Ask the Wizard

It's time to take up that new year's resolution to post more often and crank out my q1 post.

There's been some discussion in the tech blogosphere about startups and their need to have a clear business model, and some confusion from entrepreneurs about why it's ok for some businesses not to have known business models when they are expected to show three year pro-formas and be grilled about their model during any investor pitch.

I generally believe that for many technology companies, you need not necessarily have any idea how you will make money when you get started, and if you show good progress on the product and customer adoption, you need not make any commitments to a business model for some time. You do need to intimately understand where you sit in the proverbial value chain and what your position there means for your company, but you don't need to know precisely how you will extract value. In fact, I'll go farther and say that focusing on business model too early can hurt a company's prospects. When asked about Google's lack of a clear business model when he backed the company, John Doerr is said to have responded "With this kind of traffic, we'll figure it out". It's hard for some people to make sense of this when juxtaposed against their own experience pitching VC's, during which an obviously best-guess business model is grilled and questioned. What's going on here?

I have said before in this blog (or if not here, then certainly in my own mind) that I think all startups should think of the long road in front of them in three phases: during phase 1, you need to be passionate about the product (or service); during phase 2, you need to be passionate about your customers (*and* the product); during phase 3, you need to be passionate about revenue (*and* customers *and* the product). That may sound like some statement out of a "7 Habits of Highly Successful Startups" manual, but what does it really mean?

First, it's important to remember that you (you being the startup or entrepreneur) have limited resources. In the beginning, you are the most limited in terms of resources but the least limited in terms of range of motion. It's easier to innovate and change directions in the early days, but it's harder to do nine things at once. This is probably the founding team's favorite part of the lifecycle of the company. Everything is possible, and you can really focus on building the most awesome product/service possible, nimbly making changes in direction on the fly and rolling out different or new capabilities easily while simultaneously shutting down capabilities that seem to make no sense as part of the evolving vision. This is one reason I hate to see very early stage companies sign a big customer before the product is baked. You are encumbered by product commitments and customer support before you truly know what the market wanted. You have to be passionate about a customer and the product when you should be laser focused on the product. The customer's needs and your goals vis a vis the market may diverge. In an effort to show progress, however, the marquee customer is attractive in the belief it will help attract investment (and this may indeed be true). In a previous life before FeedBurner, my founders and I made the mistake of signing a big name customer to a paid monthly contract before we really knew what the product's place in the market should be. Won't ever do that again.

So, you grow, and the product gets to the point where it's usable and people start climbing in the bus, and if you're really lucky, it's growing like a weed and customer adoption is rampant. So, now we come to this curious world in which some people start to say "sure it's great, but what's the business model" while other people are saying "don't worry about the model right now, grow grow grow" (which is in turn interpreted by the first group as either "forgetting what happened in the bubble" or greedy or just stupid). I strongly believe that while you are growing in this phase, and expanding your initial team, you need only be passionate about the product and passionate about the customer. So, what does it mean to be passionate about the customer? Come closer and pay attention because I might not say what you think i'm going to say. If you ask a customer what being passionate about the customer means, you might generally hear "great customer service". This is not necessarily what I mean in the business sense. Passionate about the customer means that you are doing everything in your power to a) get more customers and b) make sure that your existing customers have little reason to want to stop using your product (what's referred to as "churn" in the antiseptic parlance that is preferred by some). Is great customer service one way to accomplish this? It can be, yes. What are some other mechanisms by which you can be passionate about the customer? Well, if you want to minimize churn, your product needs to be as usable and bug-free as possible. Nothing offers the competition an opportunity to show its stripes like your product not working. I think of response time, for example, as part of the passionate about the customer bucket, not the passionate about the product bucket. Slow response times can reduce new customer growth and give existing customers reason to try out a competitive offering.

It is absolutely critical, however, that you not make the fatal mistake of interpreting "passionate about the customer" with a mindset of being in reaction to a specific customer or customers. What the heck does "in reaction to a specific customer" mean? Ted Rheingold, the founder of Dogster and Catster, likes to say "the customer that emails you all the time is not all your customers". If you have a thousand customers, and you think that you are being passionate about the customer because you immediately respond to the two customers that repeatedly send emails like "YOUR SERVICE IS ACTING LIKE A *$#@! !!! PLEASE FIX THIS NOW. WHY CANT YOU PEOPLE GET A CLUE AND GROW THE !@#$! UP???", then you aren't being passionate about the customer, you're just feeding the raccoons. It is really really hard to get this through your head. You want to help everybody that's using your service. Here are a couple people that seem to want to use your service but repeatedly complain like this...if you are trying to help them, then you must be passionate about your customers. Instead, all you're really doing here is causing your team and company a lot of aggravation. I'll use a stupid analogy for those of you who play golf. When you make a bad shot, your inclination on the next shot is to think specifically about fixing that thing you just did wrong and think about making sure you don't do those two specific things wrong again. Of course, this is a recipe for disaster. The right way to play the game is to have a very consistent approach to every shot, irrespective of what just happened on the very last shot. So it is with an approach to being passionate about the customer. You need to understand what things you are going to do, how you are going to communicate with ALL your customers, etc. in order to maximize the number of new customers that will try your service, and at the same time minimize the number of people who you give a reason to try something else. Maybe this includes responding immediately to all caps emails that contain > 50% vulgarity, maybe it means ignoring those. Maybe it means being in reaction to every blog post you see, maybe it means never responding to any of those but frequently letting your community of customers know what's going on at HQ. Maybe it means using your constrained resources to do no communication at all and focus 100% on having the fastest and most highly available service. That's for you to figure out. We happened to be of the "hypercommunication with customers" mindset and practice at FeedBurner, but I know of wildly successful internet companies that had absolutely no customer feedback mechanism and yet almost never lost a customer because the service just worked.

So, we come to the point of the whole post: business model. Let's say you have 20 people in your company working with you. Let's say your initial product is a big hit, and people are adopting it with such enthusiasm that your growth rate is beyond your wildest dreams. The product is still in its relative infancy, but you're working out the kinks.
Is it critical that you figure out your business model as soon as possible? No.
Is it critical that you have enough cash to make sure you can grow the business? Yes.
Might it be the case that you can't get access to capital unless you have a sound business model? Yes.
Is life fair? No.
Don't you ultimately have to figure out how the heck you're going to make money? Of course, but....

You've got limited resources. It's still early. It is very likely the case that the first business model you try will not work (or will need to be amended or supplemented with other mechanisms). So, while you should be laser focused on having your company be passionate about product and passionate about customers, you don't need to be (and in fact you shouldn't be) passionate about revenue until the business model reveals itself. How the heck does a business model reveal itself? You try different things....the less you worry about fixating on a specific model, the more different things you can try. Maybe it's an ad model, maybe it's a free/premium model, maybe it's a private label model, maybe it's something else altogether. But leave yourself room to be in that quantum state of "it could be this or it could be that" until you figure out what works. Only then do you have to ramp up sales, finance, sales engineering, etc. and go out to the market with a very specific model. Announcing your model to the market before you really figure out what works forces you into multiple binds....the model may not scale, the model may be wrong, and you're now in a position where you have very limited resources and you are trying to get your company to be passionate about three things: product, customer, revenue. You also signal to the market and your investors that the clock is now ticking. Didn't hit your q1 revenue number? Uh oh, you're now going to be a lot more focused in q2 on figuring out how to hit that revenue target but you're also still in hyper-growth mode so the product and customer base require everybody's critical attention. Much better to be internally focused on fostering continued growth and innovation while tinkering around on the side with potential models, knowing that the ultimate model may not present itself for some time.

Conundrum: if this is true, then why do potential investors always drill you on your business model?! Because they want to understand how you think of the company and the business. It will ultimately have to go through these three phases. Does any of your thinking about business models sound even remotely plausible? Is it the case that you are starting a company in an area in which many others have tried and failed? If so, then why do you think yours will work? What you are hearing when potential investors ask you this question is not: "I don't see how that business model will make the 9 million in top line, with 39% margins that you show on page 10", instead you are hearing "help me understand how you see this ultimately functioning as a business". It may be that your answer is "look, we think there is a free/premium model here that works if X and Y are true. However, if A and B are true, and so far that appears to be the case, then it's more likely that we go go go on product innovation for the next year and then attack this as a private label model when enterprises follow consumers into the market". Bottom line: Investors are trying to see how you're thinking about this, not whether you have the right answer.

Conundrum Part II: Our service is free and because we don't have a business model, should we pursue charging for it as one of the potential models? Uh, I suppose you could, but why would you do that if it's going to impede growth? Look, there are plenty of great business models based on charging a subscription fee. It's also the case that we've all been burned by "now it's free, now it's not" services in the past (think ATM's, for example....it's free until we're all using it, at which point it's $2 per withdrawal). Nonetheless, it would appear that models in which revenue and earnings accrue to a company as an indirect function of its free use are the models that have the most powerful impact on the Internet today, and you work against that trend at your own peril. This is probably true even where specific industries continue not to admit it. When you add costs to using a product/service, you add friction to customer adoption (he said, stating the obvious). If somebody else comes along and figures out how to make money on such a service by providing it for free, then it's not so much fun to be you because your competitor's lack of friction is going to make life harder for you. And time and time again on the Internets, we see that somebody ultimately comes along and figures out how to make a lot of money by offering for free a service for which somebody else is charging.

When do you need to figure out your business model? Before you run out of cash. Sucks to read through that much text for such an unenlightening conclusion, but there you have it.

Posted by Dick at 12:33 PM | Permalink | Comments (0)

I’ve had a few questions recently from folks who have received first round financing term sheets in which the proposed board makeup seems over the top, from my perspective. Here is a composite (sorry, “mashup”) of the kind of first round term sheet language for Board participation I recently heard from different founders:

One CEO seat (currently founder X), two Series A investor seats, and and independent nominated by the Series A and approved by the board.

This is silly. A more cynical wizard (who would look like me but say “hmm” a lot more) might interpret this as early investors trying to take control of the company immediately. Can you spot the three things we don’t like about this proposed board structure?

First, “one CEO seat (currently founder X)”. That’s nice, founder X gets a board seat. How long does founder X have a board seat? Only as long as (s)he is the CEO. New CEO, new board member and out with founder X. No more founder board seats. Let’s move on to the other troubles before we re-draft the entire proposal.

Problemo numero dos, “Two Series A seats”. Um, I don’t get why the first round investors should get two seats. If the Series A is all being done by one institution, then this is particularly annoying, but even in the case of a syndicate, the series A investors should have a single representative on the board. “But but but”, you say. “Wait wait wait”, you say. “What if you really appreciate the input of two particular members of a syndicated financing?” Excellent point; the proposed board structure might include a board seat for the lead investor on the round, and board observation rights for one or more members of the syndicate.

Finally, and particularly the way this proposed board is structured, watch out for the wording on “an independent seat nominated by the Series A and approved by the board.” In this case, the Series A investor obviously controls the independent seat completely. This entrepreneur’s post-A round board, if accepted, is going to have 3 people representing the Series A and one CEO, who may or may not be the founder six months from now. This is, in legal parlance, “sucky”. If this is one investor doing the round, note that we might also raise our eyebrows and wonder why the institution’s partners have so much free time that two of them can take board seats in the same company.

Here’s a more straightforward Series A board structure: “One founder seat, one Series A seat, and an independent nominated by the founder and approved by unanimous consent of the board”. If you’re a multi-founder company, then I might change this to: “One founder seat (founder X), one CEO seat (currently held by founder Y), one Series A seat, and one independent nominated by the CEO and approved by unanimous consent of the board”. Frankly, you could keep it even more basic in the latter multi-founder case and just go with founder/founder & ceo/series A, but I personally enjoyed having an independent board member once we’d added one ourselves, and I think it’s helpful to get this person in sooner rather than later.

In the multi-founder case, when you do a 2nd round financing and you can keep the same general structure, you still have a nicely balanced board: something like two people from founder/management, two investors, and an independent. From here you can do things like layer in more independents as you grow, etc.

Rational investors are comfortable with these sorts of structures, and in fact, in our series B negotiation at FeedBurner, it was the investors who countered with “founder seat and ceo seat currently held by founder” when we originally redlined the first term sheet with two founder seats. This is a perfectly reasonable compromise in most cases and provides the investors with some security that a “renegade founder group” can’t hold management and investors hostage, while giving a strong founder group some assurance they will have significant and balanced participation in the board. There is no reason a founder should feel obligated to cede control of the company to a single investor on an early financing.

Posted by Dick at 11:01 AM | Permalink | Comments (4)

I got a package delivered to me from Moosejaw.com a couple weeks ago, and it reminded me of something I haven’t written about here yet, namely, how important it is for your company to have a specific voice. Here’s how the pre-printed paper note that was packed with my Moosejaw shipment starts out:

“If you are actually reading this note you should be super happy. First, you have received your order, reading is fun and getting something in the mail (even if you bought it yourself) has got to make the day better. Second, I put your order together all by myself.”

That’s a fun note to read. I like Moosejaw more because of that note. Is it silly? Sure, it’s a silly note and it’s pre-printed, so I know that everybody else gets one. Why does the note make me like Moosejaw more? People like it when companies have personalities. It makes us feel like there are actual people on the other side of the communication. It’s fun to be the customer of a company with a personality. This seems totally obvious, and yet you too rarely see companies with distinct personalities really grab your attention in the marketplace. Why is this? It’s actually hard to remove personality and character from communications. So, instead of saying that companies don’t take the time to have personalities, it’s probably more accurate to state that companies don’t allow themselves to show their personalities. I’m sure there are a few different reasons for this. First, it’s risky – what if people don’t “get” your personality. Second, it’s hard to maintain a personality as you grow and have a global audience (the http return code 404 in FeedBurner, for example, results in a page that says “There is no spoon”. This can be a bit challenging for those of us that have a hard time with English and/or technology). Third, and probably not to be underestimated, we have been brought up to think that business is serious, and that we have to be serious if we want to be taken seriously. As the saying goes, this is serious business. So, we (meaning you) spend lots and lots of time depersonalizing our corporate communications, because, you know, we can’t say that!. We write press releases that use approved emotions like “we are very excited to announce the release of…” instead of writing “It is with great fear and trepidation yet in some ways it is ultimately delightful for us to let you know we’re releasing …”, etc.

It is a competitive advantage for you to have a unique voice in your market. Companies with unique personalities give themselves a leg up because people want to embrace other people, and we all dislike antiseptic and bland corporate communications.

I should also point out that when I say it’s important to have a unique voice, I don’t mean that you have to make sure people think your company is fun and cool. Your company voice can be serious or esoteric and still your customers will appreciate you for having a unique voice.

The time when it’s easiest to embrace your company’s voice is of course when you’re a startup, but even larger companies should be allowing themselves to have a unique voice. Recently, a number of Apple press releases have given the sense that Steve Jobs wrote the release himself (and that he had to tell a number of people in corporate communications that yes, dammit, I really do want to say that. It would be absolutely fantastic if he had no hand in these releases!). You never get such a sense when you read a Lucent press release; they all sound exactly the same. I bet it also takes longer to write a Lucent press release because a lot of people have to make sure it scores 100 on the dehumanizer before it can be released. I pick on Lucent because I used to own the stock and actually waded through some of the releases, but you could look at 95% of the public company press releases out there and draw the same conclusions. Why the heck did I used to own Lucent stock? Um, I made some mistakes in my youth, and then I made a lot more mistakes in my not youth.

Don’t talk to your customers the way most Fortune 500 companies talk to their customers. Your customers want to like you. Your employees want to like the company they work for. Communicate with your customers and the marketplace in a way that makes them feel closer to you, and the way you do that is by allowing your company to have a voice.

Note that having a company blog is not a checkmark that equates to having a company voice. Company blogs are great, and I can think of very few companies that shouldn’t be blogging. Your voice, however, has to be everywhere your company interacts with the market and customers. It’s more than the brand, it’s all your communications, including customer service responses and presentations that employees give at conferences.

Post-Script: I think I’m slowly going insane because the structure and grammar of my posts seems to get progressively worse. It’s like I’m the lead character in Flowers for Algernon and the brain surgery is wearing off. Soon I’ll be writing in all consonants and uploading pencil sketches.

Posted by Dick at 11:13 PM | Permalink | Comments (5)

A wizard follower (I call them followers now; this is how one builds one’s own cult) writes to ask: We’re growing the business from four people to twenty, and in our current structure, everybody reports to me. That’s obviously untenable long-term. What’s the best way to grow organizationally so that the company is structurally prepared for 20/30/40 employees?

It’s hard enough to find great people, and hoping that you will find both great people and a consistenly smooth balance of experience across departments is almost impossible. What’s the right way to address this and how do you attack the problem?

I once heard serial entrepreneur Mike Cassidy (most recently founder/CEO of Xfire) tell a large group of CEO’s that given a choice in the early days between hiring very experienced senior people or extremely enthusiastic and energetic junior people, he always looks to hire experience. I agree with this, and I’ll discuss why. First of all, in the first year to eighteen months of the business, everybody is generally heads down and go, go, go. By bringing in experienced people who understand the industry, their roles, and what needs to get done, you as entrepreneur are less likely to have to play grown-up and deal with the management issues that can frequently pop-up among a largely junior staff. It’s critical in the first 12-18 months to run as fast as possible, and by bringing in experienced players that can hit the ground running, you give yourself an opportunity to get a lot accomplished quickly. Secondly, as the organization grows from 4 to 20, if your first few people are senior, you can be confident that the future leaders of your organization are do-ers, people who rolled up their sleeves in the early life of the business and know how things operate ‘under the hood’. We never liked to bring in people to run a part of the organization if we were unsure of how hands-on they could be. You don’t have this problem if the senior people are doing all the heavy lifting themselves in the early life of the business. Finally, once you’re at 4 or 5 people and you need to start ramping staff more quickly, if your first few people were experienced people, you can feel comfortable hiring either experienced or junior people as employees 5-10, but if your first few hires are inexperienced juniors that look to you for lots of management help, your next several hires have to start including a couple key senior people with great experience, just when you’re in the mode where you need to hire more aggressively and it’s going to be harder to find those key people quickly without some serendipity.

Ok, so if you’re at a couple people right now and you’re just getting ready to grow, you’ve got my advice….your next hires should include a couple experienced players who can fill key roles as you grow. They have to be do-ers, not people who are just waiting to manage the next people that come in. What if, on the other hand, you’ve already hired your first five people, they’re all junior engineers or designers or customer service, and everybody reports to you? Now what? Here’s what I think I’d do if I were in that position (warning: conjecture ahead!). I’d try to hire somebody with significant experience in your product or service area that can play an operations executive role as the company grows. Even if this person will report to you and everybody else will still initially report to you, as you grow to 20 people, an operations executive that could ultimately grow into a senior management role will give you some flexibility in your next set of hires. For example, as you grow, you’ll obviously need to start offloading some of the tasks you’ve been handling as founding entrepreneur. If you’re growing and your first experienced hire is CTO, you’ve got no room to move on the finance, business development, legal, HR side of the house and you will still have to manage all of that yourself. You probably shouldn’t expect the CTO to be able to handle payroll while you’re out visiting that customer next week. Same thing for vp finance or the like. You can’t expect them to facilitate a product development meeting with the junior team members while you go meet with VC’s. What do I mean by an “operations executive”? I’m not saying you should try to recruit the COO of Dell. I’m speaking more about somebody who’s run a large product or service team and had to deal with things like budgets and forecasts, project management, product development, etc. If they've got actual operations executive experience, swell. By positioning the potential role as providing a path toward senior management in the company, you will hopefully attract well qualified experienced people who are looking for an opportunity to take a big step forward to the next level in their careers.

In fact, the first senior hire start-ups usually bring in is a VP, Business Development. You are eager to get out there and do business, you’ve got revenue projections and big plans, you need somebody who can start business developing. I think you’re better suited to get an operations executive in place that can start laying the groundwork for future organization growth, and then start to bring in additional staff opportunistically with this core role in place. The BD person, like the finance or technology executive, doesn’t provide you with the flexibility you may want depending on how the next set of hires line up…..if you end up finding three great junior engineers next, the operations exec can play product/project manager to that group, whereas you’re going to have to play that role (or worse, try to hire a technology team lead too quickly) if your first experienced hire is the BD executive. Finally, it’s also the case that if you don’t bring in the operations exec early, you probably don’t end up bringing them in until too late, because the needs of specific teams within the organization will quickly start to demand very specific functional leads, and pretty soon you’ve got an org with no structural core and no approach or processes for growth.

Notice how this kind of approach also fits in with my Best Available Athlete thinking about hiring. You want your more experienced early hires to be as much like stem cells as possible….able to take on differing roles in the organism depending on where they’re needed if the business or market or hiring experience shifts from expectations.

All of these issues are less critical if you’ve got a group of cofounders that can wear multiple hats, but of course, most entrepreneurs don’t find themselves in this situation.

NB: it’s also worth pointing out that lots of founders don’t particularly want to be CEO after the company gets to a certain size. Having an operating executive on board early allows you to also evaluate this person as a potential CEO should that opportunity or necessity arise. More on the transition from founder to senior management in a future post.

I believe the grammar in this post is absolutely miserable, but sometimes you just can't bring yourself to wade through the thing and purty it up, language-wise.

Posted by Dick at 03:17 PM | Permalink | Comments (3)

Let’s pull a question from the MBA bin. I’ve spoken a few times to MBA schools that have mistakenly invited me in to talk about starting and running companies, and the question I always get at these events is “what is your exit strategy?”

I don’t think you can be very successful, and you certainly won’t be happy, if you are running a business and thinking about your exit strategy. If there is one theme that I hope I am conveying here over the course of many posts, it’s that you can’t predict what is going to happen to your company.

My cofounders and I have never entered a business or market thinking “the goal is to take this company public” or “we need to get this in front of the M&A team over at Toys ‘R Us”, or “if we have 50% of the online humidifier market by june 09, we’ll be a great acquisition target”, nor do I think you can unilaterally pursue exit goals successfully. The old adage “great companies are bought, not sold” is sometimes taken to mean that if you’re out there hawking your wares to M&A teams, your product/service must be second rate, but I think the more salient takeaway from this adage is that great companies are pretty focused on what they need to do in order to grow the business, execute on the strategy, and hit the revenue/operations targets.

The bottom line is that you have to take something of a zen approach to what the “result” of your company will be. Your business will either be successful or it won’t. If it’s successful, then the outcome will take care of itself. How will it take care of itself? It’s impossible to predict.

The enlightened reader is now thinking, “wait a minute, if you don’t have an exit strategy or outcome in your head, then how do you know how to finance the company? How do you decide what you want to do next in terms of growth? How do you decide if an offer (financing or acquisition or otherwise) is worth it?" Around this same point in the conversation at the MBA events, I usually get a raised eyebrow that accompanies the comment “well, your VC’s are certainly thinking about exits even if you’re not, so how can you say you’re not thinking about an exit strategy if 60% of your company is owned by people who want a fast exit”.

I have generally the same answer to both questions/comments. First of all, contrary to what I seem to read almost weekly, technology VC’s (at least the early stage folks we’ve worked with) are more interested in growing successful businesses by financing them and less interested in figuring out how to get liquid within 18 months. Obviously, there comes a point or many points in the life of a successful company in which there are liquidity options, including acquisitions, mergers, and public offerings. I can tell you that if you are running a growing company with solid investors, those investors will generally be encouraging you to keep growing the business and financing it for further growth and ignore everything else. At some point, the preferred financing is a public offering through which the investors have some ability to approach liquidity. So, the notion that you are on the speed clock to exit when you raise venture money just isn’t generally true. No doubt there are exceptions – say a fund is underwater, and you’re the last company in the portfolio and you’re doing 8 figures a year top line in your third year and you want to stay private as long as possible – ok, you're definitely going to have a fidgety investor on your hands. From the entrepreneur’s standpoint, the answer to the question,“If you don’t have an exit strategy, how do you know how to finance the company? How do you know where you’re going?” is similar. You treat any acquisition/merger/etc. entreaties as financing offers, realizing that financings that result in 100% acquisition of the equity are going to look different than those involving the purchase of 10% of preferred Series D stock. Since you should always have a general sense of how your company would be valued on a financing, you can then more easily react to other offers pretty quickly, without having to run around like a chicken with its head cut off. They either make sense vis-à-vis how you would finance the continued growth of the company based on your current trajectory or they don’t.

Don’t interpret my comments here as "never talk to your executive team about how much you think the company is worth right now" or “you don’t even talk to people that want to talk to you about financings, m&a, mergers, etc. until you are ready to finance the company for further growth”. That’s not at all what I’m saying, and in fact, I’d say the exact opposite. I almost always met with people that wanted to talk to us about these topics (almost always financings), even if we weren’t a stage where we needed to raise money. I’ll go into this more in a future post, but again, this is all part of our philosophy that you can’t try to steer your company down a pre-ordained path: “we’re not going to talk to VC’s now because our business plan has the A round lasting 12 months”, or “we’re not going to start talking to investors now because we’d really like to sell the company in six months”. Potential investors, potential acquirers, potential partners – these are all opportunities that you should weigh in the context of what’s happening to your business in this market. How these opportunities will play out is impossible to predict. Make a map of how you want to grow the business, not a map of what you want to happen to the company.

Posted by Dick at 03:45 PM | Permalink | Comments (6)

Good question about organizational behavior in startups and office configuration, a topic about which the FeedBurner cofounders have very definite opinions.

“Oh great Wizard, what is the ideal office space configuration? Cubes with some private offices, combination of open workspace, cubes, and private offices, or some other crazy configuration?”

Yes, we’re all getting cute with the ‘oh great wizard’ stuff….serves me right. My opinion for technology startups is totally open space with some large conference rooms, some very small conference rooms which double as phone rooms for personal/private phone calls, and no private offices, and if that’s not possible (no such rental space in a neighborhood, etc.) then make your existing space as open as possible and turn private offices into rooms with 2-3 desks. When FeedBurner was about 35 people, I was with a collection of CEO’s at one of our investors’ entrepreneur summits, and I stated that this was the winning formula in my book. I was widely disagreed with, mostly on the grounds that you can’t sustain open space with no private offices beyond 40-50 people. Since we were only at about 30 people at the time, I figured maybe that was true, and I certainly couldn’t prove that it wasn’t. My short time at another much larger company with generally open space makes me think my first instincts were correct. I’ve certainly seen that it’s not true that you can’t scale the open space approach beyond 30 people. Let’s talk about why I like this open configuration in startups, and why I hate dislike offices:

1. Speed of communication begets speed of execution. News travels a lot faster in a big open room with no walls than it does in an office with corridors and private offices. When everybody is up to speed on what’s happening in the company in real time, it’s easier for everybody to zig and zag at the same time. True/simple/stacked-deck example: We once were working on a partnership with another small company – fortunately, for the sake of this example, they were in a *very* private office culture, and FeedBurner was totally open floor plan - no offices, everybody has a desk and no walls. Our marketing director received a call from their marketing person about a change their engineering team requested. Our marketing person put down the phone and just said to me “hey dick, they want to do blah instead of bluh”, and I got up to walk across the room to the engineering person on our side and he just said “yeah, that’s fine, no problem” before I even got over there. We’re all up to speed in 10 seconds. Meanwhile, over at private offices company, the marketing director and their lead engineer know about this, but the founder, who is in the office that day, sends me an email three hours later, saying “hey, I just found out our guys wanted to do bluh instead of blah, but I wanted it to be blah because [insert rationale]. So let’s go back to blah.” Then, separately, two hours after that, I get an email from the CEO, who is also in the office that day, and who also has a private office, that says “hey dick, understand we’re now doing bluh, that’s probably even better.” Ok, at this point, their executives aren’t even on the same page on this simple integration. Granted, this is one silly example. Yes, I know that this could have just as easily happened to us if one of us was traveling that day. Yes, I know this could just as easily have happened to us if our marketing director wasn’t at her desk when the phone rang and this became an evening email thread. The point is that all things being equal, our office configuration was far more adept at dealing with instantaneous change (what Newton called “calculus”), and the private offices at the other company prevented what should have been rapid communication given that they were all in the office that day. Private offices create distance when what you require is proximity.

2. Friction begets friction, transparency begets transparency. Can you tell that the key word in this post is “begets”? One function of a very open space work environment is that you get transparency up and down the organization. When the engineering team can hear the support team constantly fighting the same battles on the phone, they have a better appreciation for the product issues. There were many times when just overhearing a phone call would help countless people in the company correct an issue before it occurred (“hey, I heard you tell that guy that XYZ will be ready in a couple weeks. It’s going to be ready but we’re starting to think we want to limit the release initially until we make sure ABC is working well”). You don’t get that serendipity in a private office environment, you get friction. Friction requires a lot more formal communications processes, and processes in small companies have the potential to create more, not less, friction. You obviously have to have a few small conference rooms or phone rooms where people can make private calls. People have personal calls to make and some people don’t particularly care to be negotiating with a major media company out in an open room when the CEO is swearing about something else in the background, you know, just to pick a hypothetical. When all the general business is conducted out in the open, there’s much less likelihood of office gossip because everybody generally knows what’s going on. I would talk to our finance team about quarterly numbers out in the open, right next to engineering. Some people will say that’s stupid, as a new/junior employee might run out to lunch and tell their friend “We only did four dollars in revenue this quarter”. My position was that everybody in the company is a grown up and we’re not going to hide and speak in hushed tones unless there are very specific non-disclosures involved, which of course come up from time to time.

3. Motivation. Look, there are days when everybody comes into work and just thinks “How many times do I have to remind myself that the words ‘more’ and ‘tequila’ do not go together?” The beauty of a big open space is that you’re not going to just sit there and dial it in, or at least if you do, everybody will take notice….when you see your sales director on the phone with a particularly tough customer and really grinding out a long negotiation, it makes you think that you can’t just sit there and suck your thumb. You feel like you have to do your part. You feel more part of a team.

We can all think of a number of startups where you might need private offices, particularly outside the realm of technology startup. Companies where customer/partner confidence is imperative and employees would feel that every phone call had to be taken in a private room. I can imagine some financial services companies, some health care companies, and some consulting companies require that just about everybody have a private office. If every one of your customer calls has to take place in a private phone room, well then, you should probably just have an office, however, I believe this is not the case for 99% of technology startups. I just do not buy that the director of sales or the CEO have to be on private calls more than once or twice a day, at most.

Frankly, whether people will admit it or not, most of the time you end up in an environment with a private office for status reasons, not business reasons, and status is not a particularly compelling argument for a specific office configuration. In fact, status has the downside of causing people in the company to work toward status instead of working toward results.

There is one humorous side effect of this kind of environment, which is that people from traditionally status-oriented industries (say, banking, just to pick on a vertical) don’t take you as seriously when they visit your office. You can’t possibly be doing that well as a company if the CEO is just sitting out here in the middle of the room with the rest of the huddled masses!

Posted by Dick at 09:58 AM | Permalink | Comments (13)

A brieft post! The first and possibly the last. I and Chicago-based technology entrepreneur and investor Dan Malven got into an email discussion a few months ago after my financing term sheet post on liquidation preferences. Dan has created a very cool spreadsheet that first-time entrepreneurs can use to understand how participation, preference multiples, and even participation caps will affect distributions and ownership post-money and on exit. Dan's one of those excel masters who has awesome spreadsheet voodoo skills, and this is a very cool document. Be sure to read Dan's post that points to his worksheet.

Posted by Dick at 01:22 PM | Permalink | Comments (0) | TrackBacks (0)

To say that the Wizard has not been answering his mail would be a dramatic understatement. Woe betide the person that has mistakenly turned to me for guidance over the past couple months. What can I say, there are only so many hours in the day, and I only get about half way through my to do list by midnight.

One of the questions I received over the past few weeks was “What are the biggest lessons you’ve learned in the past five years?”…. when the question came in there was no question mark at the end, but through my amazing powers of grammatical intuition, I have perceived that it was meant as a question, so I’ve taken the wizardly liberty of adding a question mark to the end. Onward.

I have a bunch of different answers to this question, but I’ll start with one that came up in a conversation with Fred Wilson in regards to some random topic, and Fred noted that I should post it. I’ll try to keep adding to this as a series of posts over time.

Lesson #1: What is obvious to you is not necessarily obvious to others (and vice-versa).

….and this isn’t as obvious as it may seem. I remember the first time I saw Twitter and thought “I don’t get it”, and then somebody explained it to me and I thought “uh-huh. I don’t get it”, and then somebody explained it to me again, and I thought “Ah!... I don’t get it.” Only after I saw somebody using it in a way that I found valuable did I finally get it.

It isn't always the case that I'm on the slow boat; sometimes I'll hear an idea that seems so obvious to me that I can't understand why nobody'd come up with it sooner, while other people will hear the same idea and think "I don't get it".

When we built FeedBurner, I would tell people about it, and some people would say “hey, that sounds very cool” and others would reply “uh-huh”, which is web2.0-speak for “huh?”. It was obvious to us that FeedBurner was a very powerful concept around which an ecosystem could flourish. It wasn’t obvious to most other people until they actually saw several examples of people using FeedBurner in powerful ways.

What’s the point? The point is that “build it and they will come” isn’t true. You need to build it, and then show them exactly how it can be used, and then show them several explicit examples of why it’s powerful, and then they might come.

Why is this so? Here I stray *way* outside the bounds of my knowledge and pretend to be Malcolm Gladwell, but without the cool retro afro. We all have mental models that we’ve built up over the years and we use these models to judge new ideas and services that we see, and this is the reason people came up with terms like “horseless carriage” when cars were invented….we try to make things fit into our existing models, and we all have slightly to very different mental models. Make sure you provide explicit examples of the powerful use or implementation of your service and don’t just expect people to ‘find’ it on their own. Similarly, pay careful attention to the things that people do with your technology/service/product, because some of them may have discovered a powerful use for it that has completely evaded you. Note that this is another reason to strongly believe that services and products that are more open and adaptive will always prevail over solutions that are less open. Open solutions enable the ecosystem to discover the optimal value of the solution, whereas less open systems are at the mercy of their creator having guessed at the optimal solution in the first place.

Posted by Dick at 11:45 AM | Permalink | Comments (4)

A Wizard reader writes (or I should say "wrote", as this came in almost a month ago):

“My product is almost ready to go, it will make money in the early going as the model is pretty straightforward, but we need to raise money in order to scale the business. There are three of us right now. How much money should we raise in an A round, how long should we expect that to last, how long will investors expect it to last, and so on and so forth?”

Well, the obvious answer is that it all depends, but on the grounds most people would find that unhelpful, I’ll pretend it doesn’t all depend and address a few specifics.

First, let’s address the hypothesis that the company will make money soon after launch. Irrespective of whether we’re talking about profits or just top-line revenue here, I would caution that it almost always takes longer to ramp your top-line than you think it will. Everybody walks into a venture pitch with their three year financial projections that have a lousy first year, a strong second year, and a monster third year. The truth is that even most ultimately successful tech startups have a slow first year, a slow second year, and then you get your spectrum of third year results ranging from really-taking-off to continued-doldrums. It just always takes longer than you think to launch, grow, ramp sales, close deals, etc.

That’s a good segue for the rest of the question – how much to raise and how long should you expect the money to last. Everybody has different thoughts on this subject, but I would say there are two helpful guidelines. First, raise enough money to last about a year or a good six months after your next big milestone. Some people like to say “raise just enough to get you to and then you will be able to do a B round at a bigger valuation”, etc., but you want to give yourself some reasonable stretch of time to be product and strategy focused after the A round before you have to hit the road again to raise more money. It’s no fun having to think about starting to raise money again only a few weeks on the heels of closing the previous round. Second, you always need more money than you think you need, especially if this is your first startup. You can have a nice detailed spreadsheet that accurately reflects market salaries, rent, and more, but you will still require more money than you think.

Those of you reading Marc Andreessen’s excellent blog will note that my advice is out of step with his advice to “raise as much as you can”. Now, Marc has co-founded a couple of hugely successful public companies and has invested in countless others and his latest post has the words "my company" and "billion dollars" in the title, so if you find yourself wondering whether you should put more credence in his words or mine, I will repeatedly point you in his direction (you start one monster company, maybe you were lucky, maybe you were in the right place at the right time. You found two billion dollar companies? You officially know what the hell you are doing. Nobody is that lucky.) Nonetheless, I’ll disagree with him on the funding amount question, especially for first time entrepreneurs, for a couple of reasons. Now, if you’re Marc or somebody like him, I don’t disagree that you should raise as much as you can on your first institutional round. Marc isn’t getting involved in a new company hoping he can eventually exit for $60 million dollars, that’s just not an interesting scale to somebody that’s created a couple companies worth well over a billion dollars. I also realize the astute first time entrepreneur in my audience is thinking “but I’m not looking to sell my company for 60 million either! My idea is huge, and I think it’s a home run and I want to go for it!” That’s obviously the right attitude, and it’s an attitude you will need, and it’s the attitude that your investors will want to see from you. Nonetheless, I don’t think it makes sense for most entrepreneurs to raise big A rounds, because you don’t want to price yourself out of interesting opportunities in the first year or two. By raising too much money, you force your hand on the kind of company that you have to build, whether you want to or not. Let’s look at two scenarios for a very promising startup with technology that may be of strategic interest to several profitable public companies (note to self - write a future post about the importance of not planning for or even thinking about exits like this):

Scenario 1: You raise 1 on 3 pre in an A round, so you’ve sold 25 percent of your company for a million bucks and you have a co-founder with whom you’ve evenly split equity, and you have a 15 percent options pool from which you quickly allocate 5 percent that fully accelerates on a change of control.

Scenario 2: You raise 10 on 40 pre in an A round, so you’ve sold 20 percent of your company for 10 million and you have a cofounder with whom you’ve evenly split equity and you have a 15 percent options pool from which you quickly allocate 1 percent that fully accelerates on change of control.

Six months into your post-A round, you are approached by Awesome Corp and they would like to buy your company for $20 million. Company that pursued Scenario 1 is in the following situation: founders each own 35% of the company. Founders each make $7 million dollars, investor takes out $5 million for a speedy 4x, and the options holders pull out the remaining million dollars. Ignoring taxes for the moment (much like ignoring friction in freshman physics, this is impossible and problematic, but humor me), this is a nice outcome for everybody. Your investors, it might surprise you, won’t be particularly thrilled, because it’s important to keep in mind that they are not in this business for IRR, they are in it for multiples, and a 4x on a fantastic new company with only $1 million invested is not that exciting. Still, at a 4x after six months, they’re probably not going to block the deal. It’s nice to make 400% returns in a short period of time. Now let’s look at the same offer if the company pursued Scenario 2. Ruh-roh. Do you think our founders are going to be cashing in any Awesome shares anytime soon? No, they are not.

But wait, don’t the founders actually own MORE of the company? Won’t they actually make MORE money individually? Why yes, they do own more of the company, but that was just a little trick I played on you. It makes no difference, because the investors, who have put up $10 million dollars, stand to take out $4 million dollars, and investors have this thing where their LP’s get very mad at them if they invest 10 and get 4 back after only 6 months. If our founders go look at their Articles of Incorporation and the term sheet they undoubtedly signed from the investors when they raised this round, they will see that the investors have blocking/veto rights, and the investors will veto this deal in a heartbeat. More likely, the company would never even get to this point, because the people at Awesome are going to look at the company cap table and realize that this deal doesn’t get done. The founders have set themselves on a course in which the only two possible outcomes are home run or failure.

I did my math above in 14 seconds and have no time for proofreading these days, so mea culpa if my percentages are off but you get the picture.

I would suggest that there are some very nice middle ground areas for the entrepreneur that hasn’t previously made a bundle of money, and many of these middle ground areas are still large enough to provide venture returns to institutional investors. By overcapitalizing your company, however, you can put yourself in situations where a potentially huge personal outcome is made impossible.

Fine. Let’s say you are only interested in huge home run or failure. The middle ground is for suckers, you say, and you are no sucker. You are an all or nothing hombre. Shouldn’t you now raise as much as you can in an A round? After all, you are in this to rock the world and make a huge difference and build the best damned company you can build.

No, I still don’t think you should raise as much as you can, for several reasons, but I’ll just highlight the most important. You will spend what you raise. If you raise $10 million, you will quickly ramp up to a burn rate of $800k a month, because the investors don’t want their money to sit in a bank account earning interest with 36 months of runway while you hire employees 2 and 3. The amount of money you raise sets you off on a course at a specific pace. Your board will want to know why you aren’t deploying capital. You will hire a marketing team because you can afford to hire a marketing team. You will hire a vp of sales before the product is ready because you can afford to hire a VP of sales. Companies that raise $10 million dollar A rounds don’t raise $5 million dollar B rounds, they raise $30 million dollar B rounds. If you have not accurately predicted how quickly you can grow the top line, you will quickly find that the cap table has gotten away from you, and you will have less flexibility to build the company the way you might like to if the market zigs when you thought it would zag. You want to give yourself the flexibility and room to react to market forces so that you can build the best company possible.

Final notes: It’s possible that by “raise as much as you can”, Marc is implying that the two first time cofounders with an idea that might sell for 20 million in six months will only be able to raise a million bucks. That’s fair enough and probably true. Still, even though I’m putting words in his mouth, I’d just caution that investors will always want to put more capital to work in a great company. Second, I hope that this post isn’t interpreted as “you should raise as little capital as possible” or “make sure you don’t invest too aggressively in your company”. Undercapitalizing your company is just as dangerous as overcapitalizing your company, with the added tragedy that undercapitalized companies sometimes miss out on their opportunities to be the gorilla in a huge market. You want to be capital efficient while making sure you are funding the growth of the business. If customer wins are accelerating and revenue is up 100% quarter to quarter, don’t try to get too cute about finessing growth on the cost side….ramp into growth and hire ahead of demand. More on that in another post.

Posted by Dick at 12:29 PM | Permalink | Comments (7)

Brad and Jason have a great post up over on Ask The VC regarding the often asked first-time entrepreneur question How many shares should I create for my new company?. This is directly related to a couple of questions I've gotten lately from employees considering offers from startups that go like this (i'm combining a couple different lines of questioning into one set here):

I'm considering joining a startup that completed an A round financing. They have offered me options, and I'd like to understand the relative size of the options offer, so I've asked them about their pre and post-money valuation on the A round (which will tell me how much of of the company is owned by the investors already), and expected dilution in my equity as a result of a next round of financing. The company has not wanted to answer any of the questions in quantitative specifics, but responds qualitatively with "a good valuation" and "not much dilution". Is this reasonable? I will know the current valuation if I knew the exercise price and multiply it by total outstanding stock,right?

There are a bunch of things to say here. First, go read Brad and Jason's response to the "how many shares" question. Back already? Such a fast reader you are. Ok, let's dive into this set of questions in not necessarily any particular order.

The first question you really want answered when you're receiving an offer like this from a private company, and it's a question the company should be prepared to answer, is "what is the total number of authorized shares". If you are offered 100 options in the company, it doesn't really matter whether the company's valuation is 5 or 500 million dollars (if the company's public, all this is moot obviously. There are loads of mechanisms for valuing options in publicly traded companies). You don't really know anything about the size of your grant unless you know the total number of authorized shares, and they should be willing to let you know that information so you can determine the relative size of the grant. Without that information, the offer only amounts to "some options".

The valuation numbers are probably not going to be answered by a private company (they have multiple reasons not to go around touting the financed value of the company, not the least of which is employees claiming two years later that 'you told me the company was worth 50 million dollars'), but again, the answers to the valuation questions are secondary in my mind to the size of your grant. The first thing you really want to know is "what percent of the total authorized shares am I being offered".

In any case, you will not know the current valuation by multiplying the exercise price by the total outstanding shares. The options you are being offered are almost definitely options to purchase common stock. The investors on an institutional A round financing almost certainly have purchased preferred stock. Since the preferred stock is paid out in preference to the common stock on any liquidity event, the common stock is probably valued at a significant discount to the preferred stock. So that calculation isn't going to help you.

Once you know the percentage of authorized shares you've been offered, and you know the company's executed a 5 million dollar A round financing, how do you calculate the probable value of your options? The short answer is "you don't" or "the current value is around zero, subject to change", take your pick. The long answer is that your options aren't worth what a VC was willing to pay for their equivalent number in preferred stock. Your options are only going to be worth what somebody is ultimately willing to pay for common stock at some point in the future, and that price is only going to be determined on an IPO or sale of the company. Just like the founders, you need to decide whether you think your percentage of shares is going to be worth some potentially meaningful amount if the company is successful in the market. The only thing you can try to know with certainty is your percentage interest in the company against which you might guestimate reasonable comparable exits in the market and calculate your percentage interest in that exit, but even here, you are subject to unknown and potentially unknowable amounts of future dilution, preference multiples (in which the investors get 2x or 3x or more their investment back before any remainder is distributed to common), etc. A question you might ask the company vis-a-vis your percentage interest is whether the existing investors have any preference multiples (because this has the potential effect of reducing the common's interest in the company on a liquidity event), but again, even if the company answers this question with total transparency, it could be very challenging for you to understand or measure the implications to any reasonable degree.

The follow-on financing dilution question is important. Too few people understand the implications of follow-on equity financings, which is that everybody (probably including the existing investors if they don't invest in this round) gets diluted on any further equity financing. The trouble with specifics around this line of questioning is that the company isn't likely to have very concrete answers as to what future financings might mean for equity dilution, even if the market's supply/demand continues to function exactly the same as the present environment. One way of at least getting a sense of the magnitude/timing of potential dilution is to ask questions that help you understand how long the current financing is expected to last.

The bottom line for potential employees is that future dilution is going to be very hard to gauge, you just need to understand that the closer you are to startup mode, the more likelihood there is of significant dilution, for you and the founders and everybody else. The company should be willing to help you understand your current percentage interest in the company and some qualitative measure of the likelihood of future dilution. Beyond that, you're in the "leap of faith" pool with everybody else. If the company is unwilling to let you know what 100 shares equates to in terms of percentage interest in the company, I'd say that's a warning sign and you should ask lots more questions.

Posted by Dick at 02:35 PM | Permalink | Comments (3)