Berkonomics – Business Insights from Dave Berkus

        Many of us belong to industry associations and find ourselves at conferences and trade shows with time to spend with competitors.  Some of these are old friends; some even former associates.  It is natural to want to associate with these people for many reasons, certainly socially. Most CEOs want to obtain information about their competitors in the most subtle and non-obvious ways.  And of course, most are willing to trade information to get information.

                In my former industry, I became an informal centralized source for knowledge about the revenues of each of the many competitors, with a special skill for asking just the right questions to obtain the information.  How many employees does the firm have today? Are you profitable yet?  Can you guess what percentage your revenue comes from recurring sources such as maintenance revenues?  In return for the answers to these several questions, I was usually able to guess a company’s gross revenues within a few percent and would state my guess to the CEO.  His reaction would guide me to increase or decrease my estimate appropriately.  He’d be a bit amazed with the quick fancy math work, and I would have yet another piece of the puzzle helping me to gauge the total size of the industry in annual revenues and the growth and size of competitors.  All of this was immensely helpful in strategic planning and marketing, even though to this day I do not think those CEOs were aware of the value of the information so easily given.  And none of this is especially considered a trade secret, violating the unspoken covenant between competitor CEOs that there is a limit to such exchanges.

 [Email readers continue here...] On the other hand, often a sales person or marketing manager would show up at my door with a complete package of a competitor’s materials, including price lists, a proposal with discount percentages clearly shown and a list of feature functionality meant to reinforce the proposal.  The source of this information was typically the purchasing decision-maker for a friendly customer or candidate customer.  The question is one of ethics, since the competitor certainly did not volunteer any of the information, which would have been the competitor employee’s violation of confidentiality and cause for being fired.  What does a CEO do with this wonderful, rich information dropped at his door at no cost or obligation? Few would destroy it and ask all to forget that it was ever in their hands. Most would absorb the information and then admonish those who had seen it to not repeat to anyone that it was in their hands.  If you’ve been in business for long enough, you’ve seen your share of this gray market information.  My advice is to be very careful, think of the golden rule, never use this information publicly, and certainly never reproduce it, let alone disseminate it internally.

                As to sharing information to get information, CEOs and executives are bound by a duty to their corporations not to share trade secrets with anyone who has not signed a confidentiality agreement, including consultants to the company.  For CEOs on the corporate board, it is a large part of the “duty of care”, a legal requirement of board members to protect the assets of the corporation first and foremost, one of those assets being the trade secrets of the corporation.

          Once a company founder has tapped the funds available from his or her resources and from friends and family, if the company needs more cash for growth, the most obvious next step is to look for money from angel investors and venture capitalists, typically in the $300,000 TO $3,000,000 range.  This money comes with restrictions a founder may not expect, including restrictions upon the sale of founder stock, clauses that require the investor be allowed to sell an equal proportion of stock upon any other person’s sale of stock, anti-dilution provisions that protect the investor from a subsequent offer of stock at a lower price, and much more. 

          Almost always, professional investors, including angel groups and venture capitalists, also require at least one seat on the corporate board.  The investor organization is granted the seat as long as the investment remains, and the documents often name the first representative assigned by the investor group to the position.

[Email readers continue here...] In subsequent insights, we will explore the legal and ethical responsibilities of board members.  But the intent of these “forced” placements of a representative on the board is obviously to watch over the company’s use of invested funds and to help grow the company in value.  The combination of restrictive covenants in the investor documents and the new dynamic of board members with an agenda make for a change in the culture of the corporation, certainly one for the CEO.

           However, outside professional investor board members can be a very good asset to the corporation with the skills, experience and broad relationships many bring to the boardroom table.

          One of the most obvious observations I make with growing company CEO’s is that planning for a new office is done with an optimistic view of the future, incorporating planned space that compromises only slightly the measured needs for the next three or more years as outlined in the financial forecast.

          The result, signing a lease for space enough to handle the growth called for in the plan, is a predictable group behavior I’ve come to label “The tyranny of the new office.”  The company plans a move to a new facility with plenty of space that is probably built out but not planned for use until the company grows to the next stage of need.  Employees move into their new cubicles and offices, spread out far more than in the previous facility.  The excitement and noise of working in too-close proximity to cohorts suddenly becomes an unexpected near silence, as everyone notices that they do not have to raise their voices any more to be heard above the din of noise. 

[Email readers continue here...] The exciting sounds of an office filled to capacity functioning in a growth environment are exhilarating to most that have experienced it.  The distractions are dealt with using iPods and earphones, concentration and tolerance; but they are dealt with by all.  The change to a near silent environment is so startling that, many times, employees express a bit of resentment or even depression, masked by the common statement that “it is so much easier to get work done without the noise.”  It is the excitement of activity that generates more and better output for most, not the isolation of silence.

          But back to “the tyranny of the new office.” Two predictable outcomes almost always follow a move into an office much larger than today’s needs. First, you’ll find subtle moves by employees into the unused, reserved space.  After all, it is there and unneeded for now.  Why not make use of the space until needed?  And second, management sees the open space and often finds it easier to justify acceleration of one or more new hires since the facility is available and infrastructure complete.  Unconsciously longing for a bit more of the excitement from the noise of the previous office, managers often make subtle unrecognized moves to fill the void with new hires earlier than plan.  That’s why the label, “tyranny” even if the word seems out of context.

          If and when asked, I always recommend more frequent moves as opposed to longer term leases.  It seems from experience that both the company and the employees gain from such staggered moves.

                 And be generous to your high achievers. 

                    Recently I was asked to review an offer letter for a senior director of business development. The CEO was concerned that he was offering far too much in the form of incentive compensation, with bonuses that could greatly exceed the base salary if all of the bonus items were achieved.  I asked the CEO to imagine what the company would look like if all of those bonus-expensive items were completely achieved in one year.  Upon reflection, he stated that revenues could double the following year, and that the company’s reputation among larger customers would be so greatly enhanced that the company could become the leader in its niche.  My obvious retort: “Then why not offer this candidate the moon if he can achieve this?”  The offer was sent and the CEO was much happier, dreaming of the possibilities, not the incremental cost.

                I love to point out that my top several sales people were making more than anyone else in the company, including their boss.  These outstanding achievers worked for salaries below those of their engineering peers, and had to put it all on the line every day to earn their keep, let alone excel.

                The best way to encourage alignment between your managers and the company’s goals is to create a bonus plan for each, with its payments made based upon the key performance indicators established for them and for their areas of responsibility, all in turn based upon the tactics and strategies contained in the company’s strategic plan. 

                It is amazing how few company CEOs grasp the concept that executives and managers should be compensated not just for doing their named job, but for exceeding expectations while advancing the corporate goals.  To align everyone in the organization in exactly the same direction is a task, one that is a powerful driver for growth.  People should be compensated well for such outstanding contributions.

[Email readers continue here...]  What is the general rule for such a bonus plan? Provide no more than five key performance indicators derived from the strategic plan and fitted to the specific job of the manager.  Set time-based goals for each.  Provide bonus opportunities that add to approximately 50% of the base salary if all are achieved within the year.  Meet and measure progress truthfully each quarter.  Perhaps pay a portion of the bonus upon completion of these meetings.  Do not make the usual mistake of ignoring or passing on the progress of any of these items by just paying a part of the bonus at yearend because no-one carefully reviewed progress, or because circumstances changed and the bonus item could not be completed as written.

                Incentives are powerful tools when used well and reviewed often.  They are a major part of a good manager’s work and should be treated as such by the CEO and all senior managers.

Equity is the currency of early stage businesses.

                 The truth of this statement may be obvious, but the execution of a good incentive program using equity is often mismanaged, damaging the corporate capitalization structure and even affecting the outcome of subsequent investment into the company.

                First, a brand new enterprise is often formed from the efforts of several “partners”, each with an expertise valued by the others.  Equity is divided between the founders and the business begun.  Although this insight does not address this point of ignition, we should note in passing that things always change over time, and formerly strong founder-contributors can become a drag upon a business or loose interest if the enterprise is not quickly successful.  To protect against this, there must be some document in place from the beginning that clearly states the expectation of each founder as to contribution of time and resources to the enterprise.  The document should also contain clear buy-sell clauses, forcing any sale of shares to first be offered to the corporate treasury, then to the other founders in proportion to their holdings, and then if no interest, to outside investors.  It should contain a mandatory sale clause in the event of separation of a founder, so that a major owner who is passive in the enterprise cannot easily vote against measures other active founders endorse. 

                The real insight here is that stock options or phantom stock are the tools of early stage businesses used to attract great talent when there is not enough cash to pay market rates.  There are some rules.  First you must create a stock option plan using your attorney, which must be registered in many states as a security offering. (The fee for registration is well under $100, so this is not an issue.)  Options are usually best with “C” corporations, but granting options for either LLC’s or “S” corporations are not a real problem. 

                Most early stage companies make the mistake of making option grants to new hires at all levels that are too aggressive and distort the capital structure of the company to a degree that damages future professional investment.  Let me try to advance a few rules of thumb to help guide you here.  [Email readers continue here...] An option plan should carve out an addition of about 15% of the “fully diluted” shares.  If there are 85,000 shares issued to the founders, then a plan calling for 15,000 shares in a pool reserved for future hires is appropriate, making the fully diluted shares 100,000.  The board must approve the plan including this number, and shareholders must approve the plan as well.  Each grant to new or existing employees must be approved by the board before issue.

                The price per share for option grants is also an important consideration.  IRS rule 409a specifically calls for an appraisal of the value of the corporation’s stock current to within a year of any grants of options, although there is an exclusion for early stage businesses in which expert members of the organization or board may make such an appraisal if they qualify according to the exemption.  It there is only one class of stock, the same as the founders, and the appraisal of the single class of shares yields, say $2.00 a share, then options must be priced at that amount.  In other words, you cannot create bargain options at below “market rates.”  If you have a preferred class of stock with special protections, that class of shares will be valued at a price higher than the founder common shares, allowing stock options to carry a lower price per share than preferred investors may have paid.  This is important because high quality candidates should be induced to consider coming aboard at lower than market salaries using the tool of “cheap” options, properly priced.

                What percentage of the total company shares should be reserved for what specific job titles?  Inducing a new CEO to come aboard usually means creation of a stock option package of 5-8%. That size of grant would take much or most of the option pool.  A vice president, or CxO candidate, typically is offered between 1% and 1.5%.  Director level employees are typically granted ½%.  All other grants usually are much lower, allowing for the typical 15% pool to last for quite awhile in most companies.

                We will cover board members and advisory board members at a later time. 

                Options typically are earned over time, which we call vesting.  If a grant of 10,000 shares is made on January First, typically there is a four year vesting period in which the employee earns the right to exercise (buy) 1/48^th of the shares each month.  Many plans also call for a one year “cliff” in which an employee who is separated from the company before a year is unable to exercise even the shares which would have been vested at that point.

                There is an important consideration that will become an issue with sophisticated candidates for VP and above.  We call these “trigger” provisions, in which selected options negotiated for a select group of senior managers, fully vest to 100% upon any change of control.  This provision allows these select individuals to perhaps profit handsomely in an acquisition by being able to exercise their options in full at the time of sale.  The negative side of this is that the buyer may not want to so enrich these managers that they may not be willing to come aboard the buyer’s organization, even if the existing options are replaced with options from the buyer company.

                If all of this seems a bit overwhelming, we have just scratched the surface of option plans and incentive compensation.  This is an area of expertise that a CEO is required to quickly learn and carefully manage with the help of the corporate attorney and the board.

Second to visionary leadership, this is your most important job. 

               Many of us go through the motions of hiring to fill a position, trying to use our intuition and skills to find the best candidate for the job.  Sometimes we use consultants or recruiters; many times we use internal talent to fill most positions. 

                And over the years, we students of business success have learned that there is a science to the hiring process that continues through the life of an employee’s tenure with the company.  Bradford Smart captured this succinctly in his book, Topgrading. His thesis is that “A” players amount only to the top ten percent of the talent pool at any given time, and that your job is to find, recruit and retain only “A” players to make a successful business.  It is hard to argue with that.  What is hard to find, is the rare CEO that makes the process of hiring top recruits such a priority that he or she spends personal time deeply involved in the specification, resumé review, interview and selection of top employees.  Most of us are “far too busy” to do all of that.  And yet, aside from managing the vision of the enterprise, the most important job of a CEO is to find, recruit and make productive “A” players for the team.

                As an investor and board member for numerous companies, it is increasingly easy for me to quickly evaluate the quality of senior team members in an organization as I probe for strengths and weaknesses in the enterprise.  Teams where the CEO is comfortable enough to delegate to “A” players and manage the strategies for growth stand out as rare and powerful.  Conversely, it takes very little for a CEO to derail what could be a great team and company, by ignoring the details involved in finding the right talent for each senior position, and by failing to communicate the strategies and empower the team to execute.

[Email readers continue here...] A successful hire is not just the responsibility of the recruiter and manager to whom the recruit will report.  Many companies require that finalist candidates be interviewed by a number of contemporaries, good employees who fill similar level positions. Some even encourage interviews with those the candidate would manage.  Agreement among the interviewers becomes an empowering experience for those conducting the interviews and agreeing to the decision to hire, and paves the way for a quicker assimilation of the new employee into the organization whose cohorts are already prepared to receive and encourage the new hire.  This is not an inexpensive process when considering the cost in time and productivity of the interviewers.  But finding “A” players is not an easy job, requiring a stretch of resources at each stage of the process.

                Earlier, we explored strategic planning within the enterprise. We spoke of developing strategies and tactics that are measurable for each department.  Now is a good time to complete that chain by suggesting that paying significant incentive compensation to the people empowered to execute those strategies and tactics is critical to the success of the plan as well as to the organization.  Aligning everyone toward the same goal and using the practice of rewarding for achievement of milestones defined by the tactics from planning, makes for a great business, managed by a leader who understands the process.

                What makes a great leader great?  Of course, it’s great execution by great employees acting as a unit in the best interests of the enterprise.  No-one can do this alone.  No CEO can do this with “B” players or less.

Time bankruptcy results from the deliberate over-commitment of core resources. 

          I created the term “time bankruptcy” almost thirty years ago when the computer software business was young, and I was a software developer building a young company based upon quality first.  Asked to speak at a number of software industry events, I found my voice and immediate audience understanding as I described variants of the following problem to my audience. The insight became clearer as I was hired again and again to pick up the pieces of failed programming efforts by other software companies in this then young industry.

          A developer would take on a new customer, customize programs as needed, and install perhaps an 80% completed system upon the customer’s brand new minicomputer system.  The customer would pay for all or at least 90% of the system, perhaps holding back a retainer awaiting completion.  Burning through the payment and needing more to cover fixed overhead, the developer would do the same for the next 80% customer, moving on to the third.  About that time, the first would call asking for completion of programming or training, firmly but politely.  The fourth installation was interrupted as the first customer suggested that he would stop giving glowing recommendations for the vendor, insisting upon a completion date, while the second customer interrupted with its first call for completion.  By the fifth or sixth (who keeps count for these stories?), the first threatens suit, the second becomes demanding and the third makes that expected call for a completion date.  So the vendor stops work on the newest installation to complete earlier installations.  Revenues dry up while overhead continues to burn though the developer’s pockets.  It’s a classic case of time bankruptcy.  The developer deliberately overcommitted his prime or core resources (in this case his personal time) leading to a loss of income and reputation that it could not recover.

[Email readers continue here...] The same story could be constructed for any company selecting a limited number of test customers for a new product. Select too many, and pay too little attention to each.  Commit all of your core resources to solving the resulting problem, and new work stops.  Time bankruptcy. Not a pretty sight, and completely avoidable.

          Be aware of this trap.  No-one but yourself can be blamed for allowing core resources to be overcommitted, even if by subordinates.  That’s because you now know the term and the impact of such an error in judgment, and understand that the simple but important remedy is to slow the commitment of those most critical resources to the front lines.

                 Here we examine the relationship between time, quality and competitiveness. If you are getting the impression from these many insights that complex relationships cause simple problems, you are right.

                We have heard the “haste makes waste” ditty since childhood.  There is little need to reinforce the obvious.  On a larger scale, there are epoch stories of giant companies eating massive losses in a recall of product, often based upon limited testing before release. 

                A marginal example was the Intel release of the Pentium Pro and new Pentium II processor to rave reviews – until a math professor found an obscure error in the chip’s code that made a rare floating point calculation error.  Posting that finding on the Internet, quickly Intel found itself defending against fears by others using the processor for math work that the processor could not be relied upon.  Intel rushed to fix the bug and offered to replace the processor to anyone requesting such a replacement.  At a cost of millions and a reputational hit, Intel recovered.  The lesson here is a bit obscure, since it is not clear whether the kind of testing then common in processor design would have surfaced the error.  It is quite clear that such an error would be found immediately today based upon changes in testing procedures made by all processor manufacturers after that event.

[Email readers continue here...]  The waste from haste in this example was in not pre-thinking of enough testing scenarios for a new product.  There is always a trade-off between cost for testing, time to market and risk of problems. 

                 Perhaps better examples to point to are easy to find in the toy industry, where recalls because of small parts that could be swallowed by infants or lead-based paint or flammable components make the news on a regular basis.

                And the other side of this coin, “To lag is to sag”, addresses the two issues of loss to the competition because of delays in release of a new product, and burning of fixed overhead while products are redesigned.  

                It becomes obvious then that there must be a balance somewhere between rushed release and too much rigor in pre-release planning and testing.  Perhaps that balance can be measured in estimating what a company could endure in lost overhead and hits to reputation before becoming crippled and unable to recover.  With that measure based upon pure estimates, the balance point changes between companies, with the largest, most profitable companies able to suffer the most risk as to resources, and the smallest suffering by far the most when measuring reputation.

                There is a relationship between time and money that is more complex than most managers think.  Fixed overhead for salaries, rent, equipment leases and more make up the majority of the “burn rate” (monthly expenses) for most companies.  Since this number is budgeted and pre-authorized, managers tend to focus upon other things such as sales, marketing and product development issues.

                There is an art to efficient management of a process, whether that is the process of bringing a product to market from R&D to production or developing a new product’s launch program.  What most managers miss is that every month cut from the time it takes to perform such tasks cuts the cost by the value of a month’s worth of fixed overhead or burn.  Although young companies rarely measure profitability this repeatedly, more mature companies usually can bring from five to ten percent of revenues to the bottom line in the form of net profit.  Ignoring cost of product for a moment to make a point,  saving a month’s fixed overhead by making processes more efficient, could easily double profits for the year.

                That relationship between fixed overhead and production time is as critical as any other factor in success of a young company.  Many of the start-ups my various angel funds have financed died a slow death, not because of poor concept but because of poor execution, wasting fixed overhead and draining the final resources from the company coffers. 

[Email readers continue here...] In the technology sector where I most often play, extended unplanned software development cycles account for the majority of these corporate failures.  We often accept that development schedules for young companies are almost always too optimistic.  But we investors often allow too little slack in our estimates as well.  The great majority of young companies developing complex products such as semiconductor-based products, new software-based systems and technologies based upon new processes greatly underestimate the time needed to bring the product to marketable condition.  So the CEO comes back “to the well”, asking for more money from the investors to complete the project.  It is not a strong bargaining position for the CEO to ask for money to complete a product promised for completion with the previous round of funding.  And professional investors often penalize the company with lower-priced down rounds or expensive loans as a result.

                I have one story that remains as vivid in my mind as when it happened several years ago.  Helping the founder create a company and build a much-needed product in an industry I knew very well, I served as chairman for the newly formed company, and along with my several rounds of early investment, led rounds of other angel investors in what I knew as a successful opportunity to fill a need in an industry I understood.   

               The company grew to be well known in this limited niche and was operating at slightly above breakeven, when the Board and CEO decided to seek venture investment from what we hoped would be a first tier VC firm in Silicon Valley.  And we were able to secure that investment along with a partner from that firm joining our board.  It did not take long for the partner to become impatient with the relatively small size of the opportunity.  Dreaming of a company many times the size, he led the board to approve a complete reversal of course, even stating that the company should ignore the existing market niche completely and redesign the product for the broad Fortune 500 corporate market.  Every one of us on the board expressed our concern that the time to make these product changes and position for the new, broader market, would eat away all of the company’s capital.  Promising the full weight of his VC firm’s resources, the board voted to make the change against the best judgment of those of us who knew the original market niche so well and thought that there was growth to spare in that niche alone.

              So the company turned the ship, slowly it seemed, as R&D worked to develop an appropriate product using the base of the original design.  Time slipped; fixed overhead continued.  And exactly as you’d expect, there came the time when the company ran out of money as it ignored its original market.  Surprise.  Since the company slipped in its R&D schedule, the partners of the VC firm voted to not add new money to the company for the project.  Not long after, the company was sold in a “fire sale” amounting to slightly less than the debt on the books. All investors, including the VC firm, lost everything.  Do you remember a previous insight, that “the last money in has the first say”?  That is what happened within the dynamic of the board, and the result is that the board was completely at the mercy of the “last money” VC to save the company in the end.  Yes, there were other issues such as a protracted patent rights fight that drained cash, but the largest problem, inefficient use of R&D time burning fixed overhead, led to the demise of the company.  Lots of good jobs were lost and many investors including myself were left with the question. “Why did the company abandon a profitable market, even if it could not generate $100 million a year in revenues?”

                We will revisit the relationship between time and money again in future insights.

First customers are critical. Greatly exceed expectations at all costs.

                 There is so much history behind this insight, and so many stories that illustrate this point.  Your first customers for any product or service form your reference base, the important group of allies that your marketing and sales people rely upon when attempting to create buzz and make a mass market for a new product.  If you’ve been involved in the launch stage of any product in the past, you should recognize the overwhelming feeling of panic when initial customers make first contact with complaints about quality, functionality, speed of service or other critical part of the new release.

                The best advice I can give is to allocate all of your resources to supporting the roll-out of a new product, at least for a short period.  Respond immediately to every question and complaint.  Capture every compliment and ask if you can use it for marketing purposes.  If the product or service is especially complex or expensive, send someone from sales or marketing or even R&D to the customer location at the moment of first use. 

                Of course most of us have limited resources for such overwhelming support of a new offering. So make the first release a limited one, sized so you can support it with existing resources, even if that means releasing it to only three carefully chosen customers at first.

                And I am serious about the “…at all costs” admonition in this insight.  If you must provide a free backup unit, personal on-sight service for a month, your personal cell phone number for the customer CEO, or any number of unexpected offers of superior service and accountability to those first customers, do just that.  Make your customer a partner in the process.   Send flowers to the staff in the department using the product for the first time if appropriate.  Call the customer CEO and thank him for helping launch a product so very important to your success.

                The result of doing this right will be to blunt criticism, reinforce compliments and provide a solid user base to build upon.  And the alternative is a lost opportunity to shine, perhaps a first wave of negative public reviews that post and report across the Internet, and a loss of reputation and goodwill that will take years to overcome.

                I don’t know about you, but I would much prefer to spend dollars reinforcing a great first customer’s experience than fighting fires in the marketplace after seeing negative reviews.  Make sure your entire staff buys into this mantra. “These first customers are critical.  You are personally empowered to do everything possible to exceed their expectations.”