problem for customers and to validate that you can make money solving that problem.

To validate that you can make money and to understand when you’ll make it, you need to build a pro forma income statement. A pro forma income statement shows how much revenue you expect to receive from the sale of your product and what expenses you expect to incur over your first few years of doing business.

Three basic approaches exist to predict startup revenues:

  • You can just guess. But beware!  Nobody will believe the numbers.
  • You can estimate that you will achieve some percentage penetration of the total available market. Sadly, nobody will believe these numbers either.
  • You can determine which processes you will use to achieve sales, estimate how efficient those processes will be, and then derive how much revenue you will achieve based on those assumptions.

This article explains how to do startup revenue estimation using the third approach. It involves the calibration of seven key variables.  You’ll start with the initial estimation of the seven key variables and then refine them as you learn actual values.

The Seven Key Variables:

  1. Customer Acquisition Cost (CAC): For those new customers that you attract as the result of your marketing activities, how much does it cost you per customer? This is one of the most difficult to estimate. You will start with just a guesstimate based on the (very) few published data from other companies in industries similar to yours and using sales techniques similar to yours.
  2. Sales Cycle (SC): How many months transpire between your expenditure of marketing dollars and the acquisition of new customers? This will also be just a guesstimate based on your past experience.
  3. Average Order Size (AOS): How much revenue do you expect to generate each time a customer makes a purchase? You should have a pretty good idea of what you want to achieve here based on your product, pricing, and business model.
  4. Periodicity (P): How often will each customer make a purchase? You should have a pretty good idea of what you want to achieve here based on your product, pricing, and business model.
  5. Retention Rate (RR): What percent of existing customers will remain customers at the end of each year?
  6. Viral Coefficient (VC): How many people will each existing customer attract and successfully convert into new customers? This is a one-time conversion; once a customer refers this many new customers, we assume they no longer refer more new customers. Very few companies achieve a VC as high as 1.0.
  7. Viral Cycle Length (VCL): How many days will transpire between customers becoming new customers and their referrals becoming new customers?

Before you launch your company, verify that the estimates you’ve made for the 7 key growth drivers could result in a successful company. That is, there must be significant revenues and profit, and solid returns for all shareholders to be considered successful. If not, realistically adjust the values until the company shows returns. But don’t just change the values to make the company look like it will be successful; the new values must be achievable!

Refine the Seven Key Variables:

After launch, every month, compare your actuals to your planned values for the 7 key growth drivers. Enter actual values for CAC, SC, AOS, P, RR, VC, and VCL into your plan. It might be helpful to graph each one. You will likely find that

  1. CAC and SC will start off quite large and will only converge to stable (and lower) values after you learn how to find your target market and how to optimize your messaging.
  2. You will not be able to ascertain actual values for RR, VC or VCL until after a year or so.

Verify that the actual values for these 7 key growth drivers still result in a successful company – i.e., significant revenues and profits, and solid returns for all shareholders. If so, you are on track! If not, you need to pivot.

How to Change Actual Values for the Seven Key Variables:

  • To decrease CAC and SC: Improve your understanding of the target market. Hone your advertisements to the specific pains of your target markets. Focus on benefits rather than features of your products. Offer better pricing or better promotions to increase close rates.
  • To increase AOS: Offer quantity discounts. Improve your product.
  • To increase P: Offer frequent buyer programs. Improve your product.
  • To increase RR: Improve your product’s stickiness.
  • To increase VC and decrease VCL: Offer referral programs, especially ones that incent both referrer and new customer. Make products so exciting that they create a buzz. Add features that increase your product’s value to customers.

Summary:

As you can see, these seven key variables are fundamental to understanding your startup’s revenue. They are not easy to estimate, but you can at least determine during the planning stage what values you must achieve to be a viable company.

ABOUT THE AUTHOR:

Alan DavisDr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.
Photograph of CoverIf you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money? If you’d like to verify that your great business idea makes financial sense, sign up for www.offtoa.com.

Startups: When Will You Be Profitable?

When Profitable PhotoAs the founder of a startup company, you should be able to determine when you will be profitable. But how can you do that before you even start?

The answer is you need to make some assumptions. In fact, you need to make many assumptions. It is very important to record all these assumptions because during the first few months of your company, you will have to create experiments that validate whether or not these assumptions are true.

So the first step in determining when you will be profitable is recording all your assumptions. See my earlier blog, What Assumptions Does an Entrepreneur Make, for a sample list of such assumptions.

The second step is to create a pro forma income statement based on those assumptions. If you are not familiar with what an income statement is, see my earlier blog, Seven Things an Income Statement Tells You.

The third and last step is to examine the row of the income statement labeled EBITDA (Earnings before Interest, Tax, Depreciation, and Amortization) from left to right looking for the first entry that is positive. If that entry is in the second column, then the answer is you will be profitable in the second year of your business. If it is in the third column, then the third year, and so on.

Most startups are not profitable in their first year. This is because of high starting expenses, as well as the inevitable high cost of goods sold associated with low volume sales. So, if your assumptions show you as profitable in year #1, you may want to rethink your assumptions. And if you are seeking investment capital, I can assure you that investors will look more favorably upon your enterprise if you show realistic numbers, not overly optimistic ones.

 

ABOUT THE AUTHOR:

Alan DavisDr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.
Photograph of CoverIf you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money? If you’d like to verify that your great business idea makes financial sense (and also as a tool to transform your assumptions into financial statements), sign up for www.offtoa.com.

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Five Fatal Flaws in Financials

One of the first and most important steps to take before you launch your startup company is to create pro forma financial statements to verify that your company makes financial sense if all the assumptions that you are making end up becoming true.

The three pro forma financial statements we will be referring to are the income statement, cash flow statement, and the balance sheet.

Three types of “financial sense” can be derived from the above financial statements:

  • Fatal flaws: These are conditions in your financial statements that indicate that the company cannot survive. These are the subjects of this blog.
  • Universal non-investible flaws: These are conditions in your financial statements that make it highly unlikely that any right-minded investor would consider investing in your endeavor. The presence of universal non-investible flaws implies that the company could survive but will not produce extremely good financial returns.
  • Situation-specific flaws: These are conditions in your financial statements that may or may not preclude good financial returns, depending on the specific industry or unique situation.

Fatal Flaw 1. Negative Cash

The bottom line of every column of the monthly cash flow statement is always labeled “Cash at End of Period.” It tells you (based on all the assumptions you have made about your company) how much cash you will have in your company’s bank account at the end of every month.

No entry in this row can be negative.

If some column has a negative value in this row, you must do something to your assumptions prior to this month, for example (these are just four of dozens of possibilities),

  • Get a loan
  • Raise money in an investment round
  • Sell more product
  • Spend less money (on expenses)

What you cannot do is just launch the company and hope that things will work out. Hope is not a strategy. The fact is many things will change once you launch, but you have to at least start with a plan that has a fighting chance of working.

Fatal Flaw 2: Negative Gross Profit

Near the top of every column of the annual income statement will be lines for

Revenues
– Cost of goods sold      
Gross profit

Gross margins indicate how efficient the company is at acquiring and using raw mate­rials for its products. Different industries tend to experience radically different gross margins based on (a) inherent cost of goods sold within those industries, and (b) level of price competition.

Your company can tolerate a negative gross profit in its first year while you figure out pricing, find best suppliers, and hone manufacturing and internal processes. However, by year 2, you had better have a positive gross profit.

New companies rarely emerge in industries where gross margins are low. Reasons should be obvious: investors will likely not see a return on their investment based on an ROE calculation.

Here are some ideas on how to increase gross margins:

  • Decrease cost of raw materials. This is the most straightforward method to reduce cost of goods sold, and yet it is the most dangerous because of potential to adversely affect product quality.Some ways are: (a) find alternative suppliers, (b) replace expensive components with less costly substitute components, especially when customers are unlikely to perceive the difference, (c) use less of a raw material in your product, and (d) purchase in larger volumes
  • Outsource, insource, offshore, or onshore. Find the lowest cost source of doing tasks while still maintaining acceptable levels of quality.
  • Increase prices.
  • Change the product. If your product cannot be sold profitably, consider selling a simpler product that solves fewer customer problems and price it lower. Or consider selling a larger product that addresses more customer pains and price it higher. Or maybe you should rent or lease the product instead of selling it?

Fatal Flaw 3: Insufficient Cash from Operations

The top third of the annual cash flow statement captures cash flows in or out of the company that result from the core business of the company. The bottom line of every column of this top third is always labeled “Net Cash Provided (Used) by Operating Activities.” It tells you (based on all the assumptions you have made about your company) how much cash the company’s business is generating without the contributions of loans, investments, or sales of property.

Almost all startups experience negative cash from operations for the first few years. During this time, they rely on infusions of cash from external sources such as investments or loans.

However, a successful company must at some point be self-sufficient; it must be able to sustain itself with being on life support.

It is possible that a high-growth company with a huge market could plan to stay on a high-growth trajectory for many years and continue to need capital infusions to fund its growth. So, I guess the best way to describe this fatal flaw is to ask if the cash from operations would be positive if the cash from financing were set to zero.

Fatal Flaw 4: Current Ratio Less than One

On the annual balance sheet, divide current assets by current liabilities for each year. This current ratio gives you a pretty good indication of whether your company will be in a condition to pay off debt when it becomes due.

A value less than 1.0 indicates that the company is going to have problems, although there could be short-term fixes for short-term problems. As your company evolves, your current ratio should become (and remain) above 1.2.

If your current ratio is less than zero, it means your current assets are negative (current liabilities can never be negative), so this is equivalent to fatal flaw 1.

Fatal Flaw 5: No Profit

Near the bottom of every column of the annual income statement is a row labeled “EBITDA,” short for earnings before interest, taxes, depreciation, and amortization. You can think of it as the company’s profit (without some of the “noise”).

Most startups experience negative EBITDA for the first one or two years, and that is okay. In fact, it is highly unlikely to have positive EBITDA during those first few years.

However, by year three or so, EBITDA should be positive, and stay positive for the remaining years.

Summary

Although many dozens of potential problems can be detected in advance by examining the pro forma financial statements, the above five conditions are easy to detect and are almost always fatal for your company if not fixed. If you find them to be present in your company’s financial statements before you launch, don’t launch! Instead, fix your plan.

After you fix the plan, and know that it is possible to succeed, then launch the company. It is always good to start knowing that failure is not guaranteed.

ABOUT THE AUTHOR:

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money? If you’d like to verify that your great business idea makes financial sense, sign up for www.offtoa.com.