The folks at Fast Company have a series on articles on starting up companies in different regions of the US. I had a chance to talk with them about Chicago, my home town. Below is the beginning and link to the article Why You Should Start a Company in…Chicago.

Why You Should Start a Company in… Chicago

By Laura Rich
 
Chicago may lack the crackling energy of other startup hotspots like Seattle [1], Austin [2], Boston [3] or Boulder [4], and its reputation for back-office, white-collar companies such as the former Andersen Consulting firm doesn't help much. But Chicago is where many Internet mainstays were launched, from the jobs site CareerBuilder and travel service Orbitz to RSS technology innovators Feedburner (bought by Google in 2007) and the online audience measurement outfit comScore. One hot startup right now is the coupon site Groupon [5].

Health-care companies also have realized great potential in the area, led by Abbott Laboratories. And lest one forget, it was at nearby University of Illinois Urbana-Champaign where Marc Andreessen developed Mosaic, the Web browser that paved the way for the commercial Web. So there's that.

These days Chicago's startup culture is aimed at the steady and sure. As Matt McCall, a partner at New World Ventures and managing director at DFJ Portage, notes, Chicago is home to many of the largest companies in the country, including Accenture, Boeing, Integrys Energy, MillerCoors, McDonald's, ACNielsen, Trans Union, and Fortune Brands. The list is long and comprehensive. For startups, it means a rich source of customers for products that fill a need or enhance their businesses.

McCall spoke with FastCompany.com about what makes Chicago's startup scene so strong.

What makes Chicago a great place for startups?

continued at Article link…

In difficult times, strategic partners can be essential to survival. As companies fight for air in these cash strapped times, larger corporations have valuable resources. Our portfolio companies have leveraged partners in several ways.
1) Pre-paying revenue. Some customers will pay in advance of delivered goods. Future takedowns are applied against this.

2) Venture leasing: if an entrepreneurial company is investing heavily in equipment and capacity for a customer ramp, see if they can help finance it. This can be thru their in-house finance group or by helping guarantee payment of the loan. They understand that they benefit from your getting this capacity funded.

3) Distribution agreements: corporations with global distribution can expand the addressable markets and customers you can reach. If you deliver revenue to them (bundling with your product or a cut of the sale), it can be a win-win.

4) Strategic investment: corporations that see your strategic value to them may be more likely to invest in your firm than the traditional venture industry.

There are a million caveats around embracing strategics. You want to avoid firms who are known to be litigious or difficult to negotiate/ work with. More so, if they are known to absorb information and then build competing product, avoid them at all costs. There are many in the consumer electronics world that frequently do this.

Realize that corporations have limited cash themselves. But bringing solutions or ideas that bring incremental revenue or discretely reduce cost today (no “productivity gains”) and they will take the discussions seriously.

Be careful not to lock yourself into having a one acquiror situation. Getting multiple strategics engaged, having other distribution channels and creating other alternatives gives you more freedom.

More importantly, use these activites as a way to start courtships with potential acquirors. Both sides will get a chance to understand where synergies and fit are. It is an investment in the future.

So, be careful but realize that strategics can provide essential lifelines to you.

Despite the markets’ gyrations, 2008 was the best year for liquidity in our firm’s history. In fact, our largest exit (Lefthand Networks) closed in November in the heart of the downdraft. In looking across these exits, the strong exits all had several common elements:

1) Self-sufficiency: the old saying in venture is that companies are bought and not sold. If the acquiror knows that time is it’s friend, they will slow roll the process, driving harder terms with each passing month. Don’t go into the process without a long runway (or a strong forcing mechanism). Your gut will tell you how much of the process is your pushing versus their pulling. Don’t push.

2) Mortal Enemies: the surest way to have a healthy process is to get two bidders that viciously compete with each other. During one process, we tried to leverage a weaker competitor to motivate our lead buyer. They laughed and encouraged us to sell to them. We subsequently engaged their fierce competitor. The result: LOI in weeks, closed in 6 weeks.

3) Existing Relationship: people do deals with people they know. You can either try to convey your value during an impersonal pitch or let them experience the specific facets/nuances of your firm or technology through interacting with you over time. Most firms know who are the likely buyers. During this downdraft, it is a good time to build these relationships. You can get their attention if you can deliver revenue to them or reduce concrete costs. Don’t ever taint this process by pushing or even hinting at selling the firm as it will set you back.

4) Few Alternatives: scarcity is at the heart of a good sale. Few or inferior alternatives swings the balance in your direction. If there are an array of available solutions, you will lose your leverage in the process. A superior/strong product can sell itself. If you have strong synergies with competitors,you can carefully & selectively consolidate or rationalize your sector. Now is the time to distance yourself from the pack, outlive competition and consolidate so you are the logical acquisition.

5) Visible Scalable: you invest in companies if they demonstrate a scaling revenue model which has visibility on the growth drivers going forward. Acquirors will do the same. Have you proven out your revenue model and can you show how it will ramp significantly if owned by them. Show it becomes more profitable with them.

6) Strategically Central: if your product or service is a central component to the acquiror’s future, you will get attention. If not, you may likely get lost in the noise. This can be the product that is missing but is a key growth driver in their industry or can protect/enhance core existing products.

So, while exits are harder today, now is a key time to position for exits when the conditions improve in coming years. Build relationships now that will be essential later.

I have always been amazed by how many of our success tech stories, as well as Fortune 500 companies, started during drastic down turns. Innovation does not take a holiday, and in fact, thrives during difficult times when pain & need are greatest. While the current downturn is historic, it pails in comparison to the 22 year depression the US experienced from 1873 to 1895, triggered by the Vienna stock market crash.  During this extended drought, a large number of Fortune 500's & major corporations started including Eli Lilly, IBM, Merck, Hershey's, Gillette, Alcoa, J&J, Chevron, GE, AT&T, Abbott, Lilly, Coors, Johnson Controls, Bristol-Myers and PPG to name a few.

During the great depression (1929-1939), Texas Instruments, HP, 20th Century Fox and United Technologies all launched. Since much of the Valley's legacy came out of HP, the seeds for the current Silicon Valley were planted while the stock market was crashing nearly 90% and unemployment approached 30%.

Other periods: during the Oil shock & market crash (1973-1976) Microsoft, Genentech & Apple started. The biotech and PC revolutions emerged when the market was down nearly 50% and inflation was racing into double digits.  In the crisis of the early 80's (1980-1982) with mortgage rates peaking at nearly 21%, Amgen, Sun, E*Trade, Autodesk, Adobe, BMC, EA and Symantec were created. The question is why does this happen?

Dogs Will Try New Dog Food
When everything is going well, few people or companies want to change behavior, process or vendors. They have little incentive to do so and risk upsetting the apple cart. However, when their hair is on fire, customers & business partners are willing to try new or different approaches to address the pain. So, while some would say that sales cycles stretch out significantly during downturns, I would argue that for new technologies that solve real problems, they compress considerably.

Take Care of Darwin
Leading entrepreneurs have a maniacal focus on efficient use of capital and on fulfilling customer needs (versus nice to have's). During troubled times, these entrepreneurs are even more focused on these. Cash is spent only when absolutely necessary and no to few features are built that aren't demanded by the customer. Those less disciplined will find themselves victim to Darwinian realities. Companies "forged in hell" have a much more durable and advantaged DNA coming out.

Power of an Equity Culture
In these times, firms either bootstrap or fund themselves from modest equity rounds. Credit, other than credit cards and such, is not readily available. Furthermore, the start-up world is an equity culture versus the credit/debt culture of buyouts. So, they are able to survive when banks won't lend and credit lines are non-existent. Equity can be a beautiful thing.

Weak Gazelles are pruned
During boom times, sectors get overfunded and weaker competitors destroy the economics for everyone involved. They create significant noise in the market place, create skeptical customers by overpromising and underdelivering and have undisciplined pricing policies. In hard times, there are many fewer competitors which allow companies to scale quietly during the trough and take significant market share when conditions improve. Furthermore, these firms enjoy rational pricing, higher profitability/margins and lower cost structures given their DNA.

So, yes it is ugly out there and about to get even harder but start-ups are used to hard times and are well suited, if managed properly, to thrive in the downturn and accelerate during the recovery. The trick is to stay alive one day longer than your competitors…

I came across an article from last year from Fortune, Steve Jobs Speaks Out, in which Steve discusses Apple's approach to business and innovation as well as its culture. Entrepreneurship is part passion & execution and part mentoring. The best entrepreneurs continually learn from the examples of those around them. They are curious about what lessons others have learned or what experiences others have had. You can learn in one of two ways: do it yourself or learn from the mistakes/successes of others. Clearly, nothing repeats itself so these efforts are more about creating, as Charlie Munger says, "Lattices of Mental Models". He is an avid student of a broad array of disciplines which he applies across discipline. Anyways, interesting article…

Minus 23 degrees. That was the absolute temperature this morning as I went out to the airport. This probably nets out to minus 30-40 wind chill. This redefines how icy cold the financial markets are. This is also what makes Midwesterners so decent and hearty. Winter puts everything in perspective !

With that said, I wanted to throw out a topic that I have pondered quite a bit — how effective are options at aligning the interests of management and Investors?

The rationale behind options is that by giving employees equity in their firm, they will think and act more like shareholders. Therefore, they are incented to act so as to maximize the future value of their stock. Additionally, this allows them to participate in the, hopefully, significant increase in company value driven by their efforts.

On the surface, this appears to make sense, especially on the upside. However, things begin to breakdown on the downside. For one, if the company underperforms or requires significant equity, Investors will suffer significant dilution unless they continue to put ever increasing amounts of money to work. Management will push for additional option grants to be made whole. This begins to make them less dilution sensitive while also further diluting Investors. Management pushes for options, which are in essence free, rather than asking to protect their ownership by buying shares. This often leads to tense discussions between Investors and management.

The second, and I would argue more troubling, issue is that options create asymetrical alignment of interest. Investors are committed and have their capital wed to the company in both the upside and downside scenarios. Options, unlike purchased stock, have no downside cost or “loss” (other than lost upside) to their holder. As a result, this does not create the stickiness or alignment that having financial skin in the game does.

Before the craziness of the Bubble, it was standard for VC’s to look at how much networth an entrepreneur had invested in the business. The reasoning went that if this was high, then the entrepreneur, having “burnt the ships”, would fight like a caged tiger for the success of the business. However, as money poured into venture and deals grew more competitive, fewer and fewer teams had large chunks of skin in the game.

Where this creates a disfunctional situation is when management, or more often a hired gun CEO with a big option package, underperforms. There is little cost to leaving. If conditions worsen and it looks like the business will need massive effort for a period of time to turn around, management may begin to look at opportunity cost. Would they be better off spending the next three years at a more promising start up?

Sure, they walk away from future option value, but are relatively unencumbered. They are not nearly as tied to the company as managers with money in the deal. This fact creates surreal negotiating leverage for them as they can threaten to leave the Company if not given more stock. Investors, on the other hand, have their capital locked up in the firm (as they should).

Sometimes, managers ask to be able to buy stock so as to start their capital gains clock. However, they often ask for a non-recourse note from the Company to do this. The result is that should the firm fail to perform (or they fail to perform), they can walk away from both the stock and note (as it is non-recourse).

Unfortunately, this downside scenario is much more common than one would expect (or than Investors would like).

My trouble with this is that Investors and Managers enter into a pact to build a company together and remain committed in good and bad times. This contract falls apart when one party can back out of the deal.

This post is not to rail against hard working entrepreneurs. Far from it, as the great majority of them stay committed and fight hard to the very end. Rather, this a complaint against an incentive structure that is flawed and can undermine the Investor/Entrepreneur relationship. I would argue that requiring management to purchase a portion of their equity (options for the remainder) would actually lead to a more stable company and stronger alignment of interests. Will this feature come back into focus or will VC’s push for disfunctional features for protection like 2x liquidation preferences. We will see.

There are an array of investor centric factors that also undermine this contract but those can be saved for a future post…

I heard a recent statistic from a Harvard study on successful sales management. In the study (caveat: which I have not seen), it supposedly concluded that a business sale takes 7 meetings on average to close. It also mentioned that the average salesman stops pursuing the sale after 5.4 meetings.  I am not certain what happens to these numbers in this more challenging environment but what it does show is that a) most people give up too early on potential sales and b) sales come from familiarity/trust which takes time and frequency to build. Often, the successful sale today comes from months (or more likely years) of cultivating relationships and staying in front of prospects. So, I'd be curious to see what happens to results if people systematically persisted with two more meetings, on average, when they were about to give up or move onto other prospects. Anyways, another data point on the power of persistence…

With the markets (job & product) becoming tougher, people are spending increasing amounts of time trying to advance the ball.  If you are wishing that you had a larger network to work off of (don't we all…), I came across an interesting post on "4 Rules".  Jimmy Gardner, in a TECH cocktail piece, expanded on a post by Andrew Hoag in GigaOm "A First Timer's Tips to Networking" (so basically, I am providing no value add by two degrees of separation…). In particular, focus on #4. As times get harder, people tend to think of themselves and their own issues. They get very insular very quickly and end up feeling isolated and frustrated. Looking up every once and a while and seeing how you can help others or lend a hand will not only possibly take your mind off your own issues, but might even start the ol' Karma wheel spinning. Jimmy's Networking comments:

Guy Kawasaki has a great post on the things to focus on in tight financial markets when launching your business in his post "The Art of Bootstrapping". It has a number of common sense suggestions for entrepreneurs: