Category Archives: Business Strategy

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Seven Steps to Starting a Startup

Step 1. Do Some Homework

If you try to know everything about your industry and market before you start your company, you will never launch it. Instead, learn the most important aspects of the market and the competitors.

Start with the great checklist of things you should try and learn about your market and industry from Mullins’s book, The New Business Road Test: What Entrepreneurs and Executives Should Do Before Launching a Lean Start-Up, but concentrate on looking for showstoppers, i.e., reasons why you perhaps should not start the company.

Step 2. State Your Business Idea as a Set of Assumptions

Since you cannot possibly know everything about the market and the industry, record all assumptions you are making about your business. What products will you sell? At what price? How large is your market? How many will you sell each year? How much will it cost you to purchase and/or manufacture the product? How many employees will you need? How much will you pay them? And on and on.

There are dozens of such assumptions. You can find a checklist at What Assumptions Does an Entrepreneur Make?  Many reasons exist to record these assumptions:

  • It forces you to think through every aspect of your business idea. You don’t want to be 6 months into a business and say “Oh, I wish I had thought of that earlier!”
  • The numeric assumptions can drive the creation of all your pro forma financial state­ments, which you will need anyway.
  • You can assign a red flag to each assumption that is not yet confirmed. Remove flags as assumptions are confirmed.
  • Assumptions that are critical to your success and still have red flags become targets for experiments. Build and deploy prototypes, run focus groups, do anything it takes to find out as early as possible if those assumptions are true or not

Step 3. Determine if Your Business Idea is Financially Sound

Pro forma financial statements enable you (and others) to easily assess the expected financial health of a company. As a result, they are extremely useful in assessing the likely outcome of a company if all your assumptions prove to be true.

So the next step is to transform your assumptions into financial statements and confirm that the company makes financial sense. Some of the checks you want to perform are:

  • When is it profitable?
  • How much cash does it need to get started?
  • Does it grow fast enough?
  • When is breakeven?
  • How much of a return do investors make?

Step 4. Refine the Assumptions

If the financial statements fail any of your checks, you need to decide how critical the failure is. For each check, you can change your business assumption, or you may have good reasons to ignore the alleged problem. If so, make sure you fully understand your rationale and can articulate it because investors and other stakeholders will ask you about it.

Step 5. Launch and Run the Business

As you start to run your company, you will discover that some assumptions you made during the planning stage will prove to be false and you will need to make adjustments. If you are smart, you will actually run myriad experiments with your customers to explicitly prove or refute the most crucial assumptions.

Step 6. Change Refuted Assumption and Determine if Your Business Idea is Still Financially Sound

Whenever you determine that a stated assumption is no longer valid, change that assumption based on what you just learned. Next check that the company is still on solid financial ground using the same techniques you used in Step 3.

If so, continue on the current path.

Step 7. Pivot when Necessary

If not, revise other assumptions to compensate for the new reality. Verify that this makes financial sense using the techniques you used in Step 3, and then manage your company in the new direction as defined by the new assumptions. This is called a pivot.

Summary

The odds of success for a startup are very low.  Improve your chances by diligently planning and being ready to adapt when new information emerges.  These 7 steps will help you balance both.

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.

Mouse Trap

Eight Things You Never Say to Investors

When you approach potential investors about investing in your new company, you should avoid certain expressions. They are traps that you either make you look weak, or from which you will have a difficult time extricating yourself. Here are some examples.

1. “I have no competitors”

Everybody has competition, even if they offer a substitute product. A sophisticated investor will be turned off immediately if you imply you have no competition.

Every startup launches because its founder has thought of something new. It is either

  • a new product or service, or
  • a new market for an existing product or service, or
  • a new way to deliver an existing product or service.

But just because you have thought of something new doesn’t mean you have no competition. You provide products and services as solutions to customers’ problems/needs/pains. Ask yourself, “How do people satisfy their problems/needs/pains currently?” Even if the answer is “They don’t,” then the status quo is competition!

Let’s look at some examples:

  • A new 3rd generation canine cancer-fighting drug. The competition includes: (a) less effective 2nd generation cancer-fighting drug, (b) not treating the dog (could be cost effective), or (c) pain killers for the dog to enhance quality of life.
  • The first online gourmet recipe ingredient store. The competition includes: (a) general on-line merchandisers like Amazon, and (b) storefront sellers of gourmet food.
  • The first allergy clinic franchise embedded inside of physician offices. The competition includes: (a) standalone allergy clinics, (b) allergists, and (c) physician assistants and nurse practitioners specializing in allergies.
  • The first online bookstore (i.e., Amazon). The competition includes all the brick and mortar bookstores.

Bottom line: just because you are the “first” does not mean you have no competition.

2. “All I need is your money; not your opinions”

Investors, whether angels or venture capitalists, usually consider their business acumen to be of considerable value to their portfolio companies. When you make a statement like this (or imply it through your actions) you will likely alienate the investors sufficiently so they will not invest.

3. “My time is worth as much as your money”

During an investor pitch, investors will often ask “how much money have you raised to date?” They want to know how much cash has been invested in the company so far. All founders devote enormous hours in birthing their companies, but labor hours just don’t count.

Yes, you can and should offer to work for no cash compensation (this could be a factor in encouraging investors to invest), and yes, you can suggest that you will accept options in lieu of such compensation. This is all good.

But don’t go into a monologue explaining how your time is worth $100,000/year, so you have thus far invested $100,000 into the company by working for a year without salary.

4. “I will guarantee you an X% return on your investment”

“Danger! Will Robinson. Danger!” You cannot guarantee anything to your investors. You are selling them securities in return for their payment and the terms of this transaction are spelled out in a written subscription agreement.

When you state that you “guarantee” such a return, you are inviting a class action law suit from investors if such a return is not delivered. Do not do this! And the limited liability of the corporation will likely not protect you as an individual (or your personal assets) from claims by the investors.

5. “This is a risk free investment”

By their very nature, startups are risky. The graph to the left shows the survival rates for startup companies, and emphasizes that the rates have been the same regardless of the year they were started. Notice that only 50% of companies survive for 5 years or more.

But even ignoring the data, making such a statement is foolhardy. You have an obligation (legally and ethically) to potential investors to understand and spell out all the risks involved in investing in your startup.

And your attorneys, when they draft your subscription agreements, will insist on including a clause that spells out the likelihood of total loss of the investment.

6. “All I have to do is build my product and the customers will come”

This is a classic statement made by engineers without any marketing savvy. By saying it, investors will know you are a geek. Only three ways exist to create revenue:

  • You can “buy” a customer. That is, you can spend resources (usually money) to raise awareness of your product, you can pull or push leads to you, and you can spend more resources to convert those leads into customers.
  • You can convince existing customers to buy more, or buy more often, or not stop being your customer.
  • You can encourage existing customers to convert non-customers to become customers.

That’s it! Nowhere in this list is “Build my product and  customers will come.” Creating and growing revenue takes work. Plain and simple. Investors know that. If you don’t know that, you will be seen as naïve, not street smart.

7. “We’re almost out of cash”

The timing of raising capital is always a challenge. If you wait too long (e.g., you get close to running out of cash), less respectable investors could take advantage of your situation by delaying their decision to invest until you are desperate and you may end up being forced to accept less-then-ideal terms.

On the other hand, if you solicit investments too early, company valuations might be lower than you would like, and you may end up having to sell a larger percentage of the company to raise necessary cash. No perfect answer exists, but unless you are about to hit a major valuation-changing milestone, I would err on the side of too-early rather than too-late.

Whatever you do, don’t ever suggest to the investor that you are desperate for cash; that will invite even scrupulous investors to make lower offers. The best advice is manage your company so you are never desperate for cash.

8. “The market is so huge; all we need to do is capture 1/10 of 1% of it.”

This might sound impressive to you, but it doesn’t to the seasoned investor. Investors want to invest in market leaders; they want you to have a large percent of some market. Market leaders lead. Market laggards lag.

Successful startups first focus on penetration of relatively narrow vertical markets; it is called the “rifle shot.” Such an approach enables you to target your desired audience with a marketing campaign designed specifically to their particular pains.

Bragging about a “huge market” and the sufficiency of a tiny capture to “make millions” demonstrates that you don’t understand the dynamics of focusing. It sounds like you are going to take the “shot gun” approach, one that usually results in failure because of overly broad messaging.

In summary

Investors are much better at negotiations than you are; after all, they do it over and over again, and you do it rarely. They have heard all the “lines” before and they can see through BS immediately. They also know how to take advantage of your vulnerabilities if they desire to.

I have a few other cautionary bits of advice. They don’t fit into the category of “never say these,” but they are close:

  • “It will be easy to steal customers from competitors because they provide such terrible customer service.” Competitors may in fact be providing terrible customer service, but never underestimate the power of inertia. Many customers would rather stick with a known, but poor, service provider than venture into the unknown.
  • “Our key differentiator is a great user interface.” Sorry, but every new startup claims that it will provide the greatest user experience. You might actually plan on doing so, and you might even be able to do so, but because you sound like every other entrepreneur, your claim will be summarily dismissed.

 

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?

“Clippesby drainage pump – overgrown door” © Copyright Evelyn Simak and licensed for reuse under Creative Commons License. Original photo from Geograph Project.

6 Reasons You Should Never Start a Company

Do Not EnterIf you are looking for reasons why you should not start a company, read on!

1. You Could Lose All Your Savings

As a founder, you are investing in your startup. You’re investing your time and your energy; you’re investing yourself. In addition to that, it’s also wise to invest financially in every round if you can. That way when you are raising money and potential investors ask “do you have skin in the game?” you can honestly answer “yes,” and when they ask or “if I say yes, will I be the first investor?” you can honestly answer “no.”

Putting you own money into the company demonstrates commitment. If this requires you to take out a second mortgage or a personal loan, so be it.

If you can’t commit to losing your savings, how can you expect others to put their assets at risk?

2. You Could Lose Other People’s Money

I thought that losing my own money was painful, but that was before I lost other people’s money. Now that’s painful! After all, when investors give you their cash in return for equity in a company you have founded and are leading, they are making a loud and clear statement that they believe in your idea and they believe in you.

Even when you involve your stakeholders and keep shareholders informed of all decisions being made, even when the vast majority of investors bear no hard feelings whatsoever, you spend considerable time looking back at past decisions wondering “what if I had done things differently?”

Bottom line: When you accept other people’s investment dollars, be prepared for the possibility that pain might follow if you fail. That pain might be self-induced, or might come from the investors.

3. You Could Hire the Wrong People

You can’t do it all yourself. You need to hire others to help make the dream come true. If you make the wrong hires, quality will be compromised, too much money will be spent, customer service will go down the tubes, the morale of the “good hires” will suffer, and so on.

4. You Could Lose Control

You like control. After all, the company you are envisioning is “your baby.” You want to control it. When you need to raise cash, you will be telling potential investors how much cash you need and what you plan to do with it. The percent of the company they get for that investment will be up for discussion.

Let’s say you need $500,000. You want to maintain control so you have no intent to sell more than 49% of the company. But the investors value your company at just $800,000. That means if you want their $500,000, you’ll need to sell them 5/8 of the company.

5. You Could Build the Wrong Product

You raise $500,000 from investors and build the “perfect product” for the market. You execute an expensive product launch with a major media presence. And nobody buys the product. The product is a total flop. You either misunderstood the needs of the market, you were too early or too late in the market window, or the competition outsmarted you with an even more impressive product.

6. Your Customer Acquisition Cost Could Be Much Higher than Expected

You did extensive financial planning, and that included modeling the sales process. Only one problem: you think it will cost you $250 to acquire each new customer. What happens if it actually costs you $750 to acquire each one? Now everything in your financial plan falls apart.

In summary

If the above situations scare you, you have an easy way to avoid them: Don’t start a company. Starting a company is not for the pessimist or for the risk-adverse. Nor is starting a company for those who want to get rich quickly and live on a beach.

Starting a company takes courage and optimism.  It requires stubbornness and the ability to rewind and clinically assess mistakes. It tolerates failure but demands success. As crazy as it may sound, if that excites you, you might be about to take your great idea and start your own company!

Let me close by sharing with you three of my favorite quotes:

 “Far better to dare mighty things, to win glorious triumphs, even though checkered by failure, than to rank with those poor spirits who neither enjoy much nor suffer much.  [They] know not victory, nor defeat.”

Theodore Roosevelt

“It is good to have an end to journey toward; but it is the journey that matters, in the end.”

Ursula K. Le Guin

“First, say to yourself what you would be; then do what you have to do.”

Epictetus

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?

Dilemmas of Founders

HartebeestsIf you are considering starting a company, or if you have recently started a company, an essential item for your reading list is Noam Wasserman’s The Founder’s Dilemmas. Based on years of solid research and experience, this book surveys many of the biggest problems facing founders of high growth start-ups. I want to share with you some of the thorniest of those problems here. But please don’t take my word for it. Buy the book for the complete story [No, I don’t get a commission].

1. Career Dilemma

You are currently employed and earn a comfortable salary. You have a great idea for a new start-up. How do you determine what to do?

If you stay with your current job, you maintain the security of a paycheck but likely give up the dream of starting a company, spreading your wings, and perhaps “getting rich.” Most investors will not invest in a startup without the founders/officers demonstrating a significant level of commitment, and that means “quitting your day job.”

If you quit your day job, you have the chance to make it big, but you give up the security of a paycheck. Can you afford to do that? Most start-ups cannot afford to pay the founders a salary for the first few years, so you need to have a significant enough nest egg put away to afford a few years of financial drought.

2. Co-Founders with Complementary Skills

Often entrepreneurs co-found companies with others who have very similar backgrounds as themselves. The advantage of this is you all speak the same language. The problem is that starting a company requires a diverse set of skills: technology, marketing, sales, financial, legal, and so on.

The best teams tend to ones that combine diverse skills and diverse personalities.

3. Title for the Founder

Many individual founders believe that they should lead their companies with a title such as CEO. Derived from Wasserman, the figure on the right shows the starting role that the “idea person” serves in start-ups. Although the initial idea person may be the perfect CEO for the start-up due to commitment and passion, the skills required for leading the company through long-term growth may not be present. Only 75% of founder-CEOs are still in the CEO position by the time of the first external investment round, and only 39% are still in that role by the time of the fourth round.

4. Who is in Charge?

Most start-ups have a single individual who serves as leader; s/he could have any
of a variety of titles; chief executive officer, president, and chief operating officer are typical. This individual reports to the board of directors. If you are considering having nobody in charge, or having two or more co-presidents in charge, think again. Tough times will come. And when those tough times arrive, somebody needs to make the tough decisions. The movie, Startup.com, exposes many start-up problems, not the least of which is what happens to relationships when one of two co-founders thinks they are “co-CEOs.”

5. Liquidation Multiples

When investors purchase preferred stock, they typical ask for (and receive) a liquidation preference, which specifies what multiple of their purchase price they will receive upon a liquidity event prior to general distribution of the remaining funds to all shareholders. I described some of the problems related to liquidation preferences in an earlier blog called Liquidation Preference and Avoiding Dilution.

According to Wasserman, Series A investors in 78% of all start-ups that raised external investments had a liquidation multiple of 1; 9% had a liquidation multiple of 1.1 to 2; 5% had a liquidation multiple of 2.1 to 3; and 8% had a liquidation multiple of greater than 3.

The dilemma is: Do you accept an investment whose terms include high liquidation preferences even though it in effect makes earlier investors’ return nil [and significantly dilutes the founders], or do you turn down the investment hoping for better terms from another investor?

If you accept the terms, you have thrown your earlier investors under the bus. If you refuse the terms, you may be throwing the entire company under the bus. Therein lays the dilemma.

6. External vs. Internal Boards

If you have a board of directors composed of the inner circle, e.g., co-founders and/or fellow officers, you can make decisions with your co-leaders and know they will be endorsed by the board. But now you have no “sounding board.” You have no independent thinkers. You have no checks and balances. The primary reason for a board should be to hear other opinions.

7. Control vs. Wealth

In an earlier blog called You Are Not Your Company, I described the problem founders have of trying to control their companies vs. distributing ownership and creating a much bigger pie to share among more mouths.

8. Compensation

Should officers of the company (and in fact all employees) receive cash compensation equal to what they would receive at a non-start-up company? Should they receive stock options as an incentive to join the company? Should they receive stock options in lieu of cash compensation? What is the right balance among these three?

There is no right answer. However, the decision is affected significantly by the amount of cash the company has (and this is affected by the desire to attract investors and/or the desire to time investments based on company valuation) and the amount of control that the founders demand or are comfortable with sharing.

9. How Long Should Vesting Be

When options are granted or stocks are sold to employees with reverse vesting, how long should the vesting period be?

On one hand, a long vesting period sounds like an incentive for the individual to stay with the company for that long period of time.

On the other hand, a long period of vesting could also cause a frustrated individual to say “I can’t wait that long; I might as well leave now.” The table on the right, from Wasserman, shows how long the vesting period is in start-up companies for founder CEOs vs. non-founder CEOs.

In summary

Starting a company is not for the faint of heart. Fortunately books like Wasserman’s Founder’s Dilemmas exist to guide you through the tough times.

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?

Photo of fighting male hartebeests by Filip Lachowski (Creative Commons)

You are Not Your Company

Some entrepreneurs insist on maintaining 51% ownership of the stock of the company “in order to maintain control.” The best leaders have a minority interest in the companies they lead, listen to all constituencies and make optimal decisions that are in the best interest of all those constituencies. Leaders have no right to ever make a decision that is in the best interest of themselves alone.

The only reason that a person could want such a controlling position would be if s/he would rather not do things that are in the best interests of the whole. A good leader maintains control by building consensus, not by outvoting others.

If your fear of losing a controlling interest in the company lies in the fear of getting fired by the shareholders, think about this. If a majority of shareholders think you are making poor decisions, then perhaps you should be fired.

If you are paranoid that you will not be a good leader, then keep the stock yourself! But don’t expect many investors. And don’t expect loyal employees.

2. How many founders shares should you create

As a general rule, people prefer to purchase large numbers of shares (and people prefer to receive large numbers of stock options). Therefore, although totally arbitrary, I recommend founders start off with, say, 1,000,000 common shares.

3. How many options in the option pool

These are the shares you want to reserve for distribution to employees, consultants, board members, and so on, as stock options.

It is a good idea to establish the option pool size as a function of the founders’ round size, however, there is little agreement on what the relationship should be. I have read many entrepreneurship books that recommend that the option pool size be set at around 25% of the founders’ round size.

In most of my start-ups, I started with a plan to have an equity distribution look like the figure to the right when a liquidity event occurred.

Thus I create my initial option pool equal to around 40% of the size of the founders round size, i.e., 400,000 shares, with the plan to use this as the option budget for the first few years, and then add additional option pools in subsequent years, adding up eventually to 1,000,000 shares.

4. How much of the company to sell to investors

Investors are looking for financial returns, period. Based on the size of the investment, financial projections, and expected exit windows, they will calculate what percent of the company they must acquire today so they can obtain the desired returns upon the likely exit, factoring in all the risk factors.

For example, let’s say you want $1,000,000 in cash, and the investors agree to invest $1,000,000. Based on financial projections, an expected exit window in, say, 4 years, and valuations for similar companies that have been acquired, the investors can estimate that the most likely valuation for your company in 4 years will be, say, $10,000,000.

Assuming that the investors desire a 40% internal rate of return, they will need to see $3,840,000 upon an acquisition. That means they will need to acquire 38.4% of the company today for $1,000,000.

Other factors come into play, such as the company’s current valuation, and the ability for current round pricing to accommodate future round price increases, but the above formula shows the essence of the primary calculation which is based on desired returns, not control.

As a result of the above, the 33% pie piece I planned (at founding time) for the investors may become larger or smaller when the time comes for seeking investments, and I can control this to a limited degree with cash burn rates and by timing of the investment rounds.

5. Does controlling voting stock help

Some founders create multiple classes of stock and give voting rights to only some classes. Then they maintain a majority of the voting shares while distributing a majority of non-voting shares to others. This dual-class share methodology demonstrates the ultimate in paranoia, and shouts “I plan to make decisions that I think are best, and I really don’t care what the rest of you think.” This is legal of course (on Wall Street).

And based on the price of Facebook since its IPO, no shortage of investors exists who are willing to take the risk with their cash even though they have no corresponding say in governance. If you want to know more about this phenomenon, read this great blog by Matt Orsagh.

6. Making decisions

Once your company has been founded and you have decided to take on a job, for example, as CEO, you should consider yourself an employee of the company. Yes, you are an important employee, but you are just an employee. Your task is to make the best decisions on behalf of the company. Some of these decisions may not be optimal for you as an individual, and that is okay! In fact the more decisions you make that are clearly not in your personal best interest, the more respect you are likely to muster from fellow employees.

If you are looking for a script for the first act, try giving up a controlling interest in “your” company!

In summary

You are not your company. Avoid forcing yourself on the company by maintaining “control.” It inhibits the company’s growth and just feeds your own ego. Rather, lead your team and your company toward success and celebrate together.

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?

Four Ways to Validate Your Great Startup Idea

You have a great idea for a start-up company.

Thumb

Validate your idea by answering four simple questions:

  • Is the market right?
  • Is the industry right?
  • Will it make money?
  • Will it need money?

Let’s explore these one at a time.

1. Is the market right?

Determining if the market is right means demonstrating that enough people exist who will purchase the product or solution you have developed, you can find them, and you can turn them into customers. For this you need to understand the size of your market and the characteristics of the buyers that personify your market.

Size of market

How large is your target market? You want your potential market (called the total available market, or TAM) to be quite large. But you want your initial target vertical market to be relatively small. By being focused, you can align your product features and marketing messaging with the unique pains/needs of this unique market.

And then you can claim you “penetrated 25% of your target market” instead of having to claim that you “penetrated .02% of your target market.” Sure sounds better to future investors!

You can measure the size of both your TAM and your initial target vertical market in terms of:

  • Number of customers
  • Dollars spent on products like yours
  • Units sold

Targeting Customers

NeedleHow easily can you find potential customers? Will they find you? Or will you find them? In either case, how? It is very easy to say “oh, we’ll just use Google AdWords and we’ll get tens of thousands of visitors every day.”

It is much harder to actually attract qualified leads. If you plan on finding the leads, how will you reach them and engage with them until they become customers?

Converting Customers

Catheter Solution 2Converting customers is not only influenced by the severity of pain your product is addressing. It is also influenced by how you position your solution and your messaging. Your target market must be able to identify with what pain your product resolves. The three bullets shown above demonstrate how one company, Adapta Medical, has honed their message to align perfectly with their target markets, C6-C7 quadriplegics and hospitals.

I like to use the words “clear and compelling” to describe the right message, i.e., when a lead hears or reads the message, they can relate immediately to the pain they are feeling and see clearly how your product will alleviate that pain.

2. Is the industry right?

If you want to do a thorough analysis of whether the industry is “right,” check out Porter’s Five Forces. But as a start, make sure you have a thorough understanding of your competitors, your potential partners, and your differentiators.

Competition

Few things turn off investors more than hearing entrepreneurs claim that they have no competitors. Every new company has competitors. If you really are the first to do something, then how are your target customers surviving currently? Here are some examples:

  • You’re “first” to provide on-line retail sales of gourmet food. Your indirect competitors include storefront retailers and catalog retailers of gourmet food. And your future competitors include on-line retailers of non-gourmet food (because they have all the logistics in place to add SKUs for gourmet food and thus become direct competitors).
  • You’re first to provide regular helicopter service from Denver to Colorado’s ski resorts. Your competitors include airlines, van shuttle services, rental car companies, and so on, all of which satisfy your target market with this capability using different means.

The way to determine if a company is a competitor is to imagine being a potential customer. If the customer could make a list of companies (including yours) and evaluate the pros and cons of each alternative (including price, convenience, safety, etc.), then those companies are competitors.

Partners

Look upstream and downstream on your supply chain. Who will you need to work with? Have you established those relationships yet? How easily will it be to establish? Can they control you (e.g., with price changes)? Or can you control them?

Differentiators

Think again about that list of competitors that a potential customer could create. What makes you special? Nobody cares about what you think makes you special! What will a potential customer think make you special when compared with the alternatives?

3. Will it make money?

In his February 20 article, Martin Zwilling explained how critical it is for you to use a financial model to determine if your company will be financially successful given the assumptions you currently believe to be true. I couldn’t agree with him more.

After creating such financial models for many dozens of startups, I would add that it takes many precious hours to create and debug such a model.

I would recommend that you use an online tool that has already considered and built in all the elements you must consider to be successful. Such tools allow you to enter your key assumptions one time, and they create your entire financial model. Then when any of your assumptions change, you just have to change one number, and your new financials are instantly created for you.


 

Offtoa Screen1


Martin provides 5 great examples of such “assumption changes” that are typical:

  • What if customers don’t want to pay the price for your product that you though they would?
  • What if the market size ends up being different than you expected?
  • What if your sales growth is different than expected?
  • What if your investors offer you an investment amount different than your expected?
  • What if your customer acquisition cost changes?

In reality, there are hundreds of such assumptions that could change.

4. Will it need money?

Another benefit of assumptions-based financial modeling is the automatic creation of monthly pro forma cash flow statements. You can easily scan the bottom row of these statements to determine exactly how much investment money you will need and when.

In summary

To prepare yourself for investors, you should thoroughly validate your business before you enter the shark tank. This article summarizes the key elements of such a validation. To summarize, here is the checklist:

☐ Is your total available market large enough?

☐ Is your initial target vertical market focused enough?

☐ Is it easy to find leads?

☐ Is it easy to convert leads into customers?

☐ Do you know your competition?

☐ Have you lined up your business partners (suppliers and distributors)?

☐ Are your differentiators unique and compelling?

☐ Will your startup make money?

☐ When your assumptions change, can you instantly see the financial effects?

☐ How much money do you need?

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.

ABOUT OFFTOA

Offtoa is a subscription-based SaaS that leads you, the entrepreneur, through a series of questions and transforms the assumptions you provide into a complete set of pro forma financial statements, including even a capitalization table and expected internal rates of return for the investors. Armed with this intelligence, you and your team are able to demonstrate to investors that you know your finances, understand your market, and have a winning proposition.

If you decide to subscribe to Offtoa because you read this blog, send me an email at adavis@offtoa.com and I’ll email you a coupon good for 50% off your first month’s subscription. This offer good only until May 31, 2015.

Needle in a Haystack photo by James Lumb (Creative Commons).

 

Even Monkeys Fall From Trees

Black-chinned_emperor_tamarin_(S._i._imperator)Saru mo ki kara ichinru . . . Japanese proverb

I was fortunate. The first startup I joined went public.

The second startup I joined was acquired by a publicly traded company in an all-cash deal with a 3x multiple of the investments.

My third startup failed.

Most serial entrepreneurs fail a few times before they succeed. In contrast, I succeeded a few times before I failed. Even monkeys fall from trees.

I’ve spent much effort studying that failure, trying to determine the precise mistakes that were made during the four years of that company’s life. Some of that study has been productive and a great learning experience; resulting in much improved entrepreneurial practices. I’ve been able to apply many of these lessons to startups #4 and #5.

And I must admit some of that study has been totally counter-productive, in effect self-flagellating. The fact is even monkeys fall from trees.

I published an article a few years ago containing a detailed post mortem of the failure (see Davis, A., and A. Zweig, “The Rise and Fall of a Software Startup,” Journal of Information Technology Case Studies and Applications, 7, 2 (2005)), but I thought I’d summarize the primary lessons learned:

Lessons Learned:

  1. Get Marketing Involved on Day #1. Lesson learned! For some strange reason (probably arrogance), we waited 6 months to get marketing involved in startup #3. What a mistake!
  2. Missionary Sales are Bad News. If the pain you are addressing is not one of the primary pains felt by your target customer, your customer acquisition cost will be huge. Our startup #3 suffered from missionary sales throughout.
  3. Sell a Simple Product Before a Complex One. Although this is how I expressed the lesson back in 2004, we all know now the value of a series of minimally viable products. Unfortunately we learned this lesson the hard way.We spent $1M building our first product, only to discover it was the wrong product. By the time we built a much smaller product and started learning from it, investor confidence had waned and the economy had crashed.
  4. Don’t Get Lured into Fancy Offices. We signed a 5-year lease for Class A office space. Not smart in retrospect. Felt right at the time. After all, everybody was doing it. In general, don’t spend money unnecessarily.
  5. When Accepting Investments, Get More than You Need. This was the subject of an earlier blog. Check out When Should You Ask for Investments?
  6. Be Careful When Partnering with Friends. In startup #3, I partnered with two of my best friends. At the end of the company, one relationship became cemented as a lifelong friend, based in part on having been in the battlefield together; the other disintegrated and I have not talked with him since.
  7. Avoid Bad Economies. This is meant to be tongue-in-cheek. Our company lasted four years from 1998 to 2002, during which a huge number of startup companies were destroyed in the unraveling economy. It would be very easy to simply blame the economy for our woes. It is much more useful to analyze decisions that are under management control.
  8. Keep Your Stakeholders Informed. This is one we did right at startup #3. With only a few exceptions, I’m still in good standing with the investors and former employees of startup #3. Many have invested in and come to work for companies I’ve started since.
  9. Every Employee Deserves Ownership. This is another one we did right at startup #3, and I continue to practice at all the startups I’ve been involved with since. I generally allocate a third of the company’s equity for the option plan, considerably more than most mentors recommend. But this fits well with my management style.Many years ago, my first mentor, Ed Bersoff, made the statement, “I expect to become wealthy as a side-effect of doing great things in this company. I would be extremely happy if many others became wealthy around me as well.” Thank you, Ed, for teaching me this!
  10. Principals Should Invest in Every Round. This is another one we did right at startup #3, and I continue to practice at all the startups I’ve been involved with since. Being the first to invest in every round has two great side effects: (a) when potential investors ask if you have skin in the game, you can answer yes, and (b) when potential investors ask if you’ve raised any money in the round yet, you can answer yes.

But even if you learn all your lessons, and you do everything right, you still may not succeed. And that’s okay. Just pick yourself up, and try again. Remember, even monkeys fall from trees.

ABOUT THE AUTHOR:

Black-chinned_emperor_tamarin_(S._i._imperator)??????????????????????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.

WYNSUMM 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?

Photo of Black Chinned Emperor Tamarin by Kevin Barret (Creative Commons)

To Plan or not to Plan: That is the Question!

SignsI have been an executive in startups since the mid-1980’s, and still am. I have always proactively planned every business in detail, but the last “business plan” document per se I wrote was in 2001. How is this possible?

I want to address some basic questions:

  • What is the difference between planning a business and writing a business plan?
  • What should you include in your planning?
  • In what format should you document your plan?
  • How much detail? What is the right time horizon for business planning?
  • Why do you need to plan your business?

What is the difference between planning a business and writing a business plan?

A business plan is a polished, organized, physical document that describes every aspect of your proposed business and its environment. It usually cover 5-7 years from inception, ramp-up, through to exit. Although occasionally requested by investors, these days it is usually requested only by academics in “business plan competitions.”

Business planning, on the other hand, is the activity of lowering your risk by studying and understanding every aspect of your proposed business and its environment.

What should you include in your planning?

At a minimum, you need to thoroughly understand:

  • The macro market, that is, demographics of the general market you are aiming for. If you are creating a fast food restaurant for diabetics, how many diabetics are there? And are their numbers growing or shrinking?If you are creating a company to provide assistance to early-age retirees, how many individuals are retiring early? And are their numbers growing or shrinking?When tracking dimensions of a macro market, you could measure it in terms of number of customers, number of dollars spent for products like yours per year, or number of products like yours sold per year.

    Great demographics for your macro market are helpful to the success of your start-up. However they are neither necessary (after all, Starbucks succeeded quite well in its North America expansion efforts in the early 1990’s even without a dramatic increase in the number of coffee drinkers) nor sufficient (even terrific growth of a market cannot compensate for sheer management incompetence).

  • The micro market. As an entrepreneur, you need to focus on a specific target market that you can penetrate successfully. By aiming for a specific (usually narrow) target market, you can create a marketing campaign aimed directly at that market and its unique pains.Members of that market then quickly see how your solution addresses their pains and become easy converts and thus customers. On the other hand, if you aim for a more general market, your marketing campaign will have to address more general pains by necessity, and will then be successful at converting a lower percentage of leads. You want all odds in your favor when you start a company.Meanwhile, start with just one target market; if you start with two, you’ll double your marketing costs (or you’ll halve the effectiveness of your marketing by watering down the message).

    The research you need to do concerning possible micro (aka target) markets includes characteristics such as size, growth rate, accessibility (i.e., how easily can you find potential customers?), ease of conversion (i.e., do potential customers “feel the pain” vs. do you have to first convince them that they have a pain? how easily can you convince them that your solution to their pain is by far the best solution available?), and so on.

    As a general rule, having an unfavorable micro market is considered by most experts to be a showstopper. If your target market is not already focused on trying to solve the problem that your product solves, you are fighting an uphill battle.

  • Your competition. Almost every prospective entrepreneur I have come across understands the need to identify “the competition,” but many limit themselves to direct competition, i.e., those companies providing products similar to the start-up’s, which address the market’s needs in a similar fashion.Don’t ignore substitute competition, which customers can choose to address their need in an entirely different fashion. For example, in the electronic note taking industry, over 200 small companies compete with 2-3 very large companies for customers. They are all direct competitors.But this industry suffers from substitute competition from at least two sources: (a) pen and paper, and (b) standard word processors on tablets. Business planning for a start-up in the electronic note taking industry must acknowledge the reality that a very large percentage of the total available market will not be purchasing any company’s electronic note taking software product.
  • Threat of entry. Ideally, (a) you want it to be easy for your start-up to enter the industry, and then (b) once you enter, you want it to be incredibly difficult for others to enter and subsequently compete against you.Concerning point b, when planning your business strategy, what can you do now to make it more difficult for others to copy you? For example, do you have intellectual property that you can protect with patents, copyrights, trademarks, and trade secrets?Can you enter the market quickly enough so that your large market penetration deters others?

    Can you establish contractual relationships with either suppliers or distributors that make it impossible for them to work with competitors?

    Can you provide such good service that no customer would want to change to a competitor?

  • Your Differentiators. What makes you special? Why is your product better than the competition? Saying that you will have a “better user interface” will not cut it; everybody says that. What specific value does your product provide that the market will appreciate and that the competition does not already provide?Here are some examples:
    • We are the only e-tailer that provides restaurant chef-quality gourmet ingredients to the home chef.
    • We are the only manufacturer of a catheter that C4-C5 quadriplegics can use for self-catheterization.
    • We enable online purchasers to donate to their favorite non-profit at no cost to them.
    • We deliver products to your door using drones within 4-hours of ordering.
    • We provide Wal-Mart prices without the long check-out lines.
  • Your Marketing and Sales Strategy. If you haven’t already done so, read Eric Ries’ The Lean Startup. In it, you will discover only three ways to create revenue:
    • You can pay for new customers. So, how do you plan to make the market aware of your products? How will you convert leads into customers? What will you do explicitly to retain customers?
    • Current customers can refer new customers? So, what will you do to encourage referrals?
    • Current customers can buy more. So, what will you do to encourage customers to increase their purchasing?
  • Pro Forma Financials. Income statement, cash flow statement, and balance sheet. Maintain all your assumptions that drive these financials in a list.
  • Cap Table. Only needed if you are interested in investors.

In what format should you document your plan?

This is a matter of taste. I strongly recommend against printing all your plans, polishing them, adding an introduction, table of contents, etc., and binding the document. The problem with this approach is that every one of the planning components is constantly evolving. If you polish and print it, it will be out of date by the following week. This is why I say I am against business plans, although I am for business planning.

Personally, I maintain a series of electronic company folders; each has a corresponding physical notebook containing selected key excerpts. Each folder contains all information I have collected on one aspect of the business. They combine “plan” and “actual” and are:

  • Market and Industry. This folder contains all my macro and micro market analyses and competitive analyses (old as well as latest in chronological order). It also contains copies of any related articles or reports others have written.
  • Marketing and Sales. This contains copies of marketing and sales plans (strategic and tactical). [Once the company starts, I add ad copy, brochures, web page designs, and so on.]
  • Equity. Initially, this contains just the projected cap table. [Once the company launches, it will also have copies of private placement memoranda, investor subscription agreements, accredited investor questionnaire forms, the stock option plan, all stock options granted, updated versions of the cap table, and so on.]
  • Board. Initially, this contains articles of incorporation and the bylaws. [Once the company launches, it will also include updated bylaws, board meeting minutes, and actions by written consent.]
  • Organization. Initially, this contains the organization chart and hiring plan. [Once the company launches, it will also contain employment contracts and updated organization charts and hiring plans.]
  • Financials. This contains pro formas by month and year for 5 years. At the front, I maintain a list of all assumptions, including all expenses (by year and by category), customer acquisition cost, sales cycle, average order size, periodicity (how often each customer will purchase), retention rate, viral coefficient, viral cycle length, and many of the items from the above folders. [Once the company launches, I add actuals.]

I also maintain a 10-minute slide presentation that captures the essence of some of the above.

How much detail? What is the right time horizon for business planning?

You should be as lean as possible without being irresponsible. Here are my thoughts on the specific parts of planning:

  • Analysis of Market. I believe that you must understand your market as thoroughly as possible or you are being foolhardy. The lean community might argue that truly revolutionary products create their own markets and it is impossible to understand the market until you test its behavior with your minimally viable product (MVP) in hand. The right answer lies somewhere between these two extremes.For example, let’s say your idea is to create fast food restaurants for diabetics. I would argue that it is important to fully understand both the demographics and the dietetic needs of diabetics before endeavoring down this path.On the other hand, you will not be able to determine exact recipes or menu items until test marketing (i.e., creating MVPs), and you won’t understand the risks associated with attracting diabetics to your restaurants when their family members are not diabetics without experimenting.
  • Analysis of Competition. Absolutely essential.
  • Threat of Entry. It is never too early to start planning for how you will protect yourself. If you delay, it may be too late.
  • Differentiators. Here, time horizon is important. You have to perform a delicate balancing act between what you believe are long-term differentiators for the majority of the market and what you believe are short-term differentiators for early adopters.The only sensible approach is to build a series of successively larger MVPs, learning as you go, adapting to what the market is telling you. All the time, however, you must acknowledge that you may not know if you are accommodating the needs of just early adopters or if they are indeed representative of the market majority.For planning purposes, do two things:

    (1) define what you believe are long-term differentiators. After all, without these, it is unclear why you should even be in business.

    (2) define a series of experiments to validate which features, delivery mechanisms, prices, promotions, marketing mechanisms, sales techniques, suppliers, and so on (collectively called differentiators), are most effective with the market.

  • Marketing and Sales Strategy. As stated above, you will have three components of your marketing and sales strategy: paid, referrals, and organic. As part of your plan, you should calibrate all three of these components with your goals. See Five Steps to Get and Keep Your Startup on Track. Once the company starts, you will revise these goals with actuals.
  • Financials. You are lean and are taking one step at a time. However, you still have a responsibility to verify that you are stepping in a direction that could yield great financial results. Create your pro forma income statement, cash flow statement, and balance sheet annually for at least 5 years, and monthly for at least the first two years.

Why do you need to plan your business?

The reality is that investors place their bets on startups less than 3% of the time[1]. The other 97% of their money goes to businesses that have already been through rounds of funding and have demonstrated that a market is willing to buy their product.

But when they bet on a startup, they demand a detailed plan for the business.

They won’t necessarily ask for a business plan per se, but they will perform due diligence. And when they do due diligence, they will be asking every possible question about your market, industry, product, marketing and sales, financials, governance, equity structure, intellectual property, and so on, so you need to have all this information somewhere.

If you are not planning on having investor money, why would you do anything less? After all, you are an investor in your own company, with time and money.

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 You 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?

[1] http://www.forbes.com/sites/dileeprao/2013/07/22/why-99-95-of-entrepreneurs-should-stop-wasting-time-seeking-venture-capital/

When should you ask for investments?

1024px-Wonderland_Walker_2A successful startup company needs to create a sustainable growth model using paid, viral, and sticky strategies. However, before it gets there, a startup usually needs some cash investments to get things going.

Let’s say you have performed a financial analysis of your startup company and have determined that you will need $1M to keep it afloat until it can sustain itself.

When should you raise the $1M? No simple answer exists. In general, the longer you wait to raise any round of investments,

  1. The higher your valuation is likely to be because you have likely reached more milestones, like generating more revenue, obtaining more partners, producing more product, and so on. The higher the valuation, the less of the company you will have to “give away” to investors for a given amount of money.
  2. The higher risk you have of running of cash, so unscrupulous investors could take advantage of you by delaying their investment decision until you are desperate, thus forcing you to accept a lower valuation.

Some advisors will tell you to ask for all the money you need at one time because the investment-seeking process is so time-consuming that you want to do it as infrequently as possible. Get it over with at one time so you don’t have to do it again.

Some advisors will tell you to always raise more than you need because you have probably been overly optimistic in many of your predictions, and you want the cash cushion.

Some advisors will tell you to always raise less than you need (i.e., be as lean as you possibly can be) because your company’s valuation will always be higher later and you can raise less expensive money later.

Only you can make this decision. It is a delicate balance act.

What does cash flow look like?

Every startup’s cash flow looks like the following graph:

Cash Flow Figure

Notice that in the ideal world a successful company would burn cash at a slower rate of speed after each successive investment round; note that the slopes of subgraphs A, B, and C increase with each round. Eventually, the company sustains itself (at point C in this case) from operations without additional infusions of cash from external sources.

If the entrepreneur waits too long to raise investment round 2, line A will continue its downward trend below the horizontal zero line and the company will be out of business. If the entrepreneur doesn’t wait that long, but long enough so investors can see the company running out of cash soon, investors could just delay their decision.

In Summary

Entrepreneurs have to make their own decisions.

Some prefer to bootstrap using revenues to grow their businesses; this approach maintains ownership among founders and employees, but usually means slower growth because they can be cash-strapped.

Others prefer to raise as much as possible . . . and then spend it as fast as possible, reducing the risk that a competitor will beat them to the market.

Others take a middle of the road position of raising just enough capital, and spending is judiciously.

All a matter of style.

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 You 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.

WYNSUMM 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?

Photo of Nik Wallenda (Wonderland Walker) courtesy of Kevint3141 (Creative Commons).

Should you sell investors common or preferred shares?

Photo PreferredPhoto CommonIn most start-ups, founders’ shares are common.  Subsequent investment rounds tend to sell preferred shares to investors, but some start-ups sell common shares to investors.

Why offer preferred shares to investors?

The reason for offering preferred shares to investors is that insiders (like founders and officers) have a huge amount of control over the success or failure of the company whereas outside investors have so little control.

The preferences that come with preferred shares lessen that almost intolerable level of risk.  These preferences reduce risk for their owners, and generally fall into two categories. The categories are downside insurance and upside insurance.

What are “downside insurance” preferences?

Downside insurance preferences provide owners with protections in case the company does not do particularly well. Two examples are liquidation rights and anti-dilution rights.

  1. Liquidation rights give the preferred shareholders a multiple of their initial investment back before a general distribution of the proceeds of a liquidity event. Say the investors purchase their shares for $600,000 and they negotiate 2x liquidation rights.

    A few years later, the company is acquired for $4,000,000.The preferred shareholders would receive 2x their initial investment, i.e., $1,200,000, and then the remaining $2,800,000 would be divided pro rata among all shareholders (including these same preferred shareholders).

  2. Anti-dilution rights give the preferred shareholders a “guaranteed best price” on their share purchase. The preference kicks in only if the company ever sells shares at a future date at a price lower than the current offering.

    Say the investors purchase 300,000 at $2 per share (for $600,000) and negotiate anti-dilution rights.

    A year later, the company has run into difficulties and is forced to sell shares at $1 per share in order to attract investors.

    If they succeed in raising this follow-on round, they will have to issue 300,000 additional shares at no cost to the original preferred shareholders (the ones who had the anti-dilution rights); this has the effect of retroactively selling them 600,000 shares at $600,000, so they actually ended up paying the better price of $1 per share.

What are “upside insurance” preferences?

Upside insurance preferences provide owners with some additional benefits in case the company does extremely well. Two examples are registration rights and warrants.

  1. Registration rights allow preferred shareholders to sell their shares at the time of the initial public offering.
  2. Warrants allow preferred shareholders to purchase additional shares at the current price. Say the investors purchase 300,000 at $2 per share (for $600,000) and negotiate a warrant to purchase an additional 100,000 shares at $2 per share.

    A year later, the company is doing poorly; the preferred shareholders will not choose to exercise their warrant.

    However, if a year later, the company is doing very well, and the shares are now worth $5, the preferred shareholders may choose to exercise their warrant and purchase the additional shares

In Summary

Some first time entrepreneurs avoid selling preferred shares to investors out of fear that they should not sell something “more valuable” than what they, the founders, own. However, most founders become officers and thus have almost complete control over the company’s success or demise, while outside investors have very little power to influence the success of the company.

Outside investors deserve some ability to reduce their risk and share in the upside. And the only way for them to do that is to negotiate the preferences that go with preferred shares.

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 You 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.

WYNSUMM 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?