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

What Do I Do Now? The Startup Lifecycle

search build growLast week I got a call from Patrick an ex-student I hadn’t heard from for 8 years. He was now the CEO of a company and wanted to talk about what he admitted was a “first world” problem. Over breakfast he got me up to date on his life since school (two non-CEO roles in startups,) but he wanted to talk about his third startup – the one he and two co-founders had started.

“We’re at 70 people, and we’ll do $40 million in revenue this year and should get to cash flow breakeven this quarter. ” It sounded like he was living the dream. I was trying to figure out why we were meeting. But then he told me all about the tough decisions, pivots and firing his best friend he had to do to get to where he was. He had been through heck and back.

“I made it this far,” he said, ”and my board agreed they’d bet on me to take it to scale. I’m going to double my headcount in the next 3 quarters. The problem is where’s the playbook? There were plenty of books for what to do as a startup, and lots of advice of what to do if I was running a large public company, but there’s nothing that describes how to deal with the issues of growing a company. I feel like I’ve just driving without a roadmap. What should I be reading/doing?”

I explained to Patrick that startups go through a series of steps before they become a large company.

Search
In this first step, the goal of a startup is to search for a repeatable and scalable business model. It typically takes multiple iterations and pivots to find product/market fit – the match between what you’re building and who will buy it.

searchYou’ll realize you’re ready to exit the Search step when you have customer validation:

  • You’ve found a sales channel that matches how the customer wants to buy and the costs of using that channel are understood
  • Sales (and/or customer acquisition in a multi-sided market) becomes achievable by a sales force (or network effect or virality) without heroic efforts from the founders
  • Customer acquisition and activation are understood and Customer Acquisition Cost (CAC) and Life Time Value (LTV) can be estimated for the next 18 months

Startups in Search mode have little process and lots of “do what it takes.” Company size is typically less than 40 people and may have been funded with a seed round and/or Series A.

Most startups die here.

Build
At about north of 40 people a company needs to change into one that can scale by growing customers/users/payers at a rate that allows the company to:

  • achieve positive cash flow (make more money than it spends) and/or
  • generate users at a rate that can be monetized…

buildUnfortunately as you hire more people, the casual, informal “do what it takes” culture, which worked so well at less than 40 people, becomes chaotic and less effective. Now the organization needs to put in place culture, training, product management, processes and procedures, (i.e. writing the HR manual, sales comp plan, expense reports, branding guidelines, etc.)

This Build phase typically begin with around 40 employees and will last to at least 175 and in some cases up to 700 employees. Venture-backed startups will often have a Series C or D or later rounds during this phase.

Grow
In the Grow phase the company has achieved liquidity (an IPO, or has been bought or merged into a larger company event) and is growing by repeatable processes. The full suite of Key Performance Indicators (KPI’s) processes and procedures are in place.

Lucky you’re not the ex-CEO
I pointed out to Patrick that he was in the middle of the transition from Search to Build. And I suggested that he was lucky to be encountering this problem as a 21st century startup rather than one a decade or two ago. In the past, when venture-funded startups told their investors they’d found a profitable business model, the first thing VC’s would do is to start looking for an “operating exec” – usually an MBA who would act as the designated “adult” and take over the transition from Search to Build. The belief then was that most founders couldn’t acquire the skills rapidly enough to steer the company through this phase. The good news is that VC firms are beginning to appreciate the value of keeping the founder in place.

I reminded Patrick that the reality is startups are inherently chaotic. As a founder he got the company to the Build phase because he was able to think creatively and independently since conditions on the ground changed so rapidly that the original well-thought-out business plan became irrelevant.

He managed chaos and uncertainty, and took action rather than waiting around for someone on his board to tell him what to do, and his decisions kept his company from dying.

Now Patrick would have to pivot himself and the company. In this Build phase he was going to have to focus on how to thoughtfully start instituting things he took for granted in the Search phase. He was going to have build into his organization training, hiring standards, sales processes and compensation programs, all the while engineering a culture that still emphasized the value of its people.

Patrick took a bunch of notes, and said, “You know when I figuring out how to search for a business model, I read the Startup Owners Manual and Business Model Generation, but where are the books for this phase? And come to think of it, in the Search phase, there are Incubators and Accelerators and even your Lean LaunchPad/I-Corps class, to give us practice. What resources are there for me to learn how to guide my company through the Build phase?”

Time to Make New Friends
I realized Patrick just hit the nail on the head. As chaotic as the Search phase was in a startup, you were never alone. There was tons of advice and resources. But in the past, the Build phase was treated like a smaller version of a large company. Operating execs hired by investors used the tools they learned in business school or larger corporations.

I suggested it was time for Patrick to consider four things:

  1. Read the sparse but available literature that did exist about this phase. For example, The Four Steps to Epiphany Chapter 6, Company Building, Ben Horowitz’s The Hard Thing About Hard Things (a series of essays) or Geoff Moore’s classic Crossing the Chasm
  2. If he already had an advisory board (formal and/or informal), add CEO’s who have been through this phase. If not, start one
  3. Get a one-one CEO coach or join a CEO peer group
  4. And potentially the most difficult, think about upgrading his board by transitioning out board members whose expertise was solely rooted in the Search

As we finished our coffees, Patrick said, “Thanks for the advice, though I wish someone had a methodology as simple as the Lean Startup for how to scale my company.”

Lessons Learned

  • Startups go from Search to Build to Scale
  • The Search to Build phase happens ~40 people
  • Very different management tools and techniques are needed to guide your company through this new phase
  • You need to reset your board and your peer advisers to people who know how to manage building a company versus starting one

It’s About Women Running Startups

Just before the holidays I had coffee with Anne, an ex MBA student running a fairly large product group at a search engine company, now out trying to raise money for her own startup. She had an interesting insight: existing content/media companies were having the same problem as hardware companies that rarely made the leap to new platforms. And she had a model for a new media company for mobile and wearables.women innovation I thought we were going to talk about her product progress, so I was a bit taken aback by her most pressing question, “Why is it so hard for a woman to still get taken seriously by a venture capitalist?”

I had lots of answers, but none of them good enough for either of us.

I had a better one when I came back from New York.

——
Entrepreneurship at Columbia
I was in New York last week teaching my annual 5-day version of the Lean LaunchPad class at the Columbia Business School. We had 130 students in 30 teams who got out of the classroom and did 2154 customer interviews in 5 days – a remarkable effort for 120 hours. Their amazing Lessons Learned presentations can be seen here.

In the last year entrepreneurship at Columbia has taken a pretty remarkable leap across the entire university. The Columbia Startup Lab is a visible symbol of how the university is making entrepreneurship an integral part of all colleges at the university.

New York Startups
The Columbia Startup Lab is in a building completely taken over by WeWork – a company that provides co-working spaces in 12 cities worldwide. I wandered through four full floors of SohoWest WeWork sticking my head into the random startups’ offices.

Looking at office after office of startups a few things stood out.

  • This was just one of the 14 WeWork co-working spaces in New York City— there are over 100 co-working spaces in New York
  • Michael Bloomberg has yet to get his due for engineering the New York entrepreneurial ecosystem
  • I was struck by something that had been slowly percolating through my head during my entire week – there are a higher percentage of women on the founding teams of New York City startups than in Silicon Valley

Women in New York Startups
This last point is definitely not a data-driven survey. However after spending a week teaching 130 entrepreneurship students, ~35% of them women, and then walking through ~100+ WeWork and TechSpace offices in New York, I get the impression that the number of women leading startups in New York is much higher than in the San Francisco Bay area.

When I mentioned this to my friends running the NYU and Columbia entrepreneurship programs, they looked at me like I just discovered that it gets dark at night. Their answer seemed to make sense: a higher percentage of startups in New York are focused on media, fashion, communications, real estate, financial tools – all the products of industries centered in NYC – and all are attempting to disrupt them with products that run on and are delivered by 21st century platforms. (Think of what Refinery29 is doing to Conde Nast.)

These are industries where women have had a history of leadership positions and more importantly, where young women entrepreneurs can find role models and mentors as their male counterparts do in Silicon Valley’s tech-centered, pay-it-forward culture.

This raises an interesting question: is the credibility of female entrepreneurs in the eyes of New York VC’s something about the venture firms, or is it about the industries they are funding?

One can make the case that New York venture capital industry is rooted in the 21st century not the 20th. While some venture firms have been around for awhile, perhaps the newer partners have a different model of what a successful founder looks like than their west coast peers.

Or perhaps it’s as simple as New York VC’s are funding startups that play on the disruption of New York’s key strengths in Media, Fashion, Finance and Real Estate, and the women founding New York startups have an existing track record in those industries, and pass a gender neutral “VC credibility” bar.

Correlation does not imply causation
Those bemoaning the dearth of women founders in Silicon Valley might want to see if there is a real disparity between the coasts or if it is just my selection bias?

If it’s real why?

  • Women founders already had leadership roles in the industries they’re about to disrupt?
  • Women can find existing role models?
  • Women have built a network of women mentors?

What role does the type of startup play?

  • Companies that get started and built in New York City tend to be applied technology
  • Companies that get started and built in Silicon Valley have historically focused on core technology

What role does venture capital play?

  • Is there any difference in funding women for old-line firms versus 21st century firms?
  • What role does industry segment play? (i.e. lots more women founders in media companies than you find in enterprise software companies.)
  • On the West Coast the history of successful startups is technology first, and perhaps VC’s weigh that more in what they want to see in founders.
  • Is it as simple as having credibility in the industry you want to startup in?

—–

I sent Anne, my student, an email when I returned, “You may want to take a trip to NY and pitch some of their VCs.”

Lessons Learned

  • Lots of entrepreneurial activity in NY
  • Different industry focus than in Silicon Valley – more media, finance, real estate
  • Women seem to be more represented as founders
  • If a NY bias toward women as founders is true, why? And what are the lessons for Silicon Valley?
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