Why Great Companies Get Started in the Downturns

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…

Apple Slices

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…

The Downside of Options

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…

Don’t Give Up Too Soon

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…

Tips for Networking

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:

1. Never, ever, underestimate anyone

Ok I admit it, you probably have the same story, but at some event you see someone who acts a little odd, looks a little different and you may tend to shy away. But think about something, that may be the founder of the next big thing. And in talking with them and taking a few seconds to get to know them could lead you places you may have never envisioned.

2. Be genuine.

Dont give people anything but who you are. They see through the facade much easier and faster than you would ever imagine.

3. Be patient.

You probably are not going to make that blockbuster deal right there after the intro over a cocktail. Just follow the other rules here and then see how things go. After events I go home, take all the business cards I have gathered and enter them into some for of CRM, like Higherise form the 37 Signals guys. I also note how and when I met them and what they do as best I can remember. I also take a minute to give a quick hello/follow up email to them. It keeps the dialogue going and you never know were that continued dialogue can take you.

4. Give before you get.

I have heard this a lot and try to follow it to a tee. People dont want someone to walk up introduce themselves and start in on everything they have going on. As in #3, be patient in the moment, and get to know the other person. See what they have going on and ask questions. It will come back around to you, trust me.

Art of the Start: Recession Style

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:

"Too much money is worse than too little for most organizations—not that
I wouldn’t like to run a Super Bowl commercial someday. Until that day
comes, the key to success for most organizations is bootstrapping. The
term bootstrapping comes from the German legend of Baron von
Munchhausen pulling himself out of the sea by pulling on his own
bootstraps. That’s essentially what you’ll have to do, too….

Forecast from the bottom up. Most entrepreneurs do a
top-down forecast: There are 150 million cars in America. It sure seems
reasonable that we can get a mere 1 percent of car owners to install
our satellite radio systems. That’s 1.5 million systems in the first
year. The bottom-up forecast goes like this: We can open up ten
installation facilities in the first year. On an average day, each can
install ten systems. So our first year sales will be 10 facilities x 10
systems x 240 days = 24,000 satellite radio systems. That’s a long way
from the conservative…"

If Larry and Sergey Asked for a Loan …

"Be fearful when others are greedy, and be greedy when others are fearful."
            — Warren Buffett

Well, there is no doubt that fear is running rampant through the streets. This will provide a great opportunity for entrepreneurs to take advantage of market inefficiencies not seen for decades. Those that intelligently manage the downside, will be well positioned for significant future upside. We call this asymmetrical risk. The key is to respect the global forces impacting our economy without letting it paralyze you. I like Friedman's distinction between risk-taking and recklessness. The former is rewarded highly and later punished severely.

Thomas Friedman had an interesting recent op-ed that Whitney Tilson recently commented on.

The hardest thing about analyzing the Bush administration is this: Some
things are true even if George Bush believes them.

Therefore, sifting through all his steps and missteps, at home and abroad,
and trying to sort out what is crazy and what might actually be true — even
though George Bush believes it — presents an enormous challenge, particularly
amid this economic crisis.

I felt that very strongly when listening to President Bush and Treasury
Secretary Hank Paulson announce that the government was going to become a
significant shareholder in the country’s major banks. Both Bush and Paulson
were visibly reluctant to be taking this step. It would be easy to scoff at
them and say: “What do you expect from a couple of capitalists who hate any
kind of government intervention in the market?”

But we should reflect on their reluctance. There may be an important
message in their grimaces. The government had to
step in and shore up the balance sheets of our major banks. But the question I
am asking myself, and I think Paulson and Bush were asking themselves, is
this: “What will this government intervention do to the risk-taking that is at
the heart of capitalism?”

There is a fine line between risk-taking and recklessness. Risk-taking
drives innovation; recklessness drives over a cliff. In recent years, we had
way too much of the latter. We are paying a huge price for that, and we need a
correction. But how do we do that without becoming so risk-averse that
start-ups and emerging economies can’t get capital because banks with the
government as a shareholder become exceedingly
cautious.

Now is one of the worst time to become risk-averse…just be intelligent about it.

Helpless or Master

"Genius is one percent inspiration and ninety-nine percent perspiration"
                                                                                     — Thomas Edison

I have often written about how the lessons and factors affecting us as children seem to strangely enough, also impact us in similar ways as adults. I find that I will see something at work and then go home, only to see a modified version of it at home. One of the most recent experiences in this realm I’ve had relates to a Scientific American article,  The Secret to Raising Smart Kids. In it, the author writes that there are two types of mindsets they see in children: fixed & growth (or helpless vs mastery). In the former, children view their success as being reliant on their inherent abilities which are fixed. In the latter, they view their success as being driven by effort and that any setback can be remedied over time by additional effort.

This distinction is also critical regarding successful entrepreneurs and those pulled under in the Darwinian tech eco-system. This has implications on how one views & motivates employees as well as how one views themselves. I won’t do the article justice summarizing it here, but highly recommend it as a read both as a parent and an entrepreneur.

"A brilliant student, Jonathan sailed through grade school. He completed
his assignments easily and routinely earned As. Jonathan puzzled over
why some of his classmates struggled, and his parents told him he had a
special gift. In the seventh grade, however, Jonathan suddenly lost
interest in school, refusing to do homework or study for tests. As a
consequence, his grades plummeted. His parents tried to boost their
son’s confidence by assuring him that he was very smart. But their
attempts failed to motivate Jonathan (who is a composite drawn from
several children). Schoolwork, their son maintained, was boring and
pointless."
                    — Carol Dweck, The Secret to Raising Smart Kids

The Art of the Start

Ironically, I drafted the following post at the same time my friend, Jim Stamos, sent me Marc Andreessen’s recent post about the current writer’s strike in Hollywood Rebuilding Hollywood in Silicon Valley’s Image.

"Last week I posted a rather pointed polemic titled "Suicide by strike"
in which I argued that the big entertainment companies were acting
suicidally in picking a fight with the writers at precisely the wrong
time.

In this post, I more dispassionately outline my theory of why that’s the case, and what I think may happen next.

The writers’ strike, and the studios’ response to the strike,
may radically accelerate a structural shift in the media industry — a
shift of power from studios and conglomerates towards creators and
talent."

I would argue that the two businesses are eerily similar today and do hinge on the creative art, execution that "pierces the veil of disbelief" and branding/share of attention. I would also comment that the current B2C phase we are in has dropped the cost for start-ups and has shifted more of the power to the "creators". That said, most large successes require significant resources (e.g. more than a Digital Video camera or more than bootstrapping a start-up) and so, the "producers" have leverage vis-a-vis their capital and their connections (to talent, financial markets, strategic information, etc). However, venture requires much more of a cooperative approach while Hollywood has tended to use the buyout "iron fist approach". Here is my original post…

ART OF THE START

Many a time, I have heard entrepreneurs bemoan the fact that their company is just like a successful competitors and yet they are not getting the traction or attention.  I have often thought that the movie and venture businesses had a great deal in common. Both are “hit” driven with high failure rates and success is driven by detailed execution and the stars involved.  Venture capitalists act much like producers whose job it is to make certain that all of the key resources are tied in and the venture has sufficient capital.  Directors are like CEO’s and the key actors are like top managers. While certain talent helps improve the odds for success, the core fundamentals of the story (business or movie) can make or break.

Rishad Tobaccowala, the interactive marketing guru at Denu/Starcom, often says that memorable, impactful campaigns have a compelling story at their heart. In the movie business, it is how the plot holds and flows. In the venture business, it depends on the impression the elevator pitch makes on the investors, customers or strategic partners. Some resonate quickly and others get thrown into the generic bucket.

I wish I could layout what the formula is for success, but it is more art than science. That said, look at the persistence of certain producers (Bruckenheimer, Bay, etc), directors (Spielberg) and stars (Ford, Cruise, Smith, etc) in cranking out wins. Successful producers and VC’s have developed certain pattern recognition advantages and have built out an array of supporting resources (camera men & editors or board members & domain experts) that they can bring in at different phases of the effort.  Success, as in venture, begets success as the most promising scripts (or business plans) will often work their way to the star producers.

A successful company starts with a quality "script". Business model, market size and economics set the foundation for everything coming together. However, few businesses think enough about how the pieces hold together, what makes them compelling and where the “drama” is. Why do people “have to see” the movie and tell their friends. It’s only after this comes together that meticulous execution can drive it to the promised land. This is what the rapid, exponential success stories have in common. The story attracts talent, the talent leads to execution (initial talent obviously comes with the story) and execution leads to success. Without the heart of the story, companies can still be very successful, but it makes it more difficult to break out of the crowd (“aren’t you just like…”).

This may all sound superficial but I do believe that success in entrepreneurship and success in movies have a lot in common. Founders should look to script writers on the art of story, CEO’s to directors for how to motivate and direct people and VC’s to producers for how to pull it all together. The same goes in reverse.  Art is art and hit businesses are hit businesses for better or worse. That said, Hollywood does need to figure out a more cooperative model that aligns the interests of the various players as Marc states above.

Other People’s Money

"There’s only one thing I love more than money. You know what that is? OTHER PEOPLE’S MONEY.
"
— Danny Devito in Other People’s Money

I haven’t posted in a while as work has been absolutely chaotic as the pre-Thanksgiving rush has begun. Start-ups, acquirers, partners are all pushing to close transactions before our business begins to wind down in the Thanksgiving to New Years period. I am up in Wisconsin with my son who is getting one last golf tournament of the year in. The aptly named “Intimidator” tournament has a steamy 40 degree wind chill, 17 mph winds and light rain. I elected not to walk the course with the other parents in his group for some reason. So, I can catch up on some posts here…

A friend of mine sent me a question I thought warranted a post. He was wondering how VC’s viewed a) founders investing their own capital in the early rounds and b) founders raising money to pay themselves normal salaries. Pre-bubble, VC’s preferred to see the founders have a significant portion of their net worth tied up in the deal. This aligned interests and kept the entrepreneur focused. Nothing like a mortgage to encourage strong commitment to a deal.

However, as top deals became more competitive and successful entrepreneurs built up sizable nest eggs, entrepreneurs began to push back on the notion and embraced the OPM (other people’s money) philosophy. They were committing time and giving up opportunity cost to pursue the venture. What more could a VC demand?

Most VC’s, while preferring to see financial skin in the game, are focused more on the quality of the team, the market and the deal terms. Additionally, true entrepreneurs are driven by a core desire to make a difference (and notch a win) so monetary sticks add only incremental leverage (though more so in downside scenarios).

Most entrepreneurs will take the middle ground. They will choose to bootstrap the business through proof of concept (site launch, etc) and then push for funding. Often they will self-fund or use angels so as to increase valuation when the larger capital comes in.

On the salary front, VC’s are not fans of entrepreneurs who raise capital and then turn around and give themselves $200,000 salaries. Knowledgeable entrepreneurs also usually don’t do this since this is expensive, dilutive capital they have raised. They are taking significant dilution in order to gain incremental salary. If the deal is successful, every early dollar will turn into $15-25 worth of foregone equity at the exit…ouch! So, it is a bit of an IQ test from the VC’s perspective. Generally, the entrepreneur passes and takes a $60-100,000 salary early on and moves this up once the company is more mature.

Some entrepreneurs are forced to take in larger salaries to pay the bills at home. This is not a great situation from which to start a business. I counsel friends thinking of starting a company to make certain they have (preferably) cash equal to two years worth of personal expenses saved up. This way, they can focus on the business and not on the wolves at the door.

Today, VC’s aren’t as focused as in the past on how much cash the entrepreneur has sunk into the business. We would still view it as a strong positive, but the realities of the market have pushed this term down the list. However, I would highly recommend that they start with a nest egg, bootstrap their business and use new capital predominantly for infrastructure and new hires.