The four “P’s” to help you build a great business

How do you manage a great business, as opposed to be a survivor?  Well, here are the four areas you should focus upon every day.

Now, some of us remember things better when given a catchy phrase or rhyme. So, here’s one to help you with squeezing the most out of your own available resources.  In this new reality in our business world, there is certainly little room for mistakes and no room for bloat within our companies. Preventing them is our responsibility.

The first “P” stands for people.  The wrong person in most any job causes everyone below or above that person in the production system that depend upon that person to operate at a reduced rate or quality of output.  And if there are people depending upon the output of that wrongly-placed individual, they too will suffer from reduced resources to complete their jobs.  The cost of a bad or failed placement in any position in a company’s critical chain is enormous and goes far beyond the salary paid to that individual.  Enough said.

The second “P” is for productivity.  But if a good person is failing at their job, it may be because you have not provided the resources necessary for that person to do the job expected.  For example: Hire a great sales person then fail to support him or her with a good marketing effort or a properly priced quality product, and that person will be set up to fail, and for reasons you might have fixed.

[Email readers, continue here…]   Then there is the third “P” – performance.  Like a great orchestra, it takes a skilled conductor (you) to bring the best out of the collective members of the group.  You are responsible for the quality of performance that defines an excellent enterprise and assures long life for the company as competition becomes more aggressive and geographically extended.

The fourth “P” is for process.  How do you efficiently get your offering from development to market?  How do you stage and tune a production line for maximum quality and output?  How do you penetrate an established market with a groundbreaking new product, but on a limited budget?  All these are process questions, often faced by management (you) when seeking success.

Kids Wooden Number Block As Symbol For Numeracy Or Counting

Now, all of us have limited resources and must deploy them effectively to gain the most possible ground in the marketplace.  Like a chain with four links, no one of these listed here can be weak so that we can us to succeed in our efforts toward success.  We’ve got to focus and pay attention to each to each of these four areas to strengthen the chain.

Future look: Over time we will explore these issues more deeply using the “theory of constraints” (TOC) method of looking into your physical and financial roadblocks.

The four “P’s”:  People, productivity, performance and process.

Ask yourself: which of these four P’s is your weakest link?  What can you do to rethink, reinforce and redirect resources and remove roadblocks to the success of that link and enhance your whole organization?

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Posted in Growth!, Protecting the business, Surrounding yourself with talent | Leave a comment

Here’s how NOT to define your competition

We investors see this all the time. An entrepreneur pitches using a deck with no slide for competition. When asked (as we always do,) the response is “This is new. We have no competition.”

Niet!  No! Unh unh.

Professional investors laugh when they hear an entrepreneur come out with that one.  That statement has killed more investment deals than almost any other.  It is a failed litmus test for the entrepreneur, even if the plan is for a totally new device or service that could take the world by storm.  Well, come to think of it, this is especially true in such an instance.

Dis you really do your research?

The statement shows a lack of research or previous thinking that is a red flag for us investors.  Whether you have not been able to find companies doing “something like” the plan, or you has not considered the most obvious killer of new ideas – doing nothing, it is a faux pas that should never be allowed to happen.

Your potential customers could choose “do nothing.”

[Email readers, continue here…]   Doing nothing is the main competitor for most products and services, whether a compelling new idea or a seasoned product long proven to be effective.   Remember that the buyer must commit resources, money and time, toward the purchase of your product, and even if the product repays its investment in a few months, there may be issues you know nothing about that make no decision the right decision for this and perhaps many buyers.

External factors to consider

Consider the state of the economy. Perhaps buyers cannot obtain attractive financing in the current market.  Maybe there is advance knowledge of new technologies around the corner that makes any decision today a risky one.  It could be that a larger competitor has met with its customers, promising to extend its product line into this very niche.  There are thousands of variants of the theme, where no decision is the right decision.

Do your homework!

So, do your homework especially well by putting yourself into the minds of your potential customers.  Widen your search to include companies with products peripheral to yours, where extension of their product would seem logical, especially if you plan to be successful early in making sales into their market.

If you are raising funds, list “do nothing” as a viable competitor in your slide deck.  If you are training your sales staff, work especially hard on responding to emotional and factual counters to a final close of a sale.  Practice overcoming the potential objection long before standing in front of investors, customers or even your board.

After all, fooling yourself should never be an option.

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Posted in Finding your ideal niche, Ignition! Starting up, Positioning, Raising money | 1 Comment

What’s the minimum information to give your investors?

Every investor wants regular information from companies taking their money.  And most of us investors are frustrated by the lack of regular communication – unless of course – the company needs more money.

On the other side, entrepreneurs and CEO’s usually have a natural fear of giving too much information to us investors after the initial investment is received.  They worry that we will not keep the information confidential and that financial data will find its way into competitors’ hands.  Others worry that we will latch onto individual line items within financial data and engage in inquisitions regarding telephone bills, marketing costs and other tactical line items in detailed financial statements.

The minimum legal requirements

First, let’s cover the absolute minimum legal requirement a company must provide to its investors.  There must be an annual meeting of the shareholders, and that meeting must be announced with a written notice at least ten days prior to the meeting. (There is a provision that a waiver of notice may be signed preventing this need, but it requires that all shareholders sign).

Required actions by shareholders

At the annual meeting (which can be attended by phone), there are actions that require a vote of the shares present either by proxy or in person. These include election or re-election of board members if required by the bylaws of the corporation, approval of any increases to stock option plans (which would dilute the worth of shares outstanding,) and approve any additions to the capital stock authorized to be issued.  Shareholders may vote on other issues during the year by written consent, including acquisitions, stock issuance, changes to the articles of incorporation and bylaws, and more.

[Email readers, continue here…]   Prepare for your annual meetings well. But don’t worry. Few investors will show up that day.  But – make it easy for them by creating a video or phone link to the meeting.  More will attend, and all will feel included.

How much financial information must our companies give?

But the question that is most often asked is: “How much financial information must be divulged?”  The answer is that the minimum requirement is to provide an income statement and balance sheet to all shareholders annually.  There is no requirement that either be detailed by general ledger account, and those statements should rarely be that detailed anyway.  Summarizing income statements with a line for revenues, cost of revenue, general and administrative expenses, sales and other direct costs – all leading to net income, would satisfy the legal requirement for statement of income and expense.

Requirements created by investment documents

When a company accepts an investment from professional or organized investment groups – such as angel groups, venture capitalists or corporations, there is usually a document signed entitled “investors rights agreement” that calls for additional financial and narrative reporting requirements due to that class of shareholder.  This could include the need for audited financials, monthly financial and narrative reporting and more.  That burden is an ongoing cost of taking the investment, much as a public company takes on the additional burden of governmental reporting, both adding to costs over time.

Good practices vs. minimum requirements

Good relations with us investors can be maintained only by keeping current with information between the company and with us.  If there is a concern over some investors gaining a competitive advantage, the amount of information may be reduced to the minimum for some classes of those investors.  A good example of this is the information provided to common stock holders, many of whom may be former employees who have exercised stock options and moved on to join the ranks of the competition.

Of course, a public company is not entitled to pare its information to reduce exposure to competitors.  That is one of the many costs of becoming a public entity as many CEO’s have found and dealt with over the years.

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Posted in Depending upon others, Raising money | 1 Comment

Think ahead when raising your early investments

Some businesses just can’t fit within the angel capital or friends and family model for raising funds.  Sooner or later you may need to seek venture capital and accommodate the needs of the venture community in negotiating the terms of an investment.

What VC’s can and cannot do

First, VC’s in general cannot invest in ‘S’ corporations or limited liability companies (LLC’s).  This is only a minor problem in that both forms can convert easily into ‘C’ corporations at low cost and little consequence.

And what VC’s worry about

More importantly, VC’s will worry over several issues when looking at a company and deciding about an investment.

First: Is the price paid for shares by previous investors excessive, creating a post-money valuation too high for the actual value of the company?  If so, the VC will contemplate a “down round” – that is: offering an investment where previous investors find their investments instantly worth less than their original value, even if the investments were made at high risk and years earlier.  No one wants to face this, but the need for money and the possible overpricing of the first rounds may have created an unsustainable valuation.

How did you structure your first round?              

[Email readers, continue here…]  Second, it is important in the first investment round to face the issues that may be required later by subsequent, more sophisticated, investors such as VC’s.  These include “tag along rights” which allow investors to sell some shares when others, such as management or founders, sell any shares.  Also included are “drag-along rights” in which minority shareholders may be forced to obey the vote of the majority in such important votes as to sell the company or take a round of financing at lower share prices.

The enlightened professional investor

Most VC’s today are becoming enlightened (as are organized angels), correctly forcing many decisions that might have been dictated by investment documents instead to the corporate board to decide.  This allows for a discussion – and perhaps a negotiation – between inside and outside board members in such instances, all for the good of the corporation, not just one class of shareholder.  You may recall that board members have a “duty of loyalty” to the corporation, and not to their constituent investors.  This enlightened thinking reinforces that duty, even sometimes at the expense of profit to the VC’s.

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Posted in Raising money | 2 Comments

How much of my business do I have to give to an investor?

If you’re looking for growth capital, this one’s for you. We’ll cover what information you’ll expect to provide, your range of expected values and amounts of investment to expect.  All to help you set your expectations.  OK?

Financial History and Projections

Let’s start with the basics. If you are a going business with a track record of revenues, then the importance of accurate current financial statements cannot be overstated. If there is no record of revenues, see the “The Berkus Method” available with any search query for valuing the business before revenues.

And you should “know your numbers and be able to defend them” during early meetings with candidate investors.  At the least, historical numbers must include the latest income statement and balance sheet, showing activity through the latest period.  If the business is not a startup, expect to supply income statements for the past several years as well, to emphasize trends in revenue and costs.

Projections for your future

You should expect to present detailed projections for the next 12 months as a basic minimum.  Beyond that, plan to prepare projections for two additional years, but not necessarily in account-by-account detailed format.  Sophisticated businesses will also create a cash flow projection for the same period, showing cash used and remaining at the end of each period.  And note that projections showing “unbelievable” rapid growth are always suspect. Careful about “hockey stick” forecasts.

How much money can you get?  

Well, here is a question with a circular answer.   To grow your business to a size that will be attractive to a VC or angel making an investment now, you’ve got to show that the business will be large enough at the time of the investor’s liquidity event (cashing out) to make the investment attractive at all.

[Email readers, continue here…] Most VC’s look for a 10x opportunity – that is – a ten times increase in the valuation from investment to liquidity event.  Later stage investors sometimes look for less, since the business has already proven its capability to stay in the game and has already completed its product development cycle, eliminating more risk for the investor.

So, you’ve got to play with the numbers to determine your level of comfort. The more you ask for – the more equity you give up.  Completing this exercise often leads you to lower your expectations about the amount of money to be raised.

It is also a factor that early stage investors don’t want a controlling interest in your company.  It is a disincentive to you and a burden to them.  “Engineer” your needs if possible so that you give 20-35% to investors on the first professional investor round.

Here’s a valuation example for you based on amount to be raised

Try this example:  You want to raise $2,000,000 today.  Your projections and the analysis we’ll undertake below lead to a possible valuation of $40,000,000 in five years, assuming that you meet your plan, and allowing for a 50% discount to your projected numbers during the investor’s evaluation.  That means – using the investor’s 10x expectation for return – making the business worth $2,000,000 today at best.  To raise $2,000,000, you must give up 50% of the post-investment equity (the current value of $2,000,000 plus the investment of $2,000,000).  The post-investment value would be $4,000,000.  When multiplied by 10x, the target valuation at exit would be the $40,000,000 quoted above.  It is a fact that very few businesses reach the $40,000,000 valuation hurdle. And it is probable that you’ll need more money to reach that target, muddying the calculation and reducing your equity percentage.

Remember your employee option allocation

Your potential investor will include the full number of shares reserved for your present or future option plan – usually 15-20% of total equity – making your personal equity 20% less when calculated as “fully diluted,” or including a reserve for options.  Therefore, in the example above, you would control less than 50% of the company at funding if you received $2,000,000.

Given your strong desire to keep controlling interest in the early stages of growth, the amount that can be raised must be lower than $2,000,000 in order to accomplish this goal.

So, the circular reasoning exercise returns.  Raise your projections (and sell your investor on the increased projections as a result) or lower the amount of capital you raise in this round.  Your future rounds should be at higher valuations if you meet your plan, making dilution of your equity less onerous at that time.

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Posted in Raising money | 3 Comments

Can you overcome five risks and create wealth?

Of course, we are speaking of increased valuation of your company when we speak of “wealth.”  Especially if you are in the early stage of growing a business, these five risks can and often do derail entrepreneurs before realizing the riches of a great exit.

So, let’s examine them and mitigate them.  Make you wealthy someday.

The carrot and the stick

In the creation of your enterprise, there are five principal risks you’ll need to navigate

around. Professional investors will probe these five risk areas and make the decision to invest based upon their comfort with each.  So, it is important for you to identify, address and mitigate each of these in order to increase valuation and decrease the risk of ultimate loss of the business.

First:  Product risk. 

Is the product or service possible to produce at all, let alone economically enough to compete in the marketplace?  One way to mitigate this is by using early money to create a prototype, to perform market research, to complete the first generation of the product, or to deliver the service to a satisfied customer.

Second: Market risk. 

[Email readers, continue here…]  Are you ahead or behind the market with your product or service?  Will the public respond in numbers to buy, license or rent your offering?  This risk can be mitigated by finding a customer willing to purchase as soon as a proven model is completed, and willing to state this in writing.  Another is to gain the support of a core vendor who is willing to offer special extended terms to the company as its investment in creating the product in a finished state.  A third demonstration of overcoming market risk is by holding controlled focus groups and gathering information from unbiased potential customers supporting the acceptance of the product or service.

Third: Management risk. 

A great idea often fails from the inexperience or inability of management to bring the idea to market.  Similarly, great management often can manipulate an original idea or business plan into one much more attuned to the market, adding tremendous value that might have been lost sticking to the original plan.  This is sometimes labeled “execution risk” addressing whether management can create and run the company producing the product acceptable to the marketplace.

Fourth: Financial risk.  

Any new enterprise is at risk if there are not enough resources to get the company to breakeven, which is a proxy for stability.  If a company truly needs five million dollars to get to breakeven, investors that provide the first million are greatly at risk of the company failing to raise the remaining capital or of subsequent investors valuing the company at a lower price than the first investors, causing a “down round” in which the early investors are punished for taking the first risk.

And fifth: Competitive risk. 

If there are high barriers to entry with such protections as patents, long development time already spent or contracts with the major potential customers, then the risk of a competitor with more resources jumping into the frothy pool and taking advantage of the demand created by the company is minimized.

The lesson: Reduction or elimination of one or more of these risks increases the valuation of the company and certainly improves its chances of survival and growth.

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Posted in Positioning, Protecting the business | 3 Comments

Could you have created a “dirty cap table?”

Oh, I know. When you started the business, you took investments from friends and family in small amounts just to get you started.  Of course, that worked at the time.  But…

Enter the need for larger investments

When you seek professional investors, whether organized angels or venture capitalists, one of the early questions you are asked is “How have you financed the business so far?”  Investors love to see entrepreneurs who have used their own money to ignite their businesses.  But often, entrepreneurs turn to others for initial capital. Describing that capital using the phrase “friends, family and fools,” or “FFF,” has become as common as to be just plain trite.

Crowd sourcing as a tool

More recently, “crowd sourcing” has become one more way to finance a business, whether by forming a single investment vehicle (“AngelList.com”) or non-equity financing (“Kickstarter.com.”)  These are newer ways to find relatively small amounts using these Internet tools and combining groups of many investors at a small amount per investment.

What would the SEC say about your investors?

[Email readers, continue here…] The problem with taking friends and family money rests in the legality of taking money from non-accredited investors, people who do not meet the SEC standard for making non-public company investments.  Currently that standard requires a minimum of $200,000 in annual income or over one million in net assets, including the value of the investor’s principal residence.  Since many small investors in a young business do not meet that standard, there is a chance that the company has taken money that it should not have taken, according to SEC rules.

An important exemption

There is an exemption for members of the entrepreneur’s family and in some cases for close friends with intimate knowledge of the entrepreneur and of the plan and, of course, for employees of the company.  It is worth checking with an attorney to see if such investors are truly exempt.

Does creating a PPM mitigate the risk?

Some small companies work to create “private placement memorandums,” attempting to protect themselves against this problem, couching the proposed investment in legal language stating the risks involved in making the investment.  The PPM does nothing to mitigate that problem when the investor is not accredited.

To compound the problem, often stock is issued by the entrepreneur without filing any report of such issuance with the state of issue.

The risk of the “dirty cap table”

The sum of these problems is that a disaffected investor can sue the entrepreneur or the entrepreneur’s company for a rescission of the investment and return of the money invested if the money was taken improperly, especially when the business has failed and the investment lost, putting the entrepreneur at risk for the loss of additional personal assets.

And the cure…

The cure for this, when professional investors enter the picture, is for the company to craft a “rescission offering” to those shareholders who invested illegally, offering to repurchase their shares at full value invested.  This is sometimes difficult since it often happens just at the time a company needs new money most and is in the process of seeking that money for growth.  If a previous investor does not accept a rescission offer, there is some insulation provided to the company against a future lawsuit by that investor.

How this could affect the future for you

So, plan to take money only from qualified investors. Check with your attorney if there is any doubt.  The risks of a problem rise with unmet investor expectations, and fade with success.  But sometimes, such behavior will cause a subsequent angel or venture capitalist to pass on an otherwise good opportunity, and that would be a shame, one that could have been avoided by diligent process in the early investment cycle.

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Posted in Ignition! Starting up, Raising money | 3 Comments

Would you sign a personal guarantee if you have investors?

It’s a fact of life that a banker, lender or lessor will ask for a personal guarantee from the founder or entrepreneur most every time. But what if you’ve diluted your interest from 100% to something less than 50%?

Should your investors expect you to carry 100% of the risk?

The short answer is “yes.”  Seems unfair, doesn’t it?

To most lenders, the guarantee is still a requirement, putting the entrepreneur in a position of additional risk that is not spread among the shareholders.

Recently, one of my companies offered the founder with a 20% remaining interest after several rounds a reward for signing two large personal guarantees necessary to grow the business – in the form of a warrant to purchase common shares at today’s common share price.  A win-win for the investor and entrepreneur assuming the company does grow and have a liquidity event someday.

The eye-opening process of borrowing for a small business

Starting and running a small or growing business can be a challenge to the most confident and optimistic entrepreneur.  And the process of borrowing money or financing asset purchases can be an eye-opener for those who are not used to today’s lender and seller aversion to grant easy credit.

The easy solution when entrepreneurs have controlling interest

[Email readers continue here…]  Most any entrepreneur with a clean credit record can obtain a bank card with a $50,000 limit, if s/he is willing to give a personal guarantee and has enough assets to back the promise it contains.  As the amounts get higher or as banks get into the picture, the negotiation around a personal guarantee becomes more of an issue with the lender and the entrepreneur.  As a rule of thumb, a company with a majority owner in control will be required to provide such a guarantee for most any borrowing of significant size in relation to assets.

Some thoughts on elimination of personal guarantees

All entrepreneurs assume risk when starting and growing a business.  It is only smart to consider ways to mitigate risks when opportunities to do so arise.  Approach your banker when times are good and discuss whether the increased collateral from growth is enough to eliminate the guarantee.  Approach your co-investors to negotiate some mitigation of personal risk, such as a backup guarantee in return for warrants.  Consider approaching another bank or lender with your increased strength and negotiate a “take-out” loan that eliminates the original lender without requiring a personal guarantee.

Most of all, keep your line of credit clean.  Communicate with your lender if a payment is going to be late.  And of course, here’s that old adage: “Never run out of cash.”

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Posted in Ignition! Starting up, Protecting the business, Raising money | 2 Comments

Oh, go ahead and ask for a five-million-dollar investment in your startup.

I cannot tell you how many times I have seen executive summaries of business plans in which the entrepreneur seeks $5,000,000 to build the business.

Four reasons you should reconsider.

First, few startups can use that much money today with all the virtual services available and increasingly inexpensive methods of development, prototyping and marketing. Second, almost no professional investor will consider putting that much into a startup until there is proof of market demand, product viability or some other mitigation of failure.

Third (if you’re keeping score), it is not wise to dilute the founder’s ownership greatly in the first round of financing.  The investors want a motivated entrepreneur, and it is certainly more difficult to motivate a twenty percent owner than a sixty percent owner.

Fourth, there is the matter of control.  Entrepreneurs have a vision for what and how to create and build a great business.  Giving control over that vision to others early on often dilutes the vision and is a disincentive to the entrepreneur.

How does this comport with “skin in the game?”

[Email readers, continue here…] Professional investors love to see companies where the first round of financing came from the entrepreneur, showing “skin in the game” and more motivation to succeed because of money invested as well as time and creativity.

There are so many resources for early money to validate an idea, turn it into a product and increase the value of the company before professional investors come into the picture.

A much more rational approach to starting up.

Starting with credit card debt or a personal loan and working through money from friends or family, or simply consulting to earn money for investment, entrepreneurs should consider early resources for capital to produce a prototype, do market research or start to build a team.  Once there is progress in any of these critical areas, raising professional investment is easier and the likelihood of a higher valuation makes for retention of more equity during the first important professional round.

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Posted in Ignition! Starting up, Raising money | 5 Comments

Once again: Is it the jockey or the horse?

Early stage investors have been arguing over this for years.  Do they bet on the entrepreneur (jockey) or the business idea and plan (the horse)?   This is serious stuff.  If you are looking for money, this question will certainly come up in one form or another when you approach professional or organized angel or VC investors.

A more complex answer

My answer always varies as I examine each deal, sometimes deferring and passing on an investment because of an uneasy feeling about the entrepreneur, even if the business plan seems able to capture the market.  Speaking for others, I see VC investors jumping into deals knowing that soon they will push to replace the entrepreneur with a professional, experienced manager that the VC has vetted and trusts.

Sometimes there’s a real surprise after the fact

I have bet on the entrepreneurial jockey numerous times and been blind-sided by after-investment behavior that completely reversed my opinion about an entrepreneur’s ability to manage growth to breakeven.  Other times, the entrepreneur went on to assemble a great team and execute the plan as it inevitably changed again and again.

[Email readers, continue here…]  Although this debate will continue for ages, I tend to fall on the side of betting on the jockey, simply because it has been a rare business plan that did not change again and again seeking a successful model in the marketplace.  And great management can morph a company to adopt without destroying the culture of the company in the process.

What if you see a great idea but no team to execute?

What if you were the investor and someone walked into your office handing you a business plan executive summary that floored you with its brilliance?  And what if that person admitted immediately that he or she had no team and was not the person to take this plan to market?  Would you, as an investor, plow money into the plan and help to incubate the idea into a real enterprise?  I would not, nor would most all of those I co-invest with.  There are millions of great plans that failed over the years for want of a great management team.  And I am sure there are many, many average plans that developed into great companies with the help of a great team.

Concentrate on a world class team

So, if you are one of the entrepreneurs without experience or ability to take your great plan to market, admit this early and form a team that investors can trust to do this, personally stepping into a position that fits your core skills, be it marketing, sales, development, or other areas required by a young company.

It would be refreshing as an investor to meet an entrepreneur with a great plan and a pre-formed management team fronted by the strongest possible leader, even if the entrepreneur offers to take a back seat in order to make the vision a grand reality.

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Posted in Depending upon others, Ignition! Starting up, Surrounding yourself with talent | 4 Comments