Silicon Valley Himalayan Expedition

Core competence

One of the things that always stood out for me at business school was the importance of core competence. So just yesterday I was telling someone that it should be a a coffee shop's core competence to ensure that the tables don't jiggle.  You basically have to get a couple of things really right to have a good coffee shop, and making sure the tables don't jiggle should be one of them.  Here I am again this morning with a beautiful Coupa Cafe latte, but I had to bend down on my hands and knees to stuff paper under the table leg to prevent the jiggling.  I don't mind this reminder, as it probably helps me look at the issue more regularly with Mozes.  Note: core competence probably involves something that competitors can't easily copy, but based on my more widespread experience with this issue, I'm willing to say that the one coffee shop that figures it out will have developed a great core competence.

Negotiating the Option Pool

The latest Cooley Godward venture capital report spells out that a common Series A financing these days is a split of 40/40/20, where 40% is for the founding team, 40% for the investors and 20% for the option pool.

One of the trickier areas for an entrepreneur to get his/her head around about the deal can be the role of the option pool.  You will often hear a venture capitalist tell you that they are not interested in owning a majority of a company, and it's more than likely true.  It just turns out that sometimes it doesn't end up that way.   The purpose of this post is to walk through a typical scenario which might help the entrepreneur approach the option pool negotiation.  It builds upon a classic post by Brad Feld here and you might read that post first since it clearly explains some of the terms I use here.

As Brad mentions, the amount of the option pool is almost always determined on a post-investment basis ( i.e. the 20% above) but it is almost always the case that investors are successful in having those options issued before the price per share of the investment is determined.   The impact is significant since it means dilution is occuring solely to the founders, not to the investors.   The two charts below show two different cap tables both before and after an investment.

In Chart A, the investor is not asking to increase the size of the option pool.  You can see that the price per share is calculated by dividing the pre-money valuation of $3m by the fully diluted stock of 5 million shares, equating to a purchase price per share of $0.60.  Thus, if the investor puts in $2m, they will be entitled to 3,333,333 shares, or 40% of the company.  Since no additional options were created, there are just 11% of fully diluted shares that are left to be issued to new employees.  Most Series A investors will find that amount insufficient to allow for the proper incentives to be issued to future employees.

In the scenario where an investor asks that 20% of stock  be available for issuance as options after the financing, watch what happens.  Chart B shows that a total of 1,200,000 new options will have to be created before the financing in order to get the amount of available options after the financing to 20%. The dilution caused by the option creation causes the valuation of the company of $3m to be divided by a lot more shares, resulting in a lower price per share.  With the lower price per share and the same investment amount of $2m, an additional 800,000 shares end up going to the investor.

Since the parties are dealing with fully diluted percentages, the investor still gets 40%.  However, since a lot of options now remain unissued, the actual percentage ownership of the company is quite different.   Whereas in the Chart A scenario the investor did not own a majority of the outstanding stock (45%) , in the Chart B scenario the investor owns more than 50%.  Thus, it is not unlikely that an entrepreneur may end up selling control of a company despite the perception of having given up only 40%.  Now the company's attorney can advise the company on the types of protections that could be put in place to prevent the investor from being in a position of being able to take control.  However, sometimes the fixation on fully diluted share count may cause this situation to be overlooked.  Obviously issuing more options to employees will correct the situation over time.

The purpose of this post is not to warn you against  selling control of your company.  There are lots of reasons why founders willingly do so on their path to building a great and big business, and the reality is that many investors truly don't have interest in having control.   Rather, I wanted to illustrate the importance that the option pool can play in negotiating a venture investment and its impact on price per share and valuation.  So long as the founders can understand this impact (particularly before settling on a final valuation amount), the focus of the parties should actually turn to whether or not 20% is the right amount of options to be available for issuance.   

I'll end with just a few final points on that negotiation. Remember that investors are looking to build big companies, and for really early stage companies the investors are going to see a long road ahead to recruiting employees and new executives.  In an ideal world, no more options will have to be issued before they exit (although most investors will accurately tell you that this situation is itself very rare).  The founding team needs to be prepared to build out an option budget for new employees - at least a few years out - which they believe adequately represents how many new options will need to be issued to make a big company.  It is around the actual option budget that intelligent discussions can occur.

It also a good idea for the founding team to look at what has already been issued to itself and other employees.  When the founding team/employee group is strong and the stock is subject to vesting as is typical for a venture financing, then there are some compelling reasons to keep the option pool lower since fewer key hires are necessary.  If an investor makes the point that one of your team members could leave and may need to be replaced, you should point out that the unvested stock can be used for that replacement.   Likewise, particularly where the investor is genuine in a concern of having a sufficient option pool to attract employees, you could suggest having any unused options revert to the founding team in the case of a successful liquidity event.  After all, if those options were never needed to get the outcome the investor wanted, why shouldn't the founders who took the dilution in the first place benefit.

Negotiating the option pool will not always hinge on an intelligent budget or rationale arguments, however, so at least ensure that you understand the impact the option pool is actually having on valuation and price per share.

Should I do my MBA?

I received a note from a prospective student asking about whether he should attend the JD-MBA program at the University of Toronto.  He indicated he had strong leanings to be an Internet entrepreneur.  My basic advice was that if he knew he would one day start a company, he should go do it now.

To be clear, I confirmed that U of T was as good a university as any to attend for the program.  The law school has new great leadership and had the benefit of a great Dean for the last ten years, who is now the Provost of Penn.  I also believe the MBA program's leadership under Roger Martin has the potential to put the program among the top 10 of North American programs in the next five years.

I'm glad I did the JD-MBA program, but I also believe I might be better off if I had just started a company instead.  It would have saved a few jokes too.  Last week I was in a conversation in which a person made fun of lawyers, and then asked if I was a lawyer.  "Yes" I said.   That's never that funny, but when he later made fun of MBAs, I have to admit we all had a pretty good chuckle when he asked that too.

Both events got me thinking about internet companies and education.  I decided to take a quick look into the education of the leaders of the top ten internet properties.  Here's what I found:

Yahoo!:  Terry Semel holds a Bachelor of Science degree from Long Island University and an honorary doctor of humane letters degree from Emerson.

MSN-Microsoft:  Steve Berkowitz received a Bachelor of Arts degree from State University of New York at Albany.

Time Warner Network:  Jonathan Miller – I couldn't locate any education.  He either never went to school or is a graduate of a JD-MBA program.

Google - Eric Schmidt has a bachelor of science degree in electrical engineering from Princeton University, and a master's and Ph.D. in computer science from the University of California-Berkeley.

eBay - Meg Whitman received a Bachelor of Economics from Princeton University and a Master of Business Administration from Harvard Business School

Ask - Jim Lanzone received his BA from U.C.L.A. and isn't shy about acknolwedging his JD/MBA from Emory University.

Amazon - Jeff Bezos graduated summa cum laude, Phi Beta Kappa in electrical engineering and computer science from Princeton University in 1986.

Myspace - Chris DeWolfe has a B.A. degree in Finance from the University of Washington and an MBA from the University of Southern California, where he had dual concentrations in Marketing and Entrepreneurial studies.

New York Times Digital - Martin Nisenholtz received a bachelor's degree in psychology from the University of Pennsylvania and a master's degree from the University of Pennsylvania Annenberg School of Communication

Verizon Communications - Ivan Seidenberg earned a bachelor’s degree in mathematics from City University of New York and a master's degree in business administration and marketing from Pace

The conclusion is mixed then, but you get the strong feeling that the MBA isn't going to give any Internet entrepreneur much of an edge.

Get 'er done

Last week I overheard our office mate Marcus talking about getting things done.  He took charge to implement a really cool thing we did for our Cinco de Mayo party - the Mozes jukebox.  Anyone at the party (or anyone in the world for that matter) could pick the next song by sending an SMS to Mozes.  This thing could take on a bit of its own life when we write about it on the Mozes blog.

I also saw he or someone else had written "Get 'er done" on a whiteboard above one of our team member's desks. 

Procastination is the persistent enemy of every well-intentioned startup and every well-intentioned entrepreneur.  There are a lot of obstacles to building a company and many of them are out of your control.   But procastination is one of those very big obstacles that is fully within your control, and if you don't beat it down every time it rears its head, you are increasing your likelihood of failure by a multiple each time.

I know I am failing as an entreprenuer when there are steps I could take to advance the business and I don't take them.  I'm not talking about the times whenI am too busy or when I am placing priority on another item.  Prioritization is an art that sometimes I believe I have fully mastered (I haven't).  I am talking about those times - on average at least 5 hours or more per week - that any individual has, regardless of how busy he or she claims to be, to take action on an item that deserves action, and choosing not to take it.   Learning that bad choices come in the form of very bad excuses is a lesson that you won't understand until it is too late.

If you want to know the secret to having a shot at making a start-up successful, it is that the entrpreneur and the team get things done.  They take action on a piece of the product that they know needs fixing.  They watch numbers closely and take corrective action when they don't add up as planned.  They make 10 sales calls a day to close those really important first few deals.  They respond to follow up information requests from investors quickly.  In other words, they get 'er done.

Chickens and eggs

Mike Arrington at Techcrunch blogged about Mozes Friday, and raised the possibility that Mozes may be dealing with the classic chicken and egg problem.  The good news is that most entrepreneurs are used to dealing with the question regardless of the business. Whether it comes to raising capital, hiring employees, building product or finding customers, you learn pretty quickly not to care which comes first - you just go and get chickens and eggs all at the same time.  At a higher level however, when it comes to the business model, it's a critical question.

I spent the six years prior to Mozes in the b2b world, having started a company in March of 2000 specifically around b2b commerce.  You may remember Chemdex (can't link to it, but a great case study here) or any of the 2,000 or so companies like it back then.   Despite the promise of massive success if every buyer and supplier agreed to play together in a vertical market, merely assuming it would happen because it made sense if it did proved to be a pretty ugly assumption.  Like Chemdex and a few others at the time, we had to learn at our company that the best way to survive was to prove value in some small but important areas, and then be relentless in demonstrating and replicating that value across the targeted market.

I recently told an investor that I'm not a believer in businesses that can only be successful at massive scale.   It reminds me of the old Saturday Night Live commercial for the  company that made money by changing a dime into 2 nickels and a nickel into 5 pennies.  Massive scale will of course mean massive success, but a company must be successful at the most basic level before it can be massive.  One of the things I love about what we are doing is that we can enable smaller community activities - such as Maker Faire this weekend.

The point isn't that we are going to go after every upcoming cool county do-it-yourself science fair in the world (as cool as that would be).    In this particularly case, we are getting the chance literally to observe our product in action and learn from that experience to advance forward (plus, it's kind of cool having a Microsoft Mobile sign tell folks to text Mozes for more info).  The real target market we are pursuing is different, but our goals are built around demonstrating small-scale value that will translate across larger market opportunities.  Whether that's chickens or eggs first, I must admit I can't really say.

The future of wireless

As an entrepreneur, it is often hard not to get carried away with possibilities for the future.  Many, not all, entrepreneurs have a strong passion to do something different and creative, and it's not just about money.  The idea of instigating change that may affect a large amount of people 5 or 10 years out can be exciting in of itself.  If you do want to make any money, however, it's pretty important to think about how you can improve the present lives of people around you.

As I walked around the CTIA conference last  week, I was struck by how many companies were pitching "the future of wireless".  There is just  something so wrong about that theme, which I feel has hung around the wireless market for 10 years.  Everytime I encountered the concept, I kept thinking to myself - why don't any of these companies want to be the present of wireless?  It is no wonder that the 250 location based services companies of 1998 have been replaced by the 250 of today.

When I was selling enterprise software for my previous company, I kept reminding myself and the sales team to sell in the context of present conditions, and not the future promise.  We were definitely introducing some very new concepts to some old style folks, and it was not uncommon because of our own excitement by the future to get carried away with all things we might one day be able to do for the customer.   I soon realized that it is almost always impossible to sell the future to anyone because by definition it doesn't exist.   The minute you paint a picture for what the future could be like, you are on an immediate downhill ride when it comes time for the customer to start really evaluating how you compare to it.  The quickest path to close any sale was to solve an immediate problem that customer was having today.

It's not that the possibilities for the future don't exist or shouldn't be discussed at all: they do entice people to enter into discussions in the first place.  It's just that what really matters to people who matter to a business is how you can affect and improve their lives today.   It was a great reminder for any mobile company:  if you want to be the future of wireless, you better make sure you are 100% focused on what you can do for people today.

The state of the union

For some reason on a plane ride to Phoenix yesterday I was thinking about how every US President manages to make the same statement each year that the state of the union is strong regardless of the actual state of the union.  Somewhere over the Sierra Nevadas, I concluded that there are a lot of personal factors tied into that decision.   Would you want to be the first President to declare: the state of the union is messed up and we've got so many problems I don't know where to begin.

In Phoenix, I met with a great friend and we stumbled into a conversation on how decisions are often made in business.  He recounted to me a story of observing first hand the study of moving a company's operations to a new city.  Much research was done by lots of people spending lots of money to determine the pros and cons of three great cities.  What did it come down to?  Where the CEO wanted to raise his kids, of course.

I related this kind of thinking to my last company.  We sold the company in 2002 because I thought it was the best option available at the time.  Six months earlier, our CEO was advocating that the company be shut down (dire details can be shared on request).  As a co-founder I argued passionately against it, and to some extent I believed the position held by the CEO came more from the point of view "if I can't run this thing, no one can", than from any sound business judgment.  I might have been wrong about that, but I was very aggressive in taking the position that there was lots of opportunity for the company and it didn't make sense to abandon it.  As a result, I ended up becoming CEO and found the company a home at which I and other employees stayed for the next three years.  But some important words came out when I was having lunch with my friend yesterday.  In the very same sentence that I was suggesting our CEO might not have been exercising sound business judgment, I said "there was no way I was going to be associated with a failed company."  I can still make a case as to why it didn't make sense to shut it down, but I can't kid myself that I'm not guilty of letting personal factors unrelated to the business impact my decisions.

It's often hard to be objective and not let personal factors get in the way.   It's important to seek as many outside, uninterested opinions about a particular issue or topic where personal factors stand a good chance of influencing the outcome.  In a way, the idea stems from a political democracy where objective people called voters often do respond with their own opinion on things.  Objectivity is what really counts, regardless of how certain individuals may declare the state of the union.

Ask the question you don't want to ask

A friend has just left Yahoo! to start her own thing.  We've been talking a lot lately about start-up life, especially hiring new people.  We agreed that it is one of the hardest parts of the early stage start-up because you want to acquire resources to execute against the plan immediately, so any negative aspect of a prospective employee tends to be overlooked or downplayed.  She made the comment "Sometimes you don't want to ask a question because you're afraid of the answer." 

Where have I heard that before?  Everywhere, not just in hiring.   It doesn't matter if you are a CEO, an executive, a manager or on the front line of the company, there is a tendency in our business lives to try to steer away from uncovering information that might get in the way of our immediate objectives.  It is particularly acute in sales, where there is a lot of pressure placed on sales results from the Board of Directors down.  So a sales rep who comes out of a great first prospect meeting will often optimistically forecast a deal for the end of the quarter, which at that time might be 80 days out.  He probably starts to realize with 30 days left that the deal is looking less likely to happen that quickly, and now has to decide what to do.   Asking the obvious question "Are you going to buy from me this quarter?" is the right thing to do, but getting a negative answer has so many negative consequences personally and for the organization,  it never seems timely.  Likewise, managers up the line fail to ask if the "in this quarter" question has been asked for the very same reason.

Don't think it just happens in sales or hiring.  As a lawyer, I saw in action a VC anxious to get one of his first deals through the investment committee  failing to ask ordinary due diligence questions of the target company.   There was no doubt the VC believed in the business, but it was also obvious to me during the process that there were certain things the VC really didn't want to know the answer to, like was that amazing multi-million dollar deal actually a signed contract (which it wasn't). 

This post may be obvious, but I bet you've steered yourself away from getting an answer that might impede your immediate progress at least once.  It is always better to have complete information, however.   If you don't ask the tough questions, it is almost certain that any progress you do make will either be undone or at least waste a lot peoples' time.   The test of a tough question is easy:  ask the question you don't want to ask.

Are you an entrepreneur?

Let me acknowledge first and foremost that entrepreneurs are of many types, so don't take my question or answer the wrong way.  There are entrepreneurs who will totally relate to the things I have gone through, and others who may think I've got it all wrong.  I ask the question because a lot of people are impressed when I tell them I started a company.  They say things like "boy, you have kahunas", "I wish I could do that" or "that's amazing", and I am surprised because I believe there are many more entrepreneurs among us than are actually credited for being one.

I for one subscribe to Jeff Hawkin's theory (outlined here thanks to Niall Kennedy ) that succeeding as an entrepreneur means transitioning out of that job into a success.

A few weeks ago I met a friend of a friend who was thinking about starting his own company after spending close to ten years at one of the big Internet companies.  He wanted to know what it's like to be an entrepreneur and I did the best that I could to tell him from my perspective.  Here's some of what I said.

First of all, it has to be in your gut to start a business, not your head or your heart.  It won't be because a spreadsheet is telling you to do it, or that you've written a business plan so beautiful that the Harvard Business School Press would publish it.  It won't be because your lifelong dream has been to start a company or that you know you will feel like you are pursuing the American dream.  All of those things may be true or none of them may be, but unless there is a feeling sitting much lower inside of you, one that tells you that you don't exactly know what you're in for but you're up for it anyway, you may not be the right person to start a business.

Let's assume it is in your gut and you make the leap.  You won't notice it right away, but in a few days you will begin to realize that there is not a single person in the world who really cares about what you are doing except you.  Sure there are lots of people who  care about you personally.   Colleagues at your last job will ask about it, your friends will take some more time to understand it, and if you're lucky like me you'll have an amazing spouse who will really get behind you.  But there's no one else who will really want to take a second of their time to know what you are doing.  No one is going to randomly call you during the day and want to partner with you or want to buy from you or want to work for you.  Clearly part of the formula behind creating a business is that you will create those inbound connections quickly, but you had better be prepared to be lonely for a fairly long time.

And in those times of isolation, be prepared to experience random moments of feeling like the smartest person and the dumbest person in the world on a fairly routine basis.  Sure the smartest person times are fun, you get a ton accomplished and you really understand why you are doing what you are doing.  You know you will be successful.  But the dumbest person times really, really suck.   The business plan you crafted will seem so obvious and plain that it will dawn on you why no one else is doing what you are about to try.  In those same moments, people will tell you that what you are doing has been tried before and failed miserably.  You will question everything about your business and your very own answers will make you feel like you are making a huge mistake.  If you believe that you have to be doubtless to start and run a business, then it is your first doubt that will cause your business to fail.

The only way to survive the tough parts of independence and self-doubt that accompanies entrepreneurship is to choose to be relentless.   You must spend almost all of your shrinking waking hours thinking about how you can make your business better.  You must pursue all avenues of success if you are going to experience even a small taste of it.  You must believe in your gut in what you are doing despite what your head and heart will question many times along the way.  Choosing to be relentless means overcoming almost every inclination to slow down or take the time out that we humans tend to prefer in the normal course of our lives.

A friend recently asked if I regretted my decision to leave a high paying, secure job to run for 7 months with no salary and a hefty personal $ investment in Mozes.   "No way.  I'm an entrepreneur," I quickly answered.  "But  I sure hope that I'm not one forever."

 

Comparing bubbles

I am still amused by talk of Bubble 2.0 and like before still don't really buy it, even if Meebo took in $3m.  There's always room to fund a really smart, energetic and youthful team in the Internet world because there is not a single investor who knows what's really going to take off and what's not.  The ones who have had the big payoffs have been wrong more times than they've been right.

If you're into the built to flip debate, go check out all the comments kickstarted by Paul K's recent post.  I'm not really sure what to think when I read about careful analysis on planning for an acquisition in this context, let alone building a company for one.  Sure you have to pay attention to market conditions and sure founders and investors need to be aligned about exit expectations at the time of investment (and of course at the time of  exit), but beyond that I think Andrew sums it up nicely with advice from his friend - build a great business and the exit will take care of itself.

To another recent case study, whether Riya wanted to be, deserved to be, or ultimately will be bought for $40 million or more is a question the market will determine too, not Riya.  As Peter Rip says, built-to-flip doesn't work because you can't reliably time someone else's agenda. The Riya team knows that it has nothing without highly committed people and great technology, and they are definitely smart enough to not get sidetracked in a way that destroys that value. 

I really like the prescient quote from Jim Collins from March 2000 which I posted to Paul's blog and below.  It got me thinking of the differences between that month and June 2005, the two months in which I respectively started HigherMarkets and Mozes.   (The irony of naming the company HigherMarkets in March 2000 was pointed out to me by the same famous person who prompted Mr. Collins to write  on why great companies relapse into good or mediocre ones).  The business we built at HigherMarkets still survives and in fact thrives, albeit as part of another company, but we sure got more than a little sidetracked back in those heady days.

One of the first major  arguments I had with someone back then was the date we were going to go "IPO" - pronounced eye-poh at the time.  Fortunately for me (and I hate sounding as sanctimonious as I do here but I want to make the point), I wasn't arguing about which date - I was arguing why in God's name we were having the discussion in the first place.   It made me so mad, but I was being told that it was an important question that every investor we were about to meet would demand an answer to.  Sadly he turned out to be pretty much right on at the time, but of course wrong in the grand scheme of things.

Let me repeat the quote from Collins:

Built to Flip can’t last. Ultimately, it cannot become the dominant model. Markets are remarkably efficient: In the long run, they reward actual contribution, even though short-run market bubbles can divert excess capital to noncontributors. Over time, the marketplace will crush any model that does not produce real results. Its self-correcting mechanisms will ensure the brutal fairness on which our social stability rests.

I like the words "brutal fairness" and I love it when fairness is brutal because it is only brutal to unfairness.

Six months into the second business, the differences between the two companies are stark.  Compared to $2.5 million we spent in half a year, I've spent about $40k to get to the same position.  We've essentially released our alpha version of the product (although not publicly) and we are certainly feeling that it is much more stable than our first release of HigherMarkets.  Maybe we were ahead on the number of free betas we were running, but that's because we're not doing it this time around.  Only one of those five became a signed paying customer for the business even though we sold close to $25 million in software before I left to start Mozes.   On the flip side, I feel a lot closer to revenue at Mozes than we actually ever were in the first two years of HigherMarkets.

I'm working hard to build a great business, taking in all of the lessons we collectively learned from the first bubble.  What I like about this bubble (in addition to it actually being a great time to start a company as outlined in this defining post), is that it looks like it is ready to disappoint anyone attempting to capture excess unfairly much more quickly than we saw in the first.  In fact, folks may just be lucky that it won't end up being as brutal to them as it was to most of the paper millionaires I knew back then.