A VC in Vacationland

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There is a great article in the April 20, 2009 New Yorker on Hanging Tough in a recession. It is short and well worth a read for entrepreneurs.  The primary message for start ups is that recessions create more opportunities for challengers, not less.  Companies targeted at the lower end of the market, such as Dollar Stores and their ilk, for example, are doing quite well in this economic environment.

But the natural reaction of many companies, even industry leaders, is to hunker down, cut costs and wait until economic growth resumes. This may be the wrong strategy. A Bain & Company study shows that during the 1900-91 recession, twice as many companies leaped from the bottom of their industries to the top as did so in the years before and after.

What are the lessons from recessions for start ups?

1. Increase marketing–with your competitors cutting marketing and advertising expenses, your marketing material will have a higher return on investment, as companies are still seeking solutions to help them save money or better serve their customers.
2. Smarter sales–highly focused sales efforts tailored to specific companies who can really benefit from your solutions is a better strategy than having your sales staff work on increasing a bigger, but questionable pipeline.
3. Love your customers–work with existing customers to make sure that they are getting the full benefits of your solution.  It also gives you an opportunity to sell into other divisions or regions, as well as land some custom features work.

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A major issue I often see in start-up business plans is what I call the "great idea syndrome" .  Someone has a great idea, but the projected success may be questionable for a number of reasons. It is rare that I see a really stupid business idea, but I have seen some.  The majority of business plans I do see fall into three categories:

1. Great idea,  few potential (or fad) customers— I do see quite a number of these.  I try and be polite as possible.  Solving only a few people's problems does usually not yield significant revenues to make a long term successful software business. Similarly, coming up with a great idea that is easily eclipsed or copied by competitors, or is likely to be a passing fad, is not interesting or fundable.
2. Great idea, too many customers–Entrepreneurs often define business models that can serve a wide range of customers, like SMB's.  The real question is how to profitably pay for the huge number of features needed to satisfy all aspects of that market.
3. Great idea, clearly defined customers–this is what I like to invest in.

So how do you avoid the "solution looking for a problem" business plan? Matt Blumberg, CEO of Return Path and fellow Blogger, put it best in a recent posting. 

"The key to get past this hurdle in the development of a business is to force
yourself to articulate one or more very clear, crisp definitions of "it solves
THIS problem for THIS person who is willing to pay THIS amount of money to have
the problem solved."  Even if you end up with two or three of these statements
to then go concept test in the market, at least you will be able to shape your
product and messaging development towards getting into the revenue jetstream
somewhere, to quote my friend David Kidder from Clickable."

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We all spend a substantial amount of time trying to find the right candidates for our companies, whether it is a CEO or a developer. I often find that founders or their hiring managers do not review three simple areas to make sure that the candidate is an honest, law abiding citizen:

1. Background Checks–companies such as Applicant Insight  and Hire Right  can provide detailed information on criminal records, lawsuits, loan defaults, foreclosures, etc. on potential candidates, often in three days or less and for no more than a few hundred dollars. 
2. W-2's–you would be surprised at the number of applicant who are willing to "lie" to you about their true earnings, especially sales candidates.  Ask candidates for the last five years of W-2's to discern trends and problems.
3. Your Own References–any applicant is going to give you his best references.  I always ask a  candidate to join me on LinkedIn, then find  someone who worked with them in a prior company and call them to get a less biased view.  Also, I will ask mutual friends if they know people from a candidate's past so that I can speak with them about the applicant's performance.

These may be uncomfortable questions to ask candidates, but trust me, everyone is doing it these days. Don't be caught with a candidate who has fabricated a background and may not perform as promised in your start up.

Happy Fourth of July….

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One of the more difficult initial questions an entrepreneur faces is how to allocate founder shares in their company. I have seen all sorts of allocation proposals from entrepreneurs and lawyers, from the most complex to the simple. My advice?  Keep it simple.

The initial "allocation temptation" is to "please" anyone who has had an impact on bringing a company into being, from Uncle Jack who put up a few bucks, to the 'rents who paid the rent for a year, to the girlfriend who had some useful insights, or to the alpha (read: free) customer who provided feedback on the product.  Forget it.  These allocations can be a huge mistake, as they give ownership to a bunch of people who really will not provide much help going forward.

Here are a few useful rules on who should get founder shares:

1. Early Decisions; Minimal Owners–founder shares should be allocated before the company is actually formed and limited to just a few key contributors.
2. Initial Rewards; Long Term Incentives–founders shares should compensate for work done up to the point of incorporation and give founders a key incentive to contribute to the long-term success of the venture.
3. Percentages Matter; Not Number of Shares–focus on the right percentage ownership for key participants, and be sure you keep at least 51% for yourself.
4. Restricted Stock; Reverse Vesting–founders shares should be restricted and subject to reverse vesting, with the right to repurchase the stock at the original prices in the agreements.
5. Forward Vesting; Timing–restricted founders stock should vest over three to four years, with perhaps 25% up front and the remaining 75% at a 25% yearly vest. The Founder's founders shares can vest immediately, although some may disagree with me.

Under any circumstances, get your corporate lawyers and tax consultants involved early in this process.  They know the federal and state laws around granting founders shares and how to structure allocations to avoid nasty tax consequences in the out years. As for Uncle Jack and other early money sources, consider a convertible debt instrument that will let them convert that loan on the same terms as your first-round venture capital investors. The girlfriend and alpha customer?  Buy them a nice dinner as thanks.

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One of the big problems with being an entrepreneur (or venture guy) in today's investment marketplace is the minimal equity exit options for private companies. You can do an IPO (good luck), sell your stock to an insider or another investor (if you can find one), or get acquired to monetize your equity.  That's about it for the moment.  With currently a six to nine year wait for either an IPO or an acquisition to happen, according to recent data from the National Venture Capital Association, one has to wait a long time for entrepreneurial rewards.

Enter Second Market. They recently announced that they would be launching a marketplace for private company equity, in addition to their markets in auction-rate securities, mortgaged backed securities, limited partner shares, among other "troubled" assets. I am sure that private company equity does not belong in the same world as these dogs, but any market in a storm.  The site identifies a number of interesting private companies, such as Twitter, Facebook, eHarmony and Etsy where trades may be offered in the future.

As anyone who has taken Econ 101 knows, a more efficient market produces better prices.  The Second Market program will bring together buyers and sellers, track trades and prices and provide some sense of fairness in selling illiquid shares.  Problems will emerge, however, as companies may gain undesirable shareholders, employees will have less incentive to work for success if they sell out and founders may bail early.  All are already problems later if a company goes public or gets acquired, but now they may happen earlier.

Before you get all excited, my gut tells me that this market will be limited initially to the "best of the best" private companies, such as those listed above. Over time, as investors and entrepreneurs get familiar with how the second market will work, opportunities may emerge for other private companies to "make the short list". Other start ups are working to create similar secondary equity markets, probably with a variety of market-clearing technologies, including bringing in foreign investors.

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