How To Keep Your Company Alive – Observe, Orient, Decide and Act

This article previously appeared in the Harvard Business Review. It’s been updated with new information about the U.S. Paycheck Protection program and the Economic Injury Disaster Loan program.

 

What cashflow-negative companies must do to survive

We’re in uncharted territory with the Covid-19 pandemic. But it’s increasingly looking grim.

Companies that outlast this crisis will have CEOs who can rapidly assess these new circumstances, recognize new patterns and opportunities, and act with urgency to take immediate action to pivot and restructure their companies. Those that don’t may not survive.

So here’s a five-day playbook to help CEOs of cash-flow negative startups, or ones about to go negative, assess the new normal and respond with speed and urgency.


Your Company Survival Depends on A Simple Formula
Your company’s survival in this downturn can be captured in a simple formula.

Survival = (speed of your understanding of the situation) x (the magnitude of the pivots/cuts/lifeboat choices you make) x (the speed of your time to make those changes)

Notice that the word speed appears twice. This is not the time for committees, study groups or widespread consensus building. Even with imperfect information, the future of your company depends on your ability to make rapid decisions and start acting.

If you’re a CEO who can’t quickly bias yourself for action and if you wait around for someone to tell you what to do, then your investors, or more likely the market, will make those decisions for you.

Huge segments of the economy have shut down: travel, hospitality, restaurants. Any place with a fixed cost that relies on foot traffic will come under pressure. With millions of people out of work in the next quarter, it’s obvious that discretionary purchases like furniture, fashion, lifestyle will take a hit. But other businesses like law firms, contracting firms, real estate firms, will take hits, too. The ripple effects won’t be obvious at first. Your customers will no longer be your customers. Your revenue plans are no longer valid. To understand the state of things, you need to rapidly assess your internal and external environments going forward.

Day 1: Prepare An Assessment of the Internal and External Environment:
What did the external and internal environment look like for your company today? What do you believe the world will look like for each of the next five quarters? For companies burning cash, such as startups, how much cash do you have? What’s your monthly cash burn at your new low revenue level? How many months of cash do you have?  Cut costs to stay alive for 24 months.

External Assessment

  1. State of the economy
    • Unemployment %
    • Shelter in place yes/no?
  2. Health of Your Current Target Market(s)
    • Actively buying? Not returning calls? Out of business?
  3. Emergence of New Market(s)
    • Are there new opportunities?
  4. Forecasted recovery date
    • Workers can return
    • Your customers start buying
  5. Check if the the Paycheck Protection Program, (here and here) which provides 100% federally guaranteed loans to small businesses, can apply to your company. Also see if the the Economic Injury Disaster Loan program applies.
  6. If you were raising money, validate whether your investors are still on board – with the same terms – or at all

Internal Assessment

  1. Operating Numbers
    • Liquidity and likely cash-out date under your worst-case scenario
    • Accounts receivable, accounts payable
    • Sales pipeline/forecast
    • Marketing programs spending
    • Payroll costs/other variable costs
  2. Sources of additional capital – For existing companies: debt commitments, and new lenders. Can the Paycheck Protection Program, (here and here) be a source of capital?For startups: source of VC money?

Don’t overthink this. And most importantly do not outsource this to your staff. Set up a war room and work with your CFO and C-level staff together until it’s done. That will start to get your team aligned about the size of the problem. The CEO should dial through as many of the largest existing customers to get a firsthand understanding of the magnitude of any revenue shortfall. If you were expecting angel or venture funding get on the phone to your investor(s). Some VC’s are walking away from signed term sheets. Others are cutting their valuations. The CFO should be on the phone to sources of additional capital. There is no market research that’s going to get it “right.” No one can predict how this plays out and for how long. All we know is that it’s going to be very different than it was a few weeks ago and likely going to be worse a few weeks from now.

Day 2: Iterate the assessment with your investors/board
Whatever assessment you develop, you need to get feedback from your board and investors. While you’re seeing just your own company, hopefully they’re getting data from multiple companies across a wider set of industries. If you’re a startup you’ll also get a sense of how much of a nuclear winter the funding scene is for your market/company.

Boards need to insist on an immediate assessment and be actively engaged. I listened in on a board call with an enterprise software company this week, and when the CEO said, “Our VP of sales assured me our pipeline won’t be affected.” Board members gave her a wakeup call: there was either going to be a much more realistic assessment tomorrow based on her first-hand customer conversations, or a new CEO. Some CEOs can and will rise to the occasion by themselves but having a unified board can accelerate the process.

But what if you think the situation is more dire and you disagree with your board’s assessment? CEOs in this position are going to face a major career decision – go along with advice you think will damage/destroy the company – or put your job on the line. Remember, a year from now no one wants to be the CEO of a company out of business whose lament is, “I did what the board told me to do.”

Once you have agreed on what the world will look like, it’s time to build the plan for your new company. This plan has three parts: Pivots to your new business model, changes to your operating plan, and what initiatives you save for the recovery. The plan must also take into account that this crisis has exposed how vulnerable companies are to a single source of supply. CEOs of companies that manufacture goods in the U.S. are about to face a moral dilemma. China and South Korea are starting their factories up again. Going forward, do you move your supply chain from China or at least create a second source from other countries? Do you source/build things there while laying off people here? What does your board suggest? What do you think is the right thing to do?

Days 3 and 4: Prepare new business model and operating plan
First, think about potential pivots. Ask yourself: Are there now new customers, new services and new channels to pursue? Which parts of your business model can now serve the new normal where business is booming – remote work/education, social cohesion over distance, telemedicine, home delivery, etc.?

For example:

  • If you had brick and mortar locations, how much can you pivot to Ecommerce (for basics), so customers can acquire goods without having to leave the house? Can you also offer specialized services?
  • Automated delivery services – the more people you can take out of the equation, the safer the product. Are there parts of your supply chain that can be repurposed? What about parts of your manufacturing lines?
  • Online/Virtual learning – schools will need to embrace virtual learning in a way they haven’t before.
  • B2B – cloud services, online meetings, virtual workforce management, collaboration tools. With more work from home happening, all of these services will see increased demand from companies
  • Virtual Travel/Tourism – how can consumers get out without leaving the safety of their house?
  • Remote Workforce automation – past the obvious conferencing tools, how do you maintain cohesion and coordination?
  • Remote health care – Can you do initial triaging/diagnosis online before having a patient come in?
  • Personalized Video Entertainment – VOD, AVOD, Short Form Social Sites, Twitch, etc. …

Next, plot out the changes to your operating plan. What cuts will you make to spending programs – marketing, service, manufacturing, R&D? What are your “lifeboat choices” – what layoffs to make, renegotiate payables, rents, leases, how to trade off cash management versus revenue growth? How can you shift focus to customer retention versus acquisition?

As part of these operating changes, make sure your heads of HR and finance recognize that they have entirely new jobs.

Your CFO now becomes the head of cash management. Draw down all debt commitments. Ask existing and new lenders for additional funding. Call all large vendors and ask for lower prices. If appropriate, offer to sign a longer agreement in exchange for lower cash payments in 2020 and 2021. See if your fixed costs are really fixed, or will they agree to defer some for higher payments at a future date. Make sure your CFO is familiar with the Paycheck Protection Program, (here and here) as a potential source of cash and to avoid/defer layoffs.

Nothing is more important than assuring the company can continue to pay its employees.

Your head of HR is now head of layoffs. He or she has 48 hours to grow into it, or you need to find someone else from the ranks to do it. Before layoffs, cut all salaries by 20%. Cut CXO salaries by at least 30%. Award equity to employees equal to the value of their reduced salaries. Try to protect the most vulnerable employees. Letting people go needs to be done with compassion and adequate compensation. And if you do it correctly, it will hopefully be done just once.

For those remaining employees, offer remote therapy to deal with the stress of working from home and pay for any equipment/network upgrades.

As you make these plans, remember: There will be a morning after. What changes in your industry will be permanent? If you have sufficient cash reserves, what initiatives do you want to keep in the lifeboat that may give you the ability to take advantage of these changes? To recover and grow quickly? Or to launch new products? Or if you have sufficient cash, now is the time to hire great people who were never available.

Although you prepared the internal and external assessment with just your C-level staff, now you want to rapidly engage the collective intelligence/wisdom of the company. Ask everyone in the company to suggest changes to the business model, operating plan and recovery plan.Your employees likely have ideas and see opportunities not visible in the C-suite. This will signal to every employee that now is the time for all-hands-on-deck and that you will be making decisions to quickly separate the crucial from the irrelevant.

You need to communicate, communicate and communicate some more to your employees about why you’re asking for their ideas. This is the perfect time to start a daily update from the C-suite. This is critical if your employees are working remotely. Let them know what you’re learning and then when you begin implementing changes, tell them why.

Day 5: Iterate with investors/board
Whatever business model, operating plan and recovery plan you come up with, you need to get feedback from your board. Keep in mind they’re likely dealing with multiple companies rapidly replanning, so remind them about the assessments you mutually agreed on. Then walk them through why the changes you’re suggesting match that plan. They may have seen new ideas from other companies in their portfolio so be open to additional suggestions.

Beyond the five-day plan, I want to specifically address two of the most challenging parts of the new operating plan you need to address: Layoffs and culture.

Carpenters use the aphorism “Measure twice, cut once.” The same applies to layoffs. In every downturn I’ve lived through, there were CEOs who handled layoffs as “a death by a thousand cuts.” For example, in a company with 1000 employees, they’d layoff a 100 people the first month, another 100 the next month, then a 100 the third month to downsize to 700 people over several months. Rather than being productive, the constant layoffs were demoralizing and paralyzed the remaining workforce. Employees saw that the direction was a downward spiral with no end in sight. And everyone worried: “Am I next?”  I’ve watched other CEOs immediately layoff 400 people and have 600 left. If/when they overshot, they could rehire 100 people (including some of the same people who had been laid off). While the mass layoffs created an immediate shock, people adjusted. They worried but began to feel more secure. When hiring began again, everyone was relieved: “The worst is over. Things are getting better.” (Remember to investigate whether the Paycheck Protection Program can save some or all of those jobs.)

To begin adjusting the culture to this new reality, communicate these business model and operating plan changes to your employees. Offer relentless optimism for survival, but ruthless cost-cutting (starting with the CXO salaries.) Let them know that as CEO you are going to be micromanaging for survival and expect each of them to do the same. You’re going to be relentless, direct and clear that once decisions are made, there are no disagreements. And remind them that together you are all working to save the company and their own jobs.

At some point this crisis will run its course. Running this five-day playbook will help your business survive so when the recovery does come, you’ll emerge stronger and ready to hire and grow again.

Lessons Learned

  • CEOs need to take control and take drastic action. Be decisive and do it immediately
  • Survival = (speed of your understanding of the situation) x (the magnitude of the pivots/cuts/lifeboat choices you make) x (the speed of your time to make those changes)
  • Involve the board and the rest of the company
  • Communicate with all employees daily
  • Move with speed and urgency, you have days — not weeks or months
  • As painful as it might be, when you make cuts do it once
  • Assume you’ll emerge on the other side. What will you wish you had kept?

Action Today for CFO’s

Jeff Epstein is on the board of Shutterstock, Twilio, Kaiser Permanente, and was the CFO of Oracle, DoubleClick, Nielsen and King World and is an operating partner at Bessemer Venture Partners. He teaches the Lean LaunchPad class at Stanford with me. And the minute he talks about financing I shut up and take notes.

He sent this message to the CFOs of his companies yesterday.
(Read it along with yesterdays survival strategy advice to CEOs.)

I thought it was important enough to share it with all of you.


Action This Day
Our first priority is the health and safety of our families, employees, customers and communities.

As CFOs, our next key priority is preserving cash.

For immediate action:
1. Evaluate your liquidity and likely cash out date under your worst-case scenario.
2. Objective: minimum of 18 months of cash. 24 months is better.

If you have more than 24 months, congratulations.

If not, take action now.

  1. Draw down all debt commitments. It’s like buying insurance. There’s a cost, but it’s worth it if things get worse. Ask existing and new lenders for additional funding.
  2. Make a list of all vendors, by $ spend amount. Call all large vendors and ask for lower prices. If appropriate, offer to sign a longer agreement in exchange for lower cash payments in 2020 and 2021.
  3. Review all marketing programs. Cut marketing by x%.
  4. Payroll costs are probably your largest cost item. If necessary, you may need to take action. Choices include:
    • Hiring freeze
    • Layoffs.
    • Cut all salaries by 20%. Cut CXO salaries by 30%. Award equity to employees equal to the value of their reduced salaries.
  5. Some of your customers will delay paying you; some will default. Credit card customers will dispute charges leading to chargebacks to you. Monitor collections and chargebacks frequently. Develop a playbook for mitigation.
  6. If you own bonds or other investments, review them for risk. Some companies, and perhaps some governments, may default.
  7. Because events are changing so quickly, have your CEO consider sending a short weekly email to your Board with any updates.
  8. Call if you’d like a sounding board to discuss the decisions you’re considering.

Most of all, stay safe.

Jeff

The Virus Survival Strategy For Your Startup

“Winter is coming.”

This is the one blog post that I hope I’m completely wrong about.

With the Covid-19 virus a worldwide pandemic, if you’re leading any startup or small business, you have to be asking yourself, “What’s Plan B? And what’s in my lifeboat?”

Here are a few thoughts about operating in uncertainty in a pandemic.


Impact
Social isolation and a declared national emergency have had an immediate impact on industries that cluster people; conferences, trade shows, airlines/cruise ships and all types of travel, the hospitability industry, sporting events, theater and movies, restaurants and schools. Large companies are sending employees to work at home. Large retail chains are shutting down their stores. While the impact on small businesses and workers in the “gig-economy” hasn’t made the news, it will be worse for them. They have fewer cash reserves and less margin of error for managing sudden downturns. The ripple and feedback effect of all of these closures will have a major impact on our economy, as each industry that gets impacted puts people out of work, and those laid off workers don’t buy products and services.

It’s no longer business as usual for the rest of the economy. In fact, shutting down the economy for a pandemic has never happened. Millions of jobs may be lost in the next few months, as entire industries get devastated, something not seen since the Great Depression of 1929-39. I hope that I’m very wrong, but the impact of this virus social and economic effects are likely to be profound, and will change how we shop, travel and work for years.

If you’re running a startup or small business, your first priority (after your family) is keeping your employees and customers safe. But next the question is, ‘What happens to my business?”

The questions every startup or small business CEO needs to ask now are:

  • What’s my Burn Rate and Runway?
  • What does your new business model look like?
  • Is this a three-month, one-year or a three-year problem?
  • What will my investors do?

Burn Rate and Runway
To answer the first question, take stock of your current gross burn rate i.e. how much cash are you spending each month. How much are fixed expenses (those you can’t change, i.e. rent?) And how much are variable expenses (salaries, consultants, commission, travel, AWS/Azure charges, supplies, etc.?)

Next, take a look at your actual revenue each month – not forecast, but real revenue coming in each month. If you’re an early stage company, that number may be zero.

Subtract your monthly gross burn rate from your monthly revenue to get your net burn rate. If you’re making more money than you’re spending, you have positive cash flow. If you’re a startup and have less revenue than your expenses, that number is negative and represents the amount of money your company loses (“burns”) each month. Now take a look at your bank account. See how many months your company can survive burning that amount of cash each month. This is your runway –  the amount of time your company has before it runs out of money. This math works in a normal market…

The World Turned Upside Down
Unfortunately, it’s no longer a normal market.

  • All your assumptions about customers, sales cycle and most importantly, revenue, burn rate and runway are no longer true.
  • If you’re a startup, you’ve likely calculated your runway to last until you raise your next round of funding. Assuming there was going to be a next round. That may be no longer true.

What does my business model look like now?
Since the world today is no longer the same as it was a month ago, and likely will be worse a month from now, if your business model today looks the same as it did at the beginning of the month, you’re in denial – and possibly out of business.

It’s the nature of startup CEOs to be optimistic, however you need to quickly test your assumptions about customers and revenue. If you are selling to businesses (a B-to-B market) have your customers’ sales dropped? Are your customers closing for the next few weeks? Laying off people? If so, whatever revenue forecast and sales cycle estimates you had are no longer valid. If you’re selling directly to consumers (a B-to-C market,) were you in a multi-sided market (consumers use the product, but others pay you for their eyeballs/data?) Are those assumptions about payers still correct? How do you know?

What are the new financial metrics? Receivables – get on top of them. Days of cash left?

You need to figure out your actual burn rate and runway in this new environment now.

Is this a three-month, one-year, or a three-year problem?
Next, you need to take a deep breath and ask, Is this a three-month problem, a one-year problem or a three-year problem? Are the shutdowns of businesses going to be a temporary blip in the economy or will they drive the U.S. and Europe into a long recession?

If it’s just three-months, (looking more unlikely by the day) then an immediate freeze on variable spending (hires, marketing, travel, etc.) is in order. But if the effects are going to reverberate in the economy longer, you need to start reconfiguring your business. You need a lifeboat strategy. That’s a fancy phrase for figuring out what are minimal things you need to keep your company alive and what to leave behind.

A one-year problem means taking a knife to your burn rate (layoffs and elimination of perks and programs to reduce your variable expenses,) renegotiating what previously seemed liked fixed expenses (rent, equipment lease payments, etc.) and putting only the essential elements for survival in the lifeboat.

[Update: Read the detailed financial advice to CFO’s here.]

If you were selling online versus in-person, you may have an advantage (assuming your customers are still there.) Or you change sales strategy.

Whatever your product/market fit was last month it’s no longer true and needs to change to meet the new normal. Does this open new value propositions or kill others? Alter the product?

And if it’s a three-year problem? Then not only do you need to jettison everything that isn’t essential for survival, it probably requires a new business model. In the short term, explore if some part of your business model can be oriented around the new rules of social isolation. Can your product be sold, delivered or produced online? Does it have some benefits if delivered that way? (See the advice from Sequoia Capital here.) If not, can your product/service be positioned as a lifeboat for others to ride out the downturn?

Leadership – Plan, Communicate and Act with Compassion
Revise your sales revenue goals, product timelines and create a new business model and operating plan – and communicate them clearly to your investors and then to your employees. Keep people focused on an achievable plan that they clearly understand. From the perspective of having lived through the last three crashes, I’ve observed the biggest mistake CEO’s made was not making draconian cuts to expenses quickly enough. They dripped out layoffs and cuts holding on to favored projects with magical thinking that somehow this was just something that would pass.  You need to act now.

If you’re in a large company considering layoffs, the first option should be to cut the salaries of the higher paid exec/employees to try to keep the people who can least afford it, employed. (Good things will come to CEOs who first try to save everyone on the ship before they jump in the lifeboat.) If/when people need to be laid off, do it with compassion. Offer extra compensation. If in the worst case you see you’re running out of cash, under no circumstances run it down to zero. Do the right thing and have enough cash on hand to offer everyone at least two weeks or more of pay.

Your Investors
One of the key elements of survival is access to capital. As a startup or small business you should realize your investors are also asking themselves how this pandemic will affect their business model. The cold hard truth is that in a crash VC’s are running their own “What do I save in the lifeboat?” exercise. They triage their deals –  first worrying about liquidity of their late stage deals which have the highest valuations. These startups typically have very high burn rates and funding for those could fall off a cliff. You and the survival of your startup may no longer be their priority and your interests are no longer aligned. (VC’s who tell you otherwise are either naïve, lying through their teeth, or not serving the interests of their investors.) In every major downturn inflated valuations disappear and the few VC’s still writing new checks find it’s a buyer’s market. (Hence the term “Vulture Capitalists.”)

Some investors have only lived in a booming market when valuations only went up and investment capital was plentiful. But investors with grey hair can remember the nuclear winter after the past recessions of 2000 and 2008 and can offer some historical patterns of crashes and recovery to CEOs running early stage startups – some who weren’t born when the crash of 1987 hit, were 10 years old in the crash of 2000 and 18 in the last crash of 2008. Keep in mind, that today’s circumstances are different. This isn’t a bear stock market. This is a conscious shutdown of most of our economy, trading jobs for saving hundreds of thousands of lives, that’s causing a bear market and a likely recession.

Data from the last large crash in 2008 had seed rounds recovering early, but later stage funding cratered and took years to recover. (see the figure below showing quarterly VC investments before and after this crash – part of this post from Tomasz Tunguz.)

This time around, the health of the venture business may depend on what hedge funds, investment banks, private equity firms, sovereign wealth funds, and large secondary market groups do. If they pull back, there will be a liquidity crunch for later stage startups (Series B, C…). For all startups in the short term, the deal terms and valuations will get worse, and there will be fewer investors looking at your deal.

As a startup CEO you need to know if your board is going to be screaming at you for not radically cutting burn rate and coming up with a new business model or, will they be yelling at you to stop being distracted and stay the course?

And if the latter, I’d want to know what skin in the game they have, if they’re wrong. It’s pretty easy for VC’s to tell you that they’ll be right behind you when you’ll need a next round, until they’re not. Unless your investors are matching their orders for “full speed ahead” with a deposit into your bank, now is not the time to be railroaded into a burn rate that is unrecoverable.

Prepare for a long cold winter.

But remember no winter lasts forever and in it smart founders and VCs will be planting the seeds for the next generation of startups.

Lessons Learned

  • This is a conscious shutdown of our economy, trading jobs for saving hundreds of thousands of lives
  • It’s likely going to cause a recession
  • The Covid-19 virus will change how we shop, travel and work for at least a year and likely three
  • It’s inconceivable that you can have the same business model today as you did 30-days ago
  • Put in place lifeboat plans for three-month, one- year and three year downturns
  • Recognize that your investors will act in their interests, which may no longer be yours
  • Take action now
  • But act with compassion

How to Raise Money – It’s a Journey Not An Event

Every year I teach classrooms full of students who leave class understanding the basics of how to search for product/market fit—and thinking their next goal is to “get funded.”

That’s a mistake.

There are two reasons to raise money:

  1. You have a killer idea that is only partially validated, that you think can get to $50M+ of revenue in 5 years with 80%+ gross margins (if margins are lower, you need a lot more revenue)and you need money to get to product-market fit, or
  2. You (think) you have product-market fit with real customers and real revenue and need money to grow and expand.

Not all startups need outside investment to grow.

What most founders don’t realize is:

  • Every stage of a startup requires a different set of metrics and milestones and founder skills. Knowing these will help a founder position her pitch to get investors’ attention.
  • Founders need to keep their eye on the prize — not just the next funding round

Luckily, I teach with two great VCs, Mar Hershenson of Pear Ventures and Jeff Epstein of Bessemer Venture Partners who both put together presentations unraveling the mysteries of how and why startups raise money. Jeff’s presentation is from the point of a view of “What Investors Want” (see resources here) while Mar’s takes it from a founder trying to figure out the funding landscape. And thanks to Ann Miura-Ko of Floodgate (my first Lean LaunchPad co-instructor) for her suggestions.

Keep in mind that there is no “one way” to raise money Different investors will almost certainly have different models, and different regions may have different math. Still, there are some benchmarks to keep in mind.

Here’s the first 2½ years of a startup journey.


The Startup Investment Landscape

For startups the early stage funding landscape looks like this:

  • Step 1: The Pre-seed round – you raise $500K-$2.5M
  • Step 2: The Seed round – you raise $2.5-$7.5M
  • Step 3: The Series A – you raise $7.5-$25M
  • Step 4: Series B – you raise $15-$65M
  • Step 5: Series, C, D….

(Btw, the definition of each startup financing stage has changed in the last decade.  What was a Series A round in 2005 is now a pre-seed or seed round. And what used to be a seed round a decade ago is now a pre-seed round. Lots of reasons for this shift, but it basically boils down to there’s a lot more money that wants to invest in startups, and all of it is racing to get in early.)

This is a journey that can be planned and measured. In a pre-seed round you are focused on building minimal viable products, testing your insights and searching for product/market fit.  In the seed round you have an early product and by the end you’ve found product/market fit and understand the scale of what you’re building and the levers that you can pull to accelerate growth. For a Series A round you want to prove you have built a repeatable and scalable sales/revenue model and understand all parts of the business model. Series B is about proving your net revenue model (can you be profitable?). Series C onwards funds growing your company to $100M in gross profit.

(At the end of this post, we’ll discuss the valuation at each step (how much the investors value your company and therefore how much of it you need to give up to get this money) and how much revenue you should generate at each step.)

Pitch
By the way, If your pitch is not going to knock investors’ socks off, if you cannot communicate a big vision and a unique insight about the 10x advantages which customers and users will care deeply about, then even if you build out the smartest, most thoughtful process of chasing fundraising, you will fail.

Team, Product, Traction, Business Model and Market
In each step of funding there are five questions you (and potential investors) will be asking: Tell me about your team, your product, your traction, your business model and the market.

Team is just what it sounds like. Tell me why you’re the right person to lead this company (bad answer “Because it’s my idea.” Better answer, “Because I’m the customer.”) Tell me about the group of people you’ve surrounded yourself with – your cofounders and then your key executives. Each stage of funding and company growth requires additional expertise and new skills, and you’ll want to demonstrate that you have these with potential investors.

Product (sometimes called the “value proposition”) is the product or service you’re building. One of the tough things for a startup is to figure out how much of the “product” has to be real and working at each stage of funding.

Traction is a fancy investor word for “Show me you’re making progress.” It’s sometimes called “product/market fit.” In a startup’s early days – pre-seed and seed – this is not about how much revenue you’ve made but more about how much customer passion your product is creating and how many more are loving it each week/month.  (Read Ann Miura-Ko’s article on product/market fit here.)

Business Model
Founders tend to fixate on the product. Now that product/market fit is part of the lexicon most understand that the product also needs passionate customers. But great product and eager customers are just part of what makes a great business. The rest that makes up a company is called its business model. These elements of the business model– revenue (pricing, pricing strategy), distribution channel, How to Get/Keep/Grow customers, Key Activities, Resources and Costs – are other, critical parts your start up needs to understand and have in place.

Market is a euphemism for “How big can your company grow?” Investors want to put their money to work in a startup that can be worth billions or tens of billions of dollars. What are your unique insights about technology, economics, change in market, etc. What evidence do you have that you can grow this big? How will you do it?

The big idea about all of this is that at each step of funding, the order and priority of team, product, traction and market changes.

Pre-seed Round of Funding
In the pre-seed stage, a startup is searching for product/market fit. There are no customers and no product, just a series of minimal viable products.

Funding:  Startups typically raise anywhere from $500K to $2,500,000 in pre-seed. At the low-end this might come from friends, family or angel investors. At the high-end pre-seed angel funds might invest. (Yes, there are venture funds that look for and invest in startups this early.)

  • Team: As you’re raising money from friends, family or angels, investors in this round are betting mostly about you and your team. Have you or your team members achieved anything important in the past? Any wins to date in your startup? Do you have co-founders who complement your skills? (Warning signs are “We were in the dorm together” or “It’s my team from the class I took.”)
  • Traction: Tell investors about your search for product/market fit and what you’ve learned from potential customers to date. Show them the evolution of your minimal viable product and its current state. You need to begin to “instrument” your customer acquisition process with analytics.

(Product/market fit means that you’ve found the match between your potential customers’ pains, gains and jobs to be done and the features of your minimal viable product. I.e. your product fits the needs of your target customers.)

  • Product: At this stage you are building a series of low-fidelity products (sometimes called a minimal viable product or MVP.) It might be a wire-frame, PowerPoint demo or prototype. The goal of the product at this stage is not a sale, but to test hypotheses about customer product/market fit. (Along with the MVP you share your three-year product vision to see if your product vision engages a passionate customer response.
  • Market: Tell us why this is going to be a huge market. Even better, start with a unique insight – what have people missed, what’s changed, what’s now possible? (Warning signs are, “No one has thought of this/is doing this/we have the exclusive patents.”)
  • Business Model: List all the parts of your business model. What are your assumptions about each part? What is some of the critical metrics that matter? Number of customers? Revenue per customer? Number of employees? Revenue, Gross Margin? Expenses? How do you plan to test them.

Goal/Time: By the end of the pre-seed stage the company ought to have evidence that it has found product/market fit. You should be thinking about an end-to-end pipeline of how to Get/Keep/Grow customers. This pre-seed stage typically takes 6-12 months.

Pre-Seed Round Paperwork: Smart investors will typically give you minimal paperwork – either a convertible note or a SAFE (Simple Agreement for Future Equity) or a KISS (Keep It Simple Securities).

Seed Round of Funding
By the end of the pre-seed stage (about a year into your startup), your startup has evidence that they’ve found product/market fit. (One sign is that you are no longer changing your website/sales PowerPoint/product/app every time you need to acquire a customer.) Now it’s time to raise money to acquire paying customers.

Funding:  Startups typically raise anywhere from $1.5 million– $7.5 million in a seed round. At the low-end this might come from angel investors and pre-seed funds. At the high-end, funds specializing in Seed rounds and Series A funds might invest.

  • Traction: For a seed round investors want to focus on traction. You need to provide proof that customers love and can’t live without your product. This means you have evidence that you’ve found product/market fit and have fanatic customers who are reference accounts. You’ve built detailed analytics tracking into your product and you should be seeing organic and viral growth; and can provide Daily/Weekly/Monthly Active Users, 30d/90d/120d retention. Retention and low attrition are good signs of customer validation.

(Note that each market – web/SAAS/physical products – and channel – online/direct sales –  has different metrics and a different funnel steps.)For example, this should translate to revenue ~$0-200K/Annual Recurring Revenue with a clear plan to reach $1.5M-2M in 18 months. The goal is to iterate on building a repeatable engine for growth that makes the economics work. This is different than focusing solely on the gross revenue number.

(Your ARR and revenue milestones will depend on what business you’re in.  For example, not all revenue is recurring and even in a subscription model for a consumer goods company, your recurring revenue will not be valued the same as if you’re selling enterprise software and operating costs are so vastly different.  As an example, $1 of revenue for a direct to consumer company is worth ~$1 in valuation at scale (Zappos was sold for $1B when they had $1B in sales).  On the other hand, in a SaaS business $1 in recurring annual revenue equals ~10x in valuation.)

  • Product: At this stage you have a high-fidelity product, one that earlyvangelists (early passionate customers) can use and pay for. Enough of the product is demonstrable enough that you can gauge customers’ price sensitivity, depth of engagement, etc. The three-year product roadmap gets earlyvangelists engaged.
  • Team: Do you have a core team that can build the first product and get early sales? The culture needs to be hypothesis > experiment > data > insight > validate/invalidate/modify hypotheses.
  • Business Model: In seed you often discover that your business has more moving parts than you originally thought. You may be in a multi-sided market with other customer segments/partners that are critical to your business. You should be testing all parts of your business model; revenue models/pricing, resources, activities and partners.
  • Market: Tell us why the data validates that this is going to be a huge market. At first the founders do the first sale, then they prove your first salespeople can repeat that sale.

Goal/Time: By the end of the seed stage, the company ought to have evidence that repeatable sales can be made by the founding team.  This typically takes 12-18 months.

Seed Round Paperwork: While founders will still want minimal paperwork – either a convertible note or a SAFE or a KISS– professional investors at this round often want an equity round with a more formal set of documents for their investments. You’ll see a Term Sheet, Stock Purchase Agreement, Amended and Restated Certificate of Incorporation, Investors’ Rights Agreement, Right of First Refusal and Co-Sale Agreement and a Voting Agreement.

Series A Round of Funding
By the end of the seed stage–about 2½ years into your startup– your startup has a repeatable and scalable sales model and a provable case that there can be a multi-billion dollar valuation.

Funding:  Startups typically raise anywhere from $7.5 million – $25 million in a Series A round. This size round typically comes from a venture fund or a corporate VC.

  • Market: You need to convince investors that this is at least a $1B+ company.
  • Product: At this stage you have a fully-featured first version of the product needed to scale sales. And you are working to the three-year product vision, iterating and course correcting based on customer feedback.
  • Traction: For a Series A round investors want to focus on a repeatable and scalable sales model with efficient growth. That means you need metrics that prove you have it. Repeatable sales means if you hire an account exec, you know that they will close $1M Annual Recurring Revenue in a year. Or if you spend $100K in ad spend, you can get 100,000 new users.Startups raising an A round typically have $ ½M-$4M Annual Recurring Revenue. Note that the focus should not just be on growth month-to-month but also on efficient growth.

For example, other metrics include achieving net retention of 80-150%, getting a Lifetime Value/Customer Acquisition Cost ratio greater than 3, getting to two times Customer Acquisition Cost Payback Period in less than 18 Months. You should have a realistic plan to grow revenue 3-5x in 12 to 18 months.

These numbers differ dramatically for e-commerce versus consumer, versus SAAS, etc. You should know what the right success metrics are for your industry. (The best VC’s will actually tell you what metrics they are looking for.)

  • Team: The core product team is working efficiently and the sales team for scale is in place and 75% are meeting quota.
  • Business Model: By the end of Series A, all parts of the business model have been tested and they add up to a scalable, repeatable and profitable business.

Goal: By the end of the Series A, the company ought to prove that you’re a business not a hobby. You need to show > $5M in gross profit.  Just to put your journey in perspective, if you want to achieve Unicorn status or go public, you ultimately need to deliver $100 million annual gross profit in Years 6 – 8.

Series A Paperwork: You’ll be seeing a Term Sheet, Stock Purchase Agreement, Amended and Restated Certificate of Incorporation, Investors’ Rights Agreement, Right of First Refusal and Co-Sale Agreement and a Voting Agreement.

Revenue Growth
Some investors think of the ideal startup revenue growth with a shorthand of “triple, triple, double, double, double.”

Years 1-3: $0-$2M in revenue
Year 4: Triple the revenue to $2-$6M
Year 5: Triple the revenue again to $6-$18M
Year 6: Double the revenue to $12-$36M
Year 7: Double the revenue again to: $24-$72M
Year 8: Double the revenue again to: $48-$144M

Valuations
Fair or not, not all startups are equal in the eye of their potential investors. Some startups may be considered “hotter” than others and get much higher valuations. A hot startup may be even able to skip the pre-seed round and go directly to a seed round – meaning more money raised at a higher valuation. The criteria for a “hot” startup include:

  • The background of the founders
    • attended a top university i.e. Stanford, MIT, Harvard
    • had previous experience at a high-growth company, ie Facebook, Google, etc.
    • serial entrepreneur
  • A “hot” market
    • It depends on the month or year – is it AI? Big Data? AR/VR, Cyber, Robotics
  • Hype
    • Do you have a big investor leading the round?
    • Have you gone through Y-Combinator?
    • Are you famous?
  • Location
    • Silicon Valley
    • Other innovation clusters
  • FOMO
    • A startup with a huge vision and story can create FOMO (fear of missing out) in investors – one of the strongest forces for accelerating your fundraising process.
    • At the same time VCs worry about FOLS: Fear of looking stupid
    • FOMO> FOLS

Lessons Learned

  • Every stage of a startup requires a different set of metrics and milestones and founder skills.
  • Knowing what investors want at each stage provides founders with guideposts
  • Founders need to keep their eye on the prize not just the next funding round

Startup Stock Options – Why A Good Deal Has Gone Bad

A version of this article first appeared in the Harvard Business Review

VC’s have just changed the ~50-year old social contract with startup employees. In doing so they may have removed one of the key incentives that made startups different from working in a large company.

For most startup employee’s startup stock options are now a bad deal.

Here’s why.


Why Startups Offer Stock Options
In tech startups stock options were here almost from the beginning, first offered to the founders in 1957 at Fairchild Semiconductor, the first chip startup in Silicon Valley. As Venture Capital emerged as an industry in the mid 1970’s, investors in venture-funded startups began to give stock options to all their employees. On its surface this was a pretty radical idea. The investors were giving away part of their ownership of the company — not just to the founders, but to all employees. Why would they do that?

Stock options for all employees of startups served several purposes:

  • Because startups didn’t have much cash and couldn’t compete with large companies in salary offers, stock options dangled in front of a potential employee were like offering a lottery ticket in exchange for a lower salary. Startup employees calculated that a) their hard work could change the odds and b) someday the stock options they were vesting might make them into millionaires.
  • Investors bet that by offering prospective hires a stake in the company’s future growth- with a visible time horizon of a payoff – employees would act more like owners and work harder– and that would align employee interests with the investor interests. And the bet worked. It drove the relentless “do whatever it takes” culture of 20th century Silicon Valley. We slept under the tables, and pulled all-nighters to get to first customer ship, man the booths at trade shows or ship products to make quarterly revenue – all because it was “our” company.
  • While founders had more stock than the other employees, they had the same type of stock options as the rest of the employees, and they only made money when everyone else did (though a lot more of it.) Back then, when Angel/Seed investing didn’t exist, to get the company started, founders put a lot more on the line – going without a salary, mortgaging their homes etc. This “we’re all in it together” kept founders and employees aligned on incentives.

The mechanics of a stock option was a simple idea – you received an option (an offer) to buy a part of the company via common stock options (called ISOs or NSOs) at a low price (the “strike price”.) If the company was successful, you could sell it at a much higher price when the company went public (when its shares were listed on a stock exchange and could be freely traded) or was acquired.

You didn’t get to own your stock options all at once. The stock trickled out over four years, as you would “vest” 1/48th of the option each month. And just to make sure you were in the company for at least a year, with most stock option plans, unless you stayed an entire year, you wouldn’t vest any stock.

Not everyone got the same amount of stock. The founders got most of the common stock. Early employees got a smaller percentage, and later employees received even a smaller piece – fractions of a percent – versus the double digits the founders owned.

In the 20th century, the best companies IPO’d in 6-8 years from startup (and in the Dot-Com bubble of 1996-1999 that could be as short as 2-3 years.) Of the four startups I was in that went public, it took as long as six years and as short as three.

One other thing to note is that all employees – founders, early employees and later ones – all had the same vesting deal – four years – and no one made money on stock options until a “liquidity event” (a fancy word to mean when the company went public or got sold.) The rationale was that since there was no way for investors to make money until then, neither should anyone else.  Everyone—investors, founders and startup employees—was, so to speak, in the same boat.

Startup Compensation Changes with Growth Capital – 12 Years to an IPO
Much has changed about the economics of startups in the two decades. And Mark Suster of Upfront Capital has a great post that summarizes these changes.

The first big idea is that unlike in the 20th century when there were two phases of funding startups–Seed capital and Venture capital–today there is a new, third phase. It’s called Growth capital.

Instead of a startup going public six to eight years after it was founded to raise capital to grow the company, today companies can do $50M+ funding rounds, deferring the need for an Initial Public Offering to 10 or more years after a company is founded.

Suster points out that the longer the company stays private, the more valuable it becomes. And if during this time VC’s can hold onto their pro-rata (fancy word for what percentage of the startup they own), they can make a ton more money.

The premise of Growth capital is that if that by staying private longer, all the growth upside that went to the public markets (Wall Street) could instead be made by the private investors (the VC’s and Growth Investors.)

The three examples Suster uses – Salesforce, Google and Amazon – show how much more valuable the companies were after their IPOs. Before these three went public, they weren’t unicorns – that is their market cap was less than a billion dollars. Twelve years later, Salesforce’s market cap was $18 billion, Google’s was $162 billion, and Amazon’s was $17 billion.To Suster’s point, it isn’t that startups today can’t raise money by going public, it’s that their investors can make more money by keeping them private and going public later – now 10-12 yearsAnd currently there is an influx of capital to do that.

Founders Rule
The emergence of Growth capital, and pushing an IPO out a decade or more, has led to a dramatic shift in the balance of power between founders and investors. For three decades, from the mid-1970s to the early 2000s, the rules of the game were that a company must become profitable and hire a professional CEO before an IPO.

That made sense. Twentieth-century companies, competing in slower-moving markets, could thrive for long periods on a single innovation. If the VCs threw out the founder, the professional CEO who stepped in could grow a company without creating something new. In that environment, replacing a founder was the rational decision. But 21st century companies face compressed technology cycles, which create the need for continuous innovation over a longer period of time. Who leads that process best? Often it is founders, whose creativity, comfort with disorder, and risk-taking are more valuable at a time when companies need to retain a startup culture even as they grow large.

With the observation that founders added value during the long runup in the growth stage, VCs began to cede compensation and board control to founders. (See the HBR story here.)

Startup Stock Options – Why A Good Deal Has Gone Bad
While founders in the 20th century had more stock than the rest of their employees, they had the same type of stock options. Today, that’s not true. Rather, when a startup first forms, the founders grant themselves Restricted Stock Awards (RSA) instead of common stock options. Essentially the company sells them the stock at zero cost, and they reverse vest.

In the 20th century founders were taking a real risk on salary, betting their mortgage and future. Today that’s less true. Founders take a lot less risk, raise multimillion-dollar seed rounds and have the ability to cash out way before a liquidity event.

Early employees take an equal risk that the company will crater, and they often work equally as hard.  However, today founders own 30-50 times more than a startup’s early employees. (What has happened in founder compensation and board control has mirrored the growth in corporate CEO compensation. In the last 50 years, corporate CEO pay went from 20 times an average employee to over 300 times their compensation.)

On top of the founder/early employee stock disparity, the VC’s have moved the liquidity goal posts but haven’t moved the vesting goal posts for non-founders. Consider that the median tenure in a startup is 2 years. By year three, 50% of the employees will be gone. If you’re an early employee, today the company may not go public until eight years after you vest.

So why should non-founding employees of startups care? You’ll still own your stock, and you can leave and join another startup. There are four problems:

  • First, as the company raises more money, the value of your initial stock option grant gets diluted by the new money in. (VC’s typically have pro-rata rights to keep their percentage of ownership intact, but employees don’t.) So while the VCs gain the upside from keeping a startup private, employees get the downside.
  • Second, when IPO’s no longer happen within the near time horizon of an employee’s tenure, the original rationale of stock options – offering prospective hires a stake in the company’s future growth with a visible time horizon of a payoff for their hard work – has disappeared. Now there’s little financial reason to stay longer than the initial grant vesting.
  • Third, as the fair market value of the stock rises (to what the growth investors are paying), the high exercise price isn’t attractive for hiring new employees especially if they are concerned about having to leave and pay the high exercise price in order to keep the shares.
  • And finally, in many high valued startups where there are hungry investors, the founders get to sell parts of their vested shares at each round of funding. (At times this opportunity is offered to all employees in a “secondary” offering.) A “secondary” usually (though not always) happens when the startup has achieved significant revenue or traction and is seen as a “leader” in their market space, on the way to an IPO or a major sale

The End of the High-Commitment/High-Performance Work System?
In the academic literature, the work environment of a startup is called a high-commitment/ high-performance work system. This is a bundle of Human Resources startup practices that include hiring, self-managing teams, rapid and decentralized decision-making, on-boarding, flexible work assignments, communication, and stock options. And there is evidence that stock options increase the success of startups.

Successful startups need highly committed employees who believe in the goals and values of the company. In exchange for sharing in the potential upside—and being valued as a critical part of the team, they’re willing to rise to the expectation of putting work and the company in front of everything else. But this level of commitment depends on whether employees perceive these practices to be fair, both in terms of the process and the outcomes.

VCs have intentionally changed the ~50-year-old social contract with startup employees. At the same time, they may have removed one of the key incentives that made startups different from working in a large company.

While unique technology or market insight is one component of a successful startup everyone agrees that attracting and retaining A+ talent differentiates the winners from the losers. In trying to keep companies private longer, but not pass any of that new value to the employees, the VC’s may have killed the golden goose.

What Should Employees Do?
In the past the founders and employees were aligned with the same type of common stock grant, and it was the VCs who got preferential stock treatment. Today, if you’re an employee you’re now are at the bottom of the stock preference pile. The founders have preferential stock treatment and the VC have preferred stock. And you’re working just as hard. Add to that all the other known negatives of a startups– no work-life balance, insane hours, inexperienced management, risk of going out of business, etc.

That said, joining a startup still has a lot of benefits for employees who are looking to work with high performance teams with little structure. Your impact likely be felt. Constant learning opportunities, responsibility and advancement are there for those who take it.

If you’re one of the early senior hires, there’s no downside of asking for the same Restricted Stock Agreements (RSAs) as the founders. And if you’re joining a larger startup, you may want to consider those who are offering restricted stock units (RSUs) rather than common stock.

What Should Investors Do?
One possibility is to replace early employee (first ~10 employees) stock options with the same Restricted Stock Agreements (RSAs) as the founders.

For later employees make sure the company offers “refresh” option grants to longer-tenured employees. Better yet, offer restricted stock units (RSUs). Restricted Stock Units are a company’s promise to give you shares of the company’s stock. Unlike a stock option, which always has a strike (purchase) price higher than $0, an RSU is an option with a $0 purchase price. The lower the strike price, the less you have to pay to own a share of company stock. Like stock options, RSU’s vest.

But to keep employees engaged, they ought to be allowed buy their vested RSU stock and sell it every time the company raises a new round of funding.

Lessons Learned

  • Venture Capital structures were set up for a world in which successful companies exited in 6-8 years and didn’t raise too much capital
  • Venture capital growth funds are now giving startups the cash they would have received at an IPO
    • “Growth Capital” moved the need for an IPO out another five years
    • This allows VCs to capture the increase in market cap in the company
    • It may have removed the incentive for non-founders to want to work in a startup versus a large company
    • As stock options with four-year vesting are no longer a good deal
  • Investors and Founders have changed the model to their advantage, but no one has changed the model for early employees
    • VCs need to consider a new stock incentive model – RSA’s for the first key hires and then RSU’s – Restricted Stock Units for everyone else
  • Large companies now have an opportunity to attract some of the talent that previously went elsewhere

Is the Lean Startup Dead?

A version of this article first appeared in the Harvard Business Review

Reading the NY Times article “Jeffrey Katzenberg Raises $1 Billion for Short-Form Video Venture,” I realized it was time for a new startup heuristic: the amount of customer discovery and product-market fit you need to find is inversely proportional to the amount and availability of risk capital.

And while the “first mover advantage” was the rallying cry of the last bubble, today’s is: “Massive capital infusion can own the entire market.”


Fire, Ready, Aim
Jeff Katzenberg has a great track record – head of the studio at Paramount, chairman of Disney Studios, co-founder of DreamWorks and now chairman of NewTV. The billion dollars he just raised is on top of the $750 million NewTV’s parent company, WndrCo, has raised for the venture. He just hired Meg Whitman. the ex-CEO of HP and eBay, as CEO of NewTV. Their idea is that consumers will want a subscription service for short form entertainment (10-minute programs) for mobile rather than full length movies. (Think YouTube meets Netflix).

It’s an almost $2-billion-dollar bet based on a set of hypotheses. Will consumers want to watch short-form mobile entertainment? Since NewTV won’t be making the content, they will be licensing from and partnering with traditional entertainment producers. Will these third parties produce something people will watch? NewTV will depend on partners like telcos to distribute the content. (Given Verizon just shut down Go90, its short form content video service, it will be interesting to see if Verizon distributes Katzenberg’s offerings.)

But NewTV doesn’t plan on testing these hypotheses. With fewer than 10 employees but almost $2-billion dollars in the bank, they plan on jumping right in.

It’s the antithesis of the Lean Startup.  And it may work. Why?

Dot Com Boom to Bust
Most entrepreneurs today don’t remember the Dot-Com bubble of 1995 or the Dot-Com crash that followed in 2000. As a reminder, the Dot Com bubble was a five-year period from August 1995 (the Netscape IPO) when there was a massive wave of experiments on the then-new internet, in commerce, entertainment, nascent social media, and search. When Netscape went public, it unleashed a frenzy from the public markets for anything related to the internet and signaled to venture investors that there were massive returns to be made investing in anything internet related. Almost overnight the floodgates opened, and risk capital was available at scale from venture capital investors who rushed their startups toward public offerings. Tech IPO prices exploded and subsequent trading prices rose to dizzying heights as the stock prices became disconnected from the traditional metrics of revenue and profits. Some have labeled this period as irrational exuberance. But as Carlota Perez has so aptly described, all new technology industries go through an eruption and frenzy phase, followed by a crash, then a golden age and maturity. Then the cycle repeats with a new set of technologies.

Given the stock market was buying “the story and vision” of anything internet, inflated expectations were more important than traditional metrics like customers, growth, revenue, or heaven forbid, profits. Startups wrote business plans, generated expansive 5-year forecasts and executed (hired, spent and built) to the plan. The mantra of “first mover advantage,” the idea that winners are the ones who are the first entrants in their market, became the conventional wisdom of investors in Silicon Valley.“ First Movers” didn’t understand customer problems or the product features that solved those problems (what we now call product-market fit). These bubble startups were actually guessing at their business model and did premature and aggressive hype and early company launches and had extremely high burn rates – all predicated on an IPO to raise more cash. To be fair, in the 20th century, there really wasn’t a model for how to build startups other than write plan, raise money, and execute – the bubble was this method, on steroids. And to be honest, VC’s in this bubble really didn’t care. Massive liquidity awaited the first movers to the IPO’s, and that’s how they managed their portfolios.

When VC’s realized how eager the public markets were for anything related to the internet, they pushed startups with little revenue and no profits into IPOs as fast as they could. The unprecedented size and scale of VC returns transformed venture capital from a financial asset backwater into full-fledged player in the financial markets.

Then one day it was over. IPOs dried up. Startups with huge burn rates – building leases, staff, PR and advertising – ran out of money. Most startups born in the bubble died in the bubble.

The Rise of the Lean Startup
After the crash, venture capital was scarce to non-existent. (Most of the funds that started in the late part of the boom would be underwater). Angel investment, which was small to start with, disappeared, and most corporate VCs shut down. VC’s were no longer insisting that startups spend faster, and “swing for the fences”. In fact, they were screaming at them to dramatically reduce their burn rates. It was a nuclear winter for startup capital.

The idea of the Lean Startup was built on top of the rubble of the 2000 Dot-Com crash.

With risk capital at a premium and the public markets closed, startups and their investors now needed a methodology to preserve capital and survive long enough to generate revenue and profits. And to do that they needed a different method than just “build it and they will come.” They needed to be sure that what they were building was what customers wanted and needed. And if their initial guesses were wrong, they needed a process that would permit them to change early on in the product development process when the cost of changes was small – the famed “pivot”.

Lean started from the observation that you cannot ask a question that you have no words for. At the time we had no language to describe that startups were not smaller versions of large companies; the first insight was that large companies executed known business models, while startups searched for them. Yet while we had plenty of language and tools for execution, we had none for search.  So we (Blank, Ries, Osterwalder) built the tools and created a new language for innovation and modern entrepreneurship. It helped that in the nuclear winter that followed the crash, 2001 – 2004, startups and VCs were extremely risk averse and amenable to new ideas that reduced risk. (This same risk averse, conserve the cash, VC mindset would return after the 2008 meltdown of the housing market.)

As described in the HBR article “Why the Lean Startup Changes Everything,” we developed Lean as the business model / customer development / agile development solution stack where entrepreneurs first map their hypotheses about their business model and then test these hypotheses with customers in the field (customer development) and use an iterative and incremental development methodology (agile development) to build the product. This allowed startups to build Minimal Viable Products (MVPs) – incremental and iterative prototypes – and put them in front of a large number of customers to get immediate feedback. When founders discovered their assumptions were wrong, as they inevitably did, the result wasn’t a crisis; it was a learning event called a pivot— and an opportunity to change the business model.

Every startup is in a race against time. It has to find product-market fit before running out of cash. Lean makes sense when capital is scarce and when you need to keep burn rates low. Lean was designed to inform the founders’ vision while they operated frugally at speed. It was not built as a focus group for consensus for those without deep convictions.

The result? Startups now had tools that sped up the search for customers, ensured that what was being built met customer needs, reduced time to market and slashed the cost of development.

Carpe Diem – Seize the Cash
Today, memories of frugal VC’s and tight capital markets have faded, and the structure of risk capital is radically different. The explosion of seed funding means tens of thousands of companies that previously languished in their basement are getting funding, likely two orders of magnitude more than received Series A funding during the Dot-Com bubble. As mobile devices offer a platform of several billion eyeballs, potential customers which were previously small niche markets now include everyone on the planet. And enterprise customers in a race to reconfigure strategies, channels, and offerings to deal with disruption provide a willing market for startup tools and services.

All this is driven by corporate funds, sovereign funds and even VC funds with capital pools of tens of billions of dollars dwarfing any of the dollars in the first Dot Com bubble – and all looking for the next Tesla, Uber, Airbnb, or Alibaba. What matters to investors now is to drive startup valuations into unicorn territory (valued at $1 billion or more) via rapid growth – usually users, revenue, engagements but almost never profits. As valuations have long passed the peak of the 2000 Internet bubble, VC’s and founders who previously had to wait until they sold their company or took it public to make money no longer have to wait. They can now sell part of their investment when they raise the next round. And if the company does go public, the valuations are at least 10x of the last bubble.

With capital chasing the best deals, and hundreds of millions of dollars pouring into some startups, most funds now scoff at the idea of Lean. Rather than the “first mover advantage” of the last bubble, today’s theory is that “massive capital infusion owns the entire market.” And Lean for startups seems like some quaint notion of a bygone era.

And that explains why investors are willing to bet on someone with a successful track record like Katzenberg who has a vision of disrupting an entire industry.

In short, Lean was an answer to a specific startup problem at a specific time, one that most entrepreneurs still face and which ebbs and flows depending on capital markets. It’s a response to scarce capital, and when that constraint is loosened, it’s worth considering whether other approaches are superior. With enough cash in the bank, Katzenberg can afford to create content, sign distribution deals, and see if consumers watch. If not, he still has the option to pivot. And if he’s right, the payoff will be huge.

One More Thing…
Well-funded startups often have more capital for R&D than the incumbent companies they’re disrupting. Companies struggle to compete while reconfiguring legacy distribution channels, pricing models and supply chains. And government agencies find themselves being disrupted by adversaries unencumbered by legacy systems, policies and history.  Both companies and government agencies struggle with how to deliver innovation at speed. Ironically, for this new audience that makes the next generation of Lean – the Innovation Pipeline – more relevant than ever.

Lessons Learned:

  • When capital for startups is readily available at scale, it makes more sense to go big, fast and make mistakes than it does to search for product/market fit.
  • The amount of customer discovery and product-market fit you need to do is inversely proportional to the amount and availability of risk capital.
  • Still, unless your startup has access to large pools of capital or have a brand name like Katzenberg, Lean still makes sense.
  • Lean is now essential for companies and government agencies to deliver innovation at speed
  • The Lean Startup isn’t dead. For companies and government the next generation of Lean – the Innovation Pipeline – is more relevant than ever.

Brown University Talk

Every year I head to the East coast for vacation. We live in a semi-rural area, just ~10,000 people in town, with a potato farm across the street and an arm of the ocean in the backyard. While they own tech, smartphones and computers, most of my neighbors can’t tell you about the latest trends in AI, Bitcoin or Facebook. In contrast, Silicon Valley is an innovation cluster, a monoculture of sorts, with a churning sea of new tech ideas, sailed by entrepreneurs who each passionately believe they’re the next Facebook or Google, with their sails driven by the hurricane winds of investor capital.

The seas are calm here. Most years out here I spend my time reading. This year has been a bit more interesting. One of the things I did was to speak to the startup community in Providence Rhode Island at Brown University.

The talk is here

It’s worth a listen.

7:54: How we used to build startups

11:40: How the Lean Startup began

13:34: Why startups are not smaller versions of large companies

14:06: The three pillars of Lean

20:10: Customer Development is an art

26:42: How we changed the way science is commercialized in the U.S.

29:14: What’s a pivot?

37:34: Customer Discovery isn’t just a bunch of random conversations

39:03: Mistakes that blow a customer meeting

42:45: How you know you’ve talked to enough customers

48:51: Why corporations are mostly doing innovation theater

54:59: Tesla started in my living room

57:28: It takes two: Why world-class startups have both a great innovator and a great entrepreneur

1:04:05: Failure sucks

1:08:43: Avoiding the startup deathtrap

1:13:22: Talk to the crazy people

1:16:05: How you know when you stop being a startup

Why Uber is The Revenge of the Founders

A version of this article is in the Harvard Business Review

Uber, Zenefits, Tanium, Lending Club CEOs of companies with billion dollar market caps have been in the news – and not in a good way.  This seems to be occurring more and more.  Why do these founders get to stay around?

Because the balance of power has dramatically shifted from investors to founders.

Here’s why it generates bad CEO behavior.

Unremarked and unheralded, the balance of power between startup CEOs and their investors has radically changed:

  • IPOs/M&A without a profit (or at times revenue) have become the norm
  • The startup process has become demystified – information is everywhere
  • Technology cycles have become a treadmill, and for startups to survive they need to be on a continuous innovation cycle
  • VCs competing for unicorn investments have given founders control of the board

20th Century Tech Liquidity = Initial Public Offering
In the 20th century tech companies and their investors made money through an Initial Public Offering (IPO). To turn your company’s stock into cash, you engaged a top-notch investment bank (Morgan Stanley, Goldman Sachs) and/or their Silicon Valley compatriots (Hambrecht & Quist, Montgomery Securities, Robertson Stephens).

Typically, this caliber of bankers wouldn’t talk to you unless your company had five profitable quarters of increasing revenue. And you had to convince the bankers that you had a credible chance of having four more profitable quarters after your IPO.  None of this was law, and nothing in writing required this; this was just how these firms did business to protect their large institutional customers who would buy the stock.

Twenty-five years ago, to go public you had to sell stuff – not just acquire users or have freemium products. People had to actually pay you for your product. This required a repeatable and scalable sales process, which required a professional sales staff and a product stable enough that customers wouldn’t return it.

Hire a CEO to Go Public
More often than not, a founding CEO lacked the experience to do these things. The very skills that got the company started were now handicaps to its growth. A founder’s lack of credibility/experience in growing and managing a large company hindered a company that wanted to go public. In the 20th century, founding CEOs were most often removed early and replaced by “suits” — experienced executives from large companies parachuted in by the investors after product/market fit to scale sales and take the company public.

The VCs would hire a CEO with a track record who looked and acted like the type of CEO Wall Street bankers expected to see in large companies.

A CEO brought in from a large company came with all the big company accoutrements – org charts, HR departments with formal processes and procedure handbooks, formal waterfall engineering methodology, sales compensation plans, etc. — all great things when you are executing and scaling a known business model. But the CEO’s arrival meant the days of the company as a startup and its culture of rapid innovation were over.

Board Control
For three decades (1978-2008), investors controlled the board. This era was a “buyer’s market” – there were more good companies looking to get funded than there were VCs. Therefore, investors could set the terms. A pre-IPO board usually had two founders, two VCs and one “independent” member. (The role of the independent member was typically to tell the founding CEO that the VCs were hiring a new CEO.)

Replacing the founder when the company needed to scale was almost standard operating procedure. However, there was no way for founders to share this information with other founders (this was life before the Internet, incubators and accelerators). While to VCs this was just a necessary step in the process of taking a company public, time and again first-time founders were shocked, surprised and angry when it happened. If the founder was lucky, he got to stay as chairman or CTO. If he wasn’t, he told stories of how “VCs stole my company.”

To be fair there wasn’t much of an alternative. Most founders were woefully unequipped to run companies that scaled.  It’s hard to imagine, but in the 20th century there were no startup blogs or books on startups to read, and business schools (the only places teaching entrepreneurship) believed the best thing they could teach startups was how to write a business plan. In the 20th century the only way for founders to get trained was to apprentice at another startup. And there they would watch the canonical model in action as an experienced executive replaced the founder.

Technology Cycles Measured in Years
Today, we take for granted new apps and IoT devices appearing seemingly overnight and reaching tens of millions of users – and just as quickly falling out of favor. But in the 20th century, dominated by hardware and software, technology swings inside an existing market happened slowly — taking years, not months. And while new markets were created (i.e. the desktop PC market), they were relatively infrequent.

This meant that disposing of the founder, and the startup culture responsible for the initial innovation, didn’t hurt a company’s short-term or even mid-term prospects.  A company could go public on its initial wave of innovation, then coast on its current technology for years. In this business environment, hiring a new CEO who had experience growing a company around a single technical innovation was a rational decision for venture investors.

However, almost like clockwork, the inevitable next cycle of technology innovation would catch these now-public startups and their boards by surprise. Because the new CEO had built a team capable of and comfortable with executing an existing business model, the company would fail or get acquired. Since the initial venture investors had cashed out by selling their stock over the first few years, they had no long-term interest in this outcome.

Not every startup ended up this way. Bill Hewlett and David Packard got to learn on the job. So did Bob Noyce and Gordon Moore at Intel. But the majority of technology companies that went public circa 1979-2009, with professional VCs as their investors, faced this challenge.

Founders in the Driver’s Seat
So how did we go from VCs discarding founders to founders now running large companies? Seven major changes occurred:

  1. It became OK to go public or get acquired without profit (or even revenue)

In 1995 Netscape changed the rules about going public. A little more than a year old, the company and its 24-year-old founder hired an experienced CEO, but then did something no other tech company had ever done – it went public with no profit. Laugh all you want, but at the time this was unheard of for a tech company. Netscape’s blow-out IPO launched the dot-com boom. Suddenly tech companies were valued on what they might someday deliver. (Today’s version is Tesla – now more valuable than Ford.)

This means that liquidity for today’s investors often doesn’t require the long, patient scaling of a profitable company. While 20th century metrics were revenue and profit, today it’s common for companies to get acquired for their user base. (Facebook’s ~$20 billion acquisition of WhatsApp, a 5-year-old startup that had $10 million in revenue, made no sense until you realized that Facebook was paying to acquire 300 million new users.)

2.     Information is everywhere
In the 20th century learning the best practices of a startup CEO was limited by your coffee bandwidth. That is, you learned best practices from your board and by having coffee with other, more experienced CEOs. Today, every founder can read all there is to know about running a startup online. Incubators and accelerators like Y-Combinator have institutionalized experiential training in best practices (product/market fit, pivots, agile development, etc.); provide experienced and hands-on mentorship; and offer a growing network of founding CEOs. The result is that today’s CEOs have exponentially more information than their predecessors. This is ironically part of the problem. Reading about, hearing about and learning about how to build a successful company is not the same as having done it. As we’ll see, information does not mean experience, maturity or wisdom.

3.     Technology cycles have compressed
The pace of technology change in the second decade of the 21st century is relentless. It’s hard to think of a hardware/software or life science technology that dominates its space for years. That means new companies are at risk of continuous disruption before their investors can cash out.

To stay in business in the 21st century, startups  do four things their 20th century counterparts didn’t:

  • A company is no longer built on a single innovation. It needs to be continuously innovating – and who best to do that? The founders.
  • To continually innovate, companies need to operate at startup speed and cycle time much longer their 20th century counterparts did. This requires retaining a startup culture for years – and who best to do that? The founders.
  • Continuous innovation requires the imagination and courage to challenge the initial hypotheses of your current business model (channel, cost, customers, products, supply chain, etc.) This might mean competing with and if necessary killing your own products. (Think of the relentless cycle of iPod then iPhone innovation.) Professional CEOs who excel at growing existing businesses find this extremely hard.  So who best to do it? The founders.
  • Finally, 20th century startups fired the innovators/founders when they scaled. Today, they need these visionaries to stay with the company to keep up with the innovation cycle. And given that acquisition is a potential for many startups, corporate acquirers often look for startups that can help them continually innovate by creating new products and markets.

4.     Founder-friendly VCs
A 20th century VC was likely to have an MBA or finance background. A few, like John Doerr at Kleiner Perkins and Don Valentine at Sequoia, had operating experience in a large tech company, but none had actually started a company. Out of the dot-com rubble at the turn of the 21st century, new VCs entered the game – this time with startup experience. The watershed moment was in 2009 when the co-founder of Netscape, Marc Andreessen, formed a venture firm and started to invest in founders with the goal of teaching them how to be CEOs for the long term. Andreessen realized that the game had changed. Continuous innovation was here to stay and only founders – not hired execs – could play and win.  Founder-friendly became a competitive advantage for his firm Andreessen Horowitz. In a seller’s market, other VCs adopted this “invest in the founder” strategy.

5.     Unicorns Created A Seller’s Market
Private companies with market capitalization over a billion dollars – called Unicorns – were unheard of in the first decade of the 21st century. Today there are close to 200. VCs with large funds (~>$200M) need investments in Unicorns to make their own business model work.

While the number of traditional VC firms have shrunk since the peak of the dot com bubble, the number of funds chasing deals have grown. Angel and Seed Funds have usurped the role of what used to be Series A investments. And in later stage rounds an explosion of corporate VCs and hedge funds now want in to the next unicorns.

A rough calculation says that a VC firm needs to return four times its fund size to be thought of as a great firm. Therefore, a VC with a $250M fund (5x the size of an average VC fund 40 years ago) would need to return $1 billion. But VCs own only ~15% of a startup when it gets sold/goes public (the numbers vary widely). Just doing the math, $1 billion/15% means that the VC fund needs $6.6 billion of exits to make that 4x return. The cold hard math of “large funds need large exits” is why VCs have been trapped into literally begging to get into unicorn deals.

6.    Founders Take Money Off the Table
In the 20th century the only way the founder made any money (other than their salary) was when the company went public or got sold. The founders along with all the other employees would vest their stock over 4 years (earning 1/48 a month). They had to hang around at least a year to get the first quarter of their stock (this was called the “cliff”).  Today, these are no longer hard and fast rules. Some founders have three-year vesting. Some have no cliff. And some have specific deals about what happens if they’re fired, demoted or the company is sold.

In the last decade, as the time startups have spent staying private has grown longer, secondary markets – where people can buy and sell pre-IPO stock — have emerged. This often is a way for founders and early employees to turn some of their stock into cash before an IPO or sale of company.

One last but very important change that guarantees founders can cash out early is “founder friendly stock.”  This allows founder(s) to sell part of their stock (~10 to 33%) in a future round of financing. This means the company doesn’t get money from new investors, but instead it goes to the founder.  The rationale is that since companies are taking longer to achieve liquidity, giving the founders some returns early makes them more willing to stick around and better able to make bets for the long-term health of the company.

7.   Founders take Control of the Board
With more VCs chasing a small pool of great deals, and all VCs professing to be the founder’s best friend, there’s an arms race to be the friendliest. Almost overnight the position of venture capitalist dictating the terms of the deal has disappeared (at least for “hot” deals).

Traditionally, in exchange for giving the company money, investors would receive preferred stock, and founders and employees owned common stock. Preferred stock had specific provisions that gave investors control over when to sell the company or take it public, hiring and firing the founder etc.  VCs are giving up these rights to get to invest in unicorns.

Founders are taking control of the board by making the common stock the founders own more powerful. Some startups create two classes of common stock with each share of the founders’ class of common stock having 10 – 20 votes. Founders can now outvote the preferred stock holders (the investors). Another method for founder control has the board seats held by the common shareholders (the founders) count 2-5 times more than the investors’ preferred shares. Finally, investors are giving up protective voting control provisions such as when and if to raise more money, the right to invest in subsequent rounds, who to raise it from and how/when to sell the company or take it public. This means liquidity for the investors is now beholden to the whims of the founders. And because they control votes on the board, the founders can’t be removed. This is a remarkable turnabout.

In some cases, 21st century VCs have been relegated to passive investors/board observers.

And this advent of founders’ control of their company’s board is a key reason why many of these large technology companies look like they’re out of control.  They are.

The Gift/Curse of Visionary CEOs
Startups run by visionaries break rules, flout the law and upend the status quo (Apple, Uber, AirBnB, Tesla, Theranos, etc.). Doing something that other people consider insanity/impossible requires equal parts narcissism and a messianic view of technological transformation.

Bad CEO behavior and successful startups have always overlapped. Steve Jobs, Larry Ellison, Tom Seibel, etc. all had the gift/curse of a visionary CEO – they could see the future as clearly as others could see the present. Because they saw it with such clarity, the reality of having to depend on other people to build something revolutionary was frustrating. And woe to the employee who got in their way of delivering the future.

Visionary CEOs have always been the face of their company, but today with social media, it happens faster with a much larger audience; boards now must consider what would happen to the valuation of the company without the founder.

With founders now in control of unicorn boards, with money in their pockets and the press heralding them as geniuses transforming the world, founder hubris and bad behavior should be no surprise.  Before social media connected billions of people, bad behavior stayed behind closed doors. In today’s connected social world, instant messages and shared videos have broken down the doors.

The Revenge of the Founders – Founding CEOs Acting Badly
So why do boards of unicorns like Uber, Zenefits, Tanium, Lending Club let their CEOs stay?

Before the rapid rise of Unicorns, when boards were still in control, they “encouraged” the hiring of “adult supervision” of the founders. Three years after Google started they hired Eric Schmidt as CEO. Schmidt had been the CEO of Novell and previously CTO of Sun Microsystems. Four years after Facebook started they hired Sheryl Sandberg as the COO. Sandberg had been the vice president of global online sales and operations. Today unicorn boards have a lot less leverage.

  1. VCs sit on 5 to 10 or more boards. That means most VCs have very little insight into the day-to-day operation of a startup. Bad behavior often goes unnoticed until it does damage.
  2. The traditional checks and balances provided by a startup board have been abrogated in exchange for access to a hot deal.
  3. As VC incentives are aligned to own as much of a successful company as possible, getting into a conflict with a founder who can now prevent VC’s from investing in the next round is not in the VCs interest.
  4. Financial and legal control of startups has given way to polite moral suasion as founders now control unicorns.
  5. As long as the CEO’s behavior affects their employees not their customers or valuation, VCs often turn a blind eye.
  6. Not only is there no financial incentive for the board to control unicorn CEO behavior, often there is a downside in trying to do so

The surprise should not be how many unicorn CEOs act badly, but how many still behave well.

Lesson Learned

  • VC/Founder relationship have radically changed
  • VC “Founder Friendly” strategies have helped create 200+ unicorns
  • Some VC’s are reaping the downside of the unintended consequences of “Founder Friendly”
  • Until the consequences exceed the rewards they will continue to be Founder Friendly

What Founders Need to Know: You Were Funded for a Liquidity Event – Start Looking

There are many reasons to found a startup.
There are many reasons to work at a startup.
But there’s only one reason your company got funded.   Liquidity.

——-

The Good News
To most founders a startup is not a job, but a calling.

But startups require money upfront for product development and later to scale. Traditional lenders (banks) think that startups are too risky for a traditional bank loan. Luckily in the last quarter of the 20th century a new source of money called risk capital emerged. Risk capital takes equity (stock ownership) in your company instead of debt (loans) in exchange for cash.

Founders can now access the largest pool of risk capital that ever existed –in the form of Private Equity (Angel Investors, family offices, Venture Capitalists (VC’s) and Hedge Funds.)

At its core Venture Capital is nothing more than a small portion of the Private Equity financial asset class. But for the last 40 years, it has provided the financial fuel for a revolution in Life Sciences and Information Technology and has helped to change the world.

The Bad News
While startups are driven by their founder’s passion for creating something new, startup investors have a much different agenda – a return on their investment.  And not just any returns, VC’s expect large returns. VC’s raise money from their investors (limited partners like pension funds) and then spread their risk by investing in a number of startups (called a portfolio). In exchange for the limited partners tying up capital for long periods by in investing in VCs (who are investing in risky startups,) the VCs promise the limited partners large returns that are unavailable from most every other form of investment.

Some quick VC math: If a VC invests in ten early stage startups, on average, five will fail, three will return capital, and one or two will be “winners” and make most of the money for the VC fund. A minimum ‘respectable’ return for a VC fund is 20% per year, so a ten-year VC fund needs to return six times (6x) their investment. This means that those two winner investments have to make a 30x return to provide the venture capital fund a 20% compound return – and that’s just to generate a minimum respectable return.

(BTW, Angel investors do not have limited partners, and often invest for reasons other than just for financial gain (e.g., helping pioneers succeed) and so the returns they’re looking for may be lower.)

The Deal With the Devil
What does this mean for startup founders? If you’re a founder, you need to be able to go up to a whiteboard and diagram out how your investors will make money in your startup.

While you might be interested in building a company that changes the world, regardless of how long it takes, your investors are interested in funding a company that changes the world so they can have a liquidity event within the life of their fund ~7-10 years. (A liquidity event means that the equity (the stock) you sold your investor can now be converted into cash.) This happens when you either sell your company (M&A) or go public (an IPO.) Currently M&A is the most likely path for a startup to achieve liquidity.

Know the End from the Beginning
Here’s the thing most founders miss. You’ve been funded to get to a liquidity event. Period. Your VCs know this, and you need to know this too.

Why don’t VCs tell founders this fact?  For the first few years, your VCs want you to keep your head down, build the product, find product/market fit and ship to get to some inflection point (revenue, users, etc.). As the company goes from searching for a business model to growth, only then will they bring in a new “professional” management team to scale the company (along with a business development executive to search for an acquirer) or prepare for an IPO.

The problem is that this “don’t worry your little head” strategy may have made sense when founders were just technologists and the strategy and tactics of liquidity and exits were closely held, but this a pretty dumb approach in the 21st century. As a founder you are more than capable of adding value to the search for the liquidity event.

Therefore, founders, you need to be planning your exit the day you get funded. Not for some short-time “lets flip the company” strategy but an eye for who, how and when you can make an acquisition happen.

acquistion steps
Step 1: Figure out how your startup generates value
For example, in your industry do companies build value the old fashion way by generating revenue? (Square, Uber, Palantir, Fitbit, etc.) If so, how is the revenue measured? (Bookings, recurring revenue, lifetime value?) Is your value to an acquirer going to measured as a multiple of your revenues?  Or as with consumer deals, is the value is ascribed by the market?

Or do you build value by acquiring users and figuring out how to make money later (WhatsApp, Twitter, etc.) Is your value to an acquirer measured by the number of users? If so, how are the users measured (active users, month-on-month growth, churn)?

Or is your value going to be measured by some known inflection point?  First-in-human proof of efficacy? Successful Clinical trials? FDA approvals? CMS Reimbursement?

If you’re using the business model canvas, you’ve already figured this out when you articulated your revenue streams and noted where they are coming from.

Confirm that your view of how you’ll create value is shared by your investors and your board.

Step 2: Figure out who are the likely acquirers
If you are building autonomous driving aftermarket devices for cars, it’s not a surprise that you can make a short list of potential acquirers – auto companies and their tier 1 suppliers. If you’re building enterprise software, the list may be larger. If you’re building medical devices the list may be much smaller. But every startup can take a good first cut at a list. (It’s helpful to also diagram out the acquirers in a Petal Diagram.) Petal diagramWhen you do, start a spreadsheet and list the companies. (As you get to know your industry and ecosystem, the list will change.)

It’s likely that your investors also have insights and opinions. Check in with them as well.

Step 3: List the names of the business development, technology scouts and other people involved in acquisitions and note their names next to the name of the target company.

All large companies employ people whose job it is to spot and track new technology and innovation and follow its progress. The odds on day-one are that you can’t name anyone. How will you figure this out? Congratulations, welcome to Customer Discovery.

  • Treat potential acquirers like a customer segment. Talk to them. They’re happy to tell anyone who will listen what they are looking for and what they need to see by way of data or otherwise for something to rise to the level of seriousness on the scale of acquisition possibilities.
  • Understand who the Key Opinion Leaders in your industry are and specifically who acquirers assemble to advise them on technology and innovation in their areas of interest.
  • Get out of the building and talk to other startup CEOs who were acquired in your industry.  How did it happen? Who were the players?

It’s common for your investors to have personal contacts with business development and technology scouts from specific companies. Unfortunately, it’s the rare VC who has already built an acquisition roadmap. You’re going to build one for them.Network diagram
After awhile, you ought to be able to go to the whiteboard and diagram the acquisition decision process much like a sales process. Draw the canonical model and then draw the actual process (with names and titles) for the top three likely acquirers

Step 4: Generate the business case for the potential acquirer
Your job is to generate the business case for the potential acquirer, that is, to demonstrate with data produced from testing pivotal hypotheses why they need is what you have to improve their business model (filling a product void; extending an existing line; opening a new market; blocking a competitor’s ability to compete effectively, etc.)

Step 5: Show up a lot and get noticed
Figure out what conferences and shows these acquirers attend. Understand what is it they read. Show up and be visible – as speakers on panels, accidently running into them, getting introduced, etc.  Get your company talked about in the blogs and newsletters they read. How do you know any of this?  Again, this is basic Customer Discovery. Take a few out to lunch. Ask questions – what do they read? – how do they notice new startups? – who tells them the type of companies to look for? etc.

Step 6: Know the inflection points for an acquisition in your market
Timing is everything. Do you wait 7 years until you’ve built enough revenue for a billion-dollar sale?  Is the market for Machine Learning startups so hot that you can sell the company for hundreds of millions of dollars without shipping a product?

For example, in Medical Devices the likely outcome is an acquisition way before you ship a product. Med-tech entrepreneurship has evolved to the point where each VC funding round signals that the company has completed a milestone – and each of these milestones represents an opportunity for an acquisition. For example, after a VC Series B-Round, an opportunity for an acquisition occurs when you’ve created a working product and you have started clinical trials and are working on getting a European CE Mark to get approval.

When to sell or go public is a real balancing act with your board. Some investor board members may want liquidity early to make the numbers look good for their fund, especially if it is a smaller fund or if you are at a later point in their fund life. If you’re on the right trajectory, other investors, such as larger funds or where you are early in their fund life, may be are happy to wait years for the 30x or greater return. You need to have a finger on the pulse of your VCs and the market, and to align interests and expectations to the greatest extent possible.

You also need to know whether you have any control over when a liquidity event occurs and who has to agree on it. (Check to see what rights your investors have in their investment documents.)  Typically, a VC can force a sale, or even block one.  Make sure your interests are aligned with your investors.

As part of the deal you signed with your investors was a term specifying the Liquidation Preference. The liquidation preference determines how the pie is split between you and your investors when there is a liquidity event. You may just be along for the ride. 

Above all, don’t panic or demoralize your employees
The first rule of Fight Club is: you do not talk about Fight Club. The second rule of Fight Club is: you DO NOT talk about Fight Club! The same is true about liquidity. It’s detrimental to tell your employees who have bought into the vision, mission and excitement of a startup to know that it’s for sale the day you start it.  The party line is “We’re building a company for long-term success.”

Do not obsess over liquidity
As a founder there’s plenty on your plate – finding product/market fit, shipping product, getting customers… liquidity is not your top of the list. Treat this as a background process. But thinking about it strategically will effect how you plan marketing communications, conferences, blogs and your travel.

Remember, your goal is to create extraordinary products and services – and in exchange there’s a pot of gold at the end of the rainbow.

Lessons Learned

  • The minute you take money from someone their business model now becomes yours
  • Your investors funded you for a liquidity event
  • You need to know what “multiple” an investor will allow you to sell the company for
    • Great entrepreneurs shoot for 20X
    • You need at least a 5x return to generate rewards for investors and employee stock options
    • A 2X return may wipe out the value of the employee stock options and founder shares
  • You can plan for liquidity from day one
  • Don’t demoralize your employees
  • Don’t obsess over liquidity, treat it strategically

I’m on the Air – On Sirius XM Channel 111

Starting this Monday, March 9th 4-6pm Pacific Time I’ll be on the radio hosting the Bay Area Ventures program on Sirius XM radio Channel 111 – the Wharton Business Radio Channel.Untitled

Over this program I’ll be talking to entrepreneurs, financial experts and academic leaders in the tech and biotech industries. And if the past is prologue I guarantee you that this will be radio worth listening to.

On our first show, Monday March 9th 4-6pm Pacific Time join me, as I chat with Alexander Osterwalder – inventor of the Business Model Canvas, and Oren Jacob, ex-CTO of Pixar and now CEO of ToyTalk on Sirius XM Radio Channel 111.

Oren Jacob - CEO ToyTalk

Oren Jacob – CEO ToyTalk

Alex Osterwalder - Business Models

Alex Osterwalder – Business Models

On Monday’s show we’ll be talking about a range of entrepreneurship topics: what’s a Business Model Canvas, how to build startups efficiently, the 9 deadly sins of a startup, the life of a startup CEO, how large companies can innovate at startup speeds. But it won’t just be us talking; we’ll be taking your questions live and on the air by phone, email or Twitter.

On April 27th, on my next program, my guest will be Eric Ries the author of the Lean Startup. Future guests include Marc Pincus, founder of Zynga, and other interesting founders and investors.

Is there anyone you’d like to hear on the air on future shows? Any specific topics you’d like discussed? Leave me a comment.

Mark your calendar for 4-6pm Pacific Time on Sirius XM Radio Channel 111:

  • March 9th
  • April 27th
  • May 11th
  • June 29th
  • July 13th
  • Aug 24th in NY
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