Berkonomics – Business Insights from Dave Berkus

     So you have a great new product or service that you and your associates love.  Early adopters should climb all over each other for a look.  But what have you done to test the concept against the realities of the marketplace?   Have you developed a prototype, alternate pricing schemes, even a PowerPoint mockup to show to potential buyers?  I would be very, very nervous without testing the product in the market as early as possible, ready to make changes and enhancements before committing to production and release. 

     Even with a perfect product, is the market ready for this?  Will you have to be both the evangelist for the product and for its marketplace as well?  Few early stage companies have the resources to do both. 

[Email readers continue here:] There are formal focus group organizations to help you, or you can attempt to test the market yourself by calling together a variety of potential users and asking a third party to facilitate a meeting where the product is exposed to the group and a conversation freely formed allowing the participants to agree with the premise or reject the product as useless to them, all without personalities getting in the way.

     No matter how you plan to test, make that plan an integral part of the development cycle, as early as possible so changes will not be costly.  Do NOT rest until you test.

Know your market and competition, or don’t spend a dime on anything else.

                I have stated previously that I love absolutes – statements with no wiggle room for gray-area responses.  Well, here is one of those, and it deals with market research first and foremost. 

                Let me tell you a short story at my own expense.  In 1994, (I know a long time ago), I invested over a million dollars into a company whose entrepreneurs had a vision that I bought into for many reasons, not the least of which was that I had industry experience and understood the need.  The first of a number of advanced products was a unique cell phone for hotel rooms, connected through a special “switch” in the hotel’s telephone room that was able to detect when a call was coming to the guest room phone and simultaneously ring the cell phone assigned to that room, no matter where it was at the moment.  A tent card beside the fully-charged phone greeted the guest entering the room for the first time, inviting the guest to pocket the cell phone for the duration of his stay.  The phone could be used for receiving incoming calls when in the restaurant, on the golf course or anywhere.  The guest could even make room-to-room or concierge calls as if dialing from the room itself.  These systems were not cheap as you might guess.  But four and five star hotels loved the concept, which included redirecting outgoing calls from the cell phone by the guest to be sent through the hotel’s land line switch, making the hotel a miniature phone company with its attendant profits.

                Here’s where some intelligent market research might have saved the company and my investment.  Fast forward several years to 1996…  [Email readers continue here...]Hotels were installing the system; guests were satisfied and the company was growing. There was even talk of some phone companies using the patented system for serving communities of guests, not just from a single hotel.  Back to 1996. That year, some of you will recall, the first digital cell phones were released to the market, smaller, cheaper and priced with roaming plans that made it no premium cost to carry these digital phones to cities far from home.  Overnight, guest use of the room cell phones dried up and hotels were left with expensive switches, phones and chargers unused.  Soon the company was drifting toward bankruptcy as the leases for the systems expired, one by one. 

                I guarantee that there were tens of thousands of people in the country who knew long beforehand of the imminent arrival of the digital cell phone and could predict its effect upon usage, especially roaming use.  And yet the company was blindsided as it continued to invest in switch and specialized analog phone hardware, soon to be instantly obsolete.  Merely adapting the switches to new digital phones would not work, since guests no longer needed the service itself, being instantly self-sufficient.  People no longer called guests in their rooms but directly to their cell phones, even when the guests were on the road.

                In this case, the competition was not from a company but a new technology.  In most cases, it is the competitor with a better product, lower price, faster service, better reputation that is the threat.

                When I listen to a pitch from an enthusiastic entrepreneur or read the summary of a business plan, one of the first questions I ask is about the strength of the competition.  Surprisingly, many entrepreneurs immediately respond. “There is no competition.”  Now, there is a statement even Alexander Graham Bell could not make about the telephone (which he pitched to his investors as a device to aid the deaf).  Bell’s competition was the written message, doing nothing, the telegraph and old fashioned word of mouth.  To say “there is no competition” is always the most red of all flags to an investor.  For most brilliant new ideas and business plans, the competition is merely to do nothing. That response is quite different than one where competitors have paved the way and existing customers prove through use that the product or service is valued.

                So I lost over a million for lack of market research.  Bell was lucky, but the pace of technology was so much slower then.  Just to make a well-earned point now that you have heard my story, know your market and competition or don’t spend a dime on anything else.  Oh, how I wish I had taken my own advice.

This statement could be considered controversial.  We have previously made the case that professional investors demand more in the form of restrictive covenants and lower valuations.  Now we explore the other side of that coin.  Professional investors usually bring “smart money” to the table, defined as money that comes along with good advice and great relationships for corporate growth.  Often, that money is worth more than the cash invested, because the investors who often become members of the board, bring a wealth of experience, insight, relationships and deeper pockets to the table. 

                I serve on the boards of several companies with just such VC talent at the table, partners in firms that made subsequent investments in companies where I either made early investments or led a group of fellow investors in early rounds of finance.  Each of these companies needed more cash than professional angel investors were willing or able to provide, and we turned to the venture community for larger investments. 

[Email readers continue here...] Attracting a VC investment means finding a partner in a VC firm who is willing to champion your opportunity before his partnership and then represent his firm with a seat on the board once the investment is made.  In a number of cases, these VC partners have made the difference between success and failure or at least growth vs. stagnation.  These VC partners have relationships with later stage investors further up the food chain, with service providers, with potential “C” level senior managers, and with other CEO’s with great timely advice or partnering opportunities.  In one such recent case, the angels were tapped out at $6 million invested, an amount far above their usual taste, but for a company with a billion dollar potential.  The VC’s that subsequently invested $18 million to date are looking for the billion dollar valuation someday, well beyond what angel investors usually are able to project from their own resources.  Whether this business and entrepreneur make it to the rare billion dollar club or not, without the VC guidance there would have been little opportunity to even dream of such a goal.  There is no question that the company took smart money and leveraged it for maximum growth, using the money, guidance, contacts and more from these large VC investors.

                So now we have explored the early stages of formation and finance.  It is time in the next posts to fine-tune the business and its strategic plan to exploit its maximum potential, finding the ideal niche for a company and its core competency…

This insight follows closely the conclusions from the previous declaration, that professional investors negotiate tough terms, from provisions of control over asset acquisition, eventual sale of the company, future investments, forced co-sale when others attempt to sell their shares and more.  And yet, in an earlier insight, we spoke of the problems that come when taking unstructured investments from friends and family.  So how does the statement above fit into this sandwich of alternatives?

                Trusted, close resources include sophisticated relatives, friends and business associates who know how to structure a deal as a win-win for you and for them, while allowing you to retain control over your vision and execution.  Their investment should be structured with the help of a good attorney who understands the mutual goal of maximum leverage of funds with minimum interference in your business decisions. 

                Remember the admonition that investment from such close sources carries an additional burden for you – to protect your investors and their investment as if they were your alter egos, offering money as if from your own pocket.  Such money should never be taken without clear understanding of the terms, whether a loan with a reasonable interest rate and strict repayment terms, or an investment valuing the company at an amount considered reasonable by a third party professional, even if as a sanity check as opposed to an appraisal.  This money is personal, an investment in you as much or more than in your company.  The degree of care you take increases with the reduced distance between you and your investor. 

                [Email readers continue here...] My very first investment as a professional angel was in a small startup where the entrepreneur’s vision fueled my imagination in the audio market niche where I had run a business in an earlier life.  I was so enthusiastic that I coached the entrepreneur to approach his mother, who invested $50,000 under the same terms as my investment.   A small venture firm and a few more angels rounded out the total investment.  As the company grew and became profitable, it became more visible to others in the market niche.  Two of us who invested served on the board of the company, advising the first-time entrepreneur with our business and industry experience.  Several years later, with the approval of the board and entrepreneur, I was able to engage a very well-known potential acquirer of the business who offered an attractive price for the still-young but successful enterprise.  After weeks of negotiation, the entrepreneur suddenly disengaged, claiming that he was no longer interested in a sale of his company.  The rest of us were shocked and disappointed that after weeks of work and a fair price, we were left with nothing but to follow his lead and disengage.  Shortly thereafter, in a board meeting, I brought up the issue of starting to pay board members for service in cash or in stock options, typical for outside board members but rarely for investors.  The entrepreneur was angry, abusive, in his negative reaction to even bringing the issue to the board for a discussion.  Five years had passed from my original investment in what I now clearly perceived as investment into a lifestyle business, one where the entrepreneur had no interest in selling or sharing.  I resigned from the board on the spot and negotiated a sale of my stock to the entrepreneur at five times the earlier investment, a fair return for both, since the company was by then worth much more.  It is now years later, and his mother along with other early investors are still in the passive game, not likely to see liquidity from this mistaken investment in an entrepreneur unwilling to take money in exchange for the eventual promise of liquidity.

                Why tell this story at all?  Mother is surely satisfied as a passive investor who probably would have given her son the money without structure.  The other investors are probably in the unhappy never land of not being able to see liquidity after a decade and unable to write off the investment as a loss for tax purposes.   This story would probably have ended in a lawsuit if a larger professional investor had been involved, since the entrepreneur did not follow the rules and seems to have no desire to do so.

                Trust works both ways.  Take money from close resources, but treat it as if the responsibility is even greater to protect the investors and their money than from a professional.   These investors trust that you will do the right thing for them if at all able.