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Friday, July 24, 2009

Focus is one off your most powerful keys when starting up

Startups: Think Big and Focus Small

It’s great to dream big, but your startup needs a laser focus in the beginning to get market and investor attention. Google did it with search engines, Apple did it with a personal computer, and even Wal-Mart did it through low prices. A business plan I saw last week to combine all the good features of several popular social networks on one site will not do it.

Trying to do everything at once probably means that none of the items will be done well. Plus it’s almost impossible to craft a message that will make your offering stand out in the minds of customers. I can’t think of a company that launched to superstardom with a broad focus. Can you?

Here are the common sense reasons why a laser focus is more likely to lead to startup business success:
  • Time to market is critical. It takes too much time to build processes and products to capitalize on a broad strategy. Meantime, small competitors will appear and seize your business opportunities and steal your targeted customers.

  • Keep infrastructure costs low. Every business needs some basic equipment and infrastructure, and ongoing development costs. Attempting to roll out the big dream internationally all at once costs lots of money. Getting more money is hard, but not as hard as building the big infrastructure and getting it right the first time.

  • Need to be nimble. Every successful startup I know has had to “dodge and weave” quickly as they learn what their customers really want, and what really works in product design and marketing. Bloated products and the grand unifying “theory of everything” won’t allow you to adapt quickly to market changes and mistakes made.

  • Proving market leadership. Success requires market leadership in your product area, and it’s easy to see that pushing more products and services dilutes your focus and attention. Market leadership isn’t a one-time thing, it means continuous innovation, or you will be left behind.

  • Maintaining quality is key. The more you try to do in parallel, the harder it is to maintain quality. Remember the old maxim that “you only get one chance to make a great first impression.” Customers are fickle, and good quality and good customer service is hard, even with a focused product.

  • Personal bandwidth is limited. When things become too messy and complex, and even you are not sure of priorities, people get disillusioned, tired, lose motivation, and tend to give up easily. A laser focus is easier to communicate, easier to manage, and more likely to get done quickly and well.
As with everything, there are two sides to every coin. When applied appropriately, focus will result in rewards exceeding your expectations. Conversely, focusing on the wrong things will result in a downward business spiral. Focus on exploiting strengths and achieving success rather than resolving weaknesses and avoiding problems. Don’t get burned by focusing on the wrong thing.

Remember that most people can confidently and competently accomplish one thing at a time, and most customers are only looking for one thing at a time. After you saturate the market with your focused offering, then you will have the time and resources to broaden your offering.

Don’t give up your grand vision, since nobody wants to buy a “one trick pony”, but also don’t try to be the “one-stop shop” for all on day one.

Marty Zwilling
CEO & Founder of Startup Professionals, Inc.; Managing Partner of Southwest Software Ventures & and Consulting; Advisory Board Member for RelGuard, Re:Think, MiraLinx, BoomerJobs, Procure Networks, Twin Cypress Group, and Healthcents

Tuesday, July 21, 2009

Understanding the deal offered by the VC's for your investment

In VC deals, Price Doesn't Matter - But The "Promote" Does

VCs have an unfair advantage when it comes to financings. They simply have more experience doing deals.

A typical start-up company will do 2-4 venture capital financings before a successful exit (or, conversely, an ignomious ending). A typical serial entreprenur may lead 2-3 companies in their career before calling it quits (or checking themselves in to an insane asylum). Thus, the universe of financings that even the most experienced entrepreneurs get directly exposed to is typically 5-10 financings over a 15-20 year career. In contrast, the typical venture capitalist, either individually or across their partnership, will do 5-10 financings in any given year. Year in, year out,

Thus, VCs and entrepreneurs are not operating on an equal playing field when it comes to negotiating financings and interpreting the impact of the terms involved.

One area that has always struck me where this assymetrical relationship comes into sharp focus is when there's a discussion around the price of the deal. Entrepreneurs often mistakenly focus solely on the pre-money valuation while VCs look at multiple knobs in the negotiation to drive to a set of terms that, in total, they find acceptable. And if they don't focus on the pre-money, they focus on their ownership position after the financing, irrespecive of the amount of capital that was raised.

In my partnership, we've come up with a new term (I think it's new - I don't see it written or talked about much) called the "promote" to help communicate with entrepreneurs the real value behind a particular deal so get them to step back from concentrating only on the pre-money valuation or post-money ownership.

What is the promote? First, let me take a step back and define a few terms. In the world of VC-backed financings, there are multiple terms that impact the ultimate price of the deal. The first, and most focused on, is something called the pre-money valuation. That is, what is the company worth prior to the money being invested? This pre-money valuation is own known in shorthand as “the pre” and you will hear entrepreneurs and VCs discussing other company finances using this term (“You were able to raise money at a $9 pre? I had to struggle to get to $6 pre and I have a prototype and real customers! Life isn’t fair.”)

But the pre-money isn’t the only term that defines price, the amount of capital raised and the post-money plays a part as well. The post-money is the pre-money plus the invested capital. That is, if a company raises $4 million at a pre-money valuation of $6 million, then the post-money is $10 million. The investors who provided the $4 million own 40% of the company and the management team owns 60%.

Another term that impacts the price is the size of the option pool. Most VCs invest in companies that need to hire additional management team members and sales and marketing and technical talent to build the business. These new hires typically receive stock options, and the issuance of those stock options dilute the other investors. In anticipation of those hiring needs, many VCs will require that an option pool with unallocated stock options be created prior to the money coming in, thereby forming a stock option budget for new hires that will not require further dilution after the investment. In our $4 million invested in a $6 million pre-money valuation example above (known in VC-speak shorthand as “4 on 6”), if the VCs insist on an unallocated stock option pool of 20%, then the investors still own 40%, there is a 20% unallocated stock option pool at the discretion of the board, and a 40% stake is owned by the management team. In other words, the existing management team/founders have given up 20% points of their ownership in order to go towards future hires.

This relationship between option pool size and price isn’t always understood by entrepreneurs, but is well-understood by VCs. I learned it the hard way in the first term sheet that I put forward to an entrepreneur. I was competing with another firm. We put forward a “6 on 7” deal with a 20% option pool. In other words, we would invest (alongside another VC) $6 million at a $7 million pre-money valuation to own 46% of the company. The founders would own 34% and we would set aside a stock option pool of 20% for future hires. One of my competitors put forward a “6 on 9” deal, in other words $6 million invested at a $9 million pre-money valuation to own 40% of the company. But my competitor inserted a larger option pool than I did – 30% – so the founders would only receive 30% of the company as compared to my deal that gave them 34%. The entrepreneur chose the competing deal. When I asked why he looked me in the eye and said, “Jeff – their price was better. My company is worth more than $7 million”.

At the time, I wasn’t facile enough with the nuances myself to argue against his faulty logic. That's why we instituted a policy at Flybridge to talk about the “promote” for the founding team more than the “pre”. The “promote”, as we have called it, is the founding team’s ownership percentage multiplied by the post-money valuation. It represents the $ value in the ownership that the founding team is carrying forward after the financing is done.

In my example of the “6 on 7” deal with the 20% option pool, the founding team owns 34% of a company with a $13 million post-money valuation. In other words, they have a $4.4 million “promote” in exchange for their founding contributions. Note that in the “6 on 9” deal, the founding team had a nearly identical promote: 30% of a $15 million post-money valuation, or $4.5 million. In other words, my offer wasn’t different than the competing offer, it just had a smaller pre and a smaller option pool.

Entrepreneurs negotiating with VCs should spend time making sure they understand all of the aspects of the deal, but particularly the elements of price - the pre-money, the post-money, the option pool - and do the simple math to calculate the "promote". There are many other elements of the deal that affect price (participation, dividends) and control (board composition, protective provisions), but make sure you think hard about the value you're carrying forward, not just the price tag you think the VC is giving your company in the "pre".

Jeff is a General Partner at Flybridge Capital Partners (fka IDG Ventures Boston), an early-stage venture capital firm in Boston.

Article by :Jeff Bussgang