November 19, 2005

How Can David Beat Goliath- Strategy #4: Create a Scale Advantage!

Posted in David vs. Goliath, management at 8:46 am by scottmaxwell


Last summer I was walking across my front porch when I was stung by a yellow jacket. When I looked around there was a large number of yellow jackets circling around a hive attached to my house…then, I ran like hell until I got far enough away! I circled around the house, went in the back door, went to the front of the house, and looked out the window to see what was going on. There was a hive about 10 feet off the ground and 8-10 inches diameter with a stream of yellow jackets going in and out…

How did this happen? Where did the yellow jackets come from? How did the hive get so large with so many yellow jackets without my noticing?

The answers are that I did not see them come, I did not see them grow the hive, and I did not see the stream of them going in and out until one stung me. The hive and the yellow jacket movement were both away from my center of attention and was too small a scale for me to notice. Meanwhile, they methodically built out their hive…

(As a side note, it turns out that some hives get very large before they are discovered!)

Just to push the point a little further, I clearly am comfortable in my house and would not be interested in occupying the space that the yellow jackets claimed (too small, exposed to elements, etc.). Also, if a neighbor came along and started building a house on my front lawn, I would take notice (and issue) very quickly. The opportunity that the yellow jackets had came from the fact that they were building up at a small scale (relative to me) in an out-of-the-way place combined with the fact that I missed the signs (the yellow jackets flying in and out) that they were there and building there presence.

The Large Company Disadvantage…

My situation with the yellow jackets is very similar to the big company issue with small markets. Small markets and/or small competitors emerge that are away from their center of attention, too small and/or out of the way to notice until the market (or the now noticeable competitor) stings them (or perhaps doesn’t sting them if they know about the market and have decided not to enter it). Big companies don’t see (or are too large to care about) small, out-of-the-way markets nearly as well as emerging growth companies.

The emerging growth company opportunity…

Your opportunity is to pick a product market that is relatively small or latent to start and probably is “tucked out of the way? (like the yellow jacket hive). The small market most likely has special needs that you can uniquely meet and the latent market (that is, a market that has not been “discovered?) is even better (although more difficult to find), as you will have no competitors, large or small.

This niche approach has been around forever, but continues to be important. It is very difficult for large companies to attack or even be interested in small, special need, markets, which effectively gives you an opportunity to grow relatively undisturbed until you are notices. (And when you are noticed, you will still have the time advantage!).
This idea is easier said than done, but here are several ideas to help your thinking:

  1. Find a product market that looks interesting to the large companies, and then look for related markets that might be too small or out of their center of attention of the large companies, such as:
    • Focusing on a different geography, culture, and/or language
    • Focusing on a different scale point (for example, bringing enterprise software to the small business market or bringing consumer ideas to the business market for B2B companies)
    • Extending the product into a vertical market that has specific needs which current competitors may not be meeting.
  2. Find a product market that the large companies do not find interesting, but believe someone should serve. These types of situations are relatively straightforward if you ask the employees at the large companies about them. (This really happens…larger companies are really open when they are not addressing a market now or in the near term!)
  3. Find a small product market or latent market that one or more emerging growth companies are attacking, and study those. A great place to look for interesting new approaches are via Venture Capitalist websites (most list current portfolio companies) as well as the social tagging sites and blogs (I have found some really interesting ideas from all these locations!)
  4. (This is more difficult) Find the latent markets that look interesting that no competitor is going after. By definition, there will be no competitors, large or small. But, the market is more difficult to discover, as it does not currently exist. The best approach is to talk to a lot of people that have a propensity to purchase and/or use products that you have the ability to create and ask them questions about what their pain points are and what they wish that they had. If you hear the same answer several times from similar types of people, you might have found a good starting point to explore (be careful, however, as many possible buyers can’t conceptualize their true needs or may give you answers that are nice to have but they might not really pay for or even use…on the other hand, some buyers may have already innovated themselves and you can learn a lot from them).

This strategy may seem similar to creating the scope advantage, but it is very different. The scope advantage is about focus; the scale advantage is about what market you should focus on.
Interestingly, large companies will discuss having economies of scale, which can be an economic advantage. However, small scale can be a strategic advantage, especially for the emerging growth companies!

Next time: Strategy 5: Create the Innovation Advantage!

November 14, 2005

How Can David Beat Goliath?- Strategy #3 Create the Scope Advantage!

Posted in David vs. Goliath, management at 8:50 am by scottmaxwell

When I was a kid, I was fascinated with the magnifying glass. I was amazed that I could make small objects appear large, but even more interested in what happened when I combined a magnifying glass with the sun and focused the energy of the sun on a single small spot on the ground. It burns! It was amazing…I would spend all kinds of time burning everything I could find (making patterns in wood was my particular favorite). At some point, my father made me wear sunglasses, as the focal point of light was pretty bright and he was concerned that the reflection of that focal point of energy into my eyes was not good (perhaps this is why I wear contacts now?).

So, what is the point? The point is that if you harness energy into a small focal point, the energy of that focal point can “burn? through anything! Even just the reflection of the focal point has a tremendous amount of energy. The key is that you need to take your available energy and focus it on a point that is small enough to do meaningful work.

The large company disadvantage…

Large companies have a difficult time with focus. They generally have many products aimed at many customer segments using many distribution approaches (they try to keep the distribution approaches and the customer segments narrow, but they naturally lose focus as they grow). Even though they have many more resources (a VERY large magnifying glass!), they need to take those resources and spread them across many different product markets (for these purposes, think of a product market as a specific product aimed at a specific customer segment using a specific distribution approach). Even with such a large magnifying glass, large companies can’t (and shouldn’t) train their resources on a single focal point. (They actually need several focal points at once, but imagine trying to hold two magnifying glasses, one in each hand, and focus the light of the sun on a pinpoint…very difficult to do!)

(Note: large companies sometimes discuss their “economies of scope? economic advantage, but it is the strategic advantage of small scope that I am talking about here!)

The emerging growth company opportunity…

This observation can be used by emerging growth companies to develop a scope advantage, by focusing on a small product market focal point and having an intense focus on meeting the needs of the target customer in that market. As a small company, you do not have as large of a magnifying glass or as large an energy source (i.e., staff), but if you focus your available resources on a small enough focal point, you will have more energy focused on that point than the large companies and, therefore, create the scope advantage!

Some ideas for how to create the scope advantage:

  1. Focus on a small niche product market. Going after the small niche product market supports the concept of focus. The most focused companies will target a specific target at a specific need (pain points, tastes, and scenarios are all needs) for a specific customer type (i.e., persona) using a specific distribution approach.
  2. Make sure that you train the energy of the entire company on your chosen niche. Once you choose your niche, you need to get the efforts of everyone in the company focused on delivering to that niche (and only that niche). The magnifying glass needs to be placed at just the right point and angle to create the burn in the target point of the wood and, likewise, the staff of the company needs to be extremely focused on delivering against the specific needs of the niche (the information advantage will help as well). The activities that you need to get focused include product activities, marketing activities, distribution activities, and customer service activities.
  3. Ensure that each person in your company is focused on his or her 2-4 major activities that will make you win in your niche. The company as a whole needs to focus, each group in the company needs to focus, and each individual in the company needs to focus. Believe me, this works! It also takes management time and attention to ensure everyone has the same focal point!
  4. Set your company up with as small a staff as possible. What, a small staff? Yes, as small a staff as possible full of truly “A? caliber people will allow you to focus your time (less management) and their time (less communication overhead) much better than a large staff. (Note: I am not saying not to hire for positions that you must have, just that you are better off with as few people as possible.)
  5. Make sure that all of the management systems reinforce the focus (corporate/department goals, plans, resource approval processes, reports, staff meetings, compensation systems, etc.). This is NOT a throw away point, as everyone in your company has ideas that they want to pursue that are not necessarily aligned with your focal point. These systems might include:
  • Don’t share your ideas outside of the focal point with the company broadly. This will reinforce their concept of you being focused and, hopefully rub off on the rest of the company.
  • Encourage brainstorming of new ideas for your current focal point while discouraging the brainstorming of new ideas outside of your focal point (this is probably somewhat controversial, but necessary in my mind).
  • Develop an elevator pitch that you can constantly reinforce with your employees, prospects, customers, and partners telling them your strategy and execution approach. Recommunicate this constantly until you here everyone in the company and outside the company repeating it.
  • Develop metrics for each department related to your focal point and publish them against goals and historicals so that you can keep everyone focused.
  • Make the employees paranoid about competitors, both real and imagined (Microsoft works this idea).
  • Keep as many people as possible in the same office space. This is not always practical when you have field sales people, an “A? caliber must have manager that lives elsewhere, or an offshore development effort, but I would strongly urge you to keep everyone together and try not to hire people that can’t be in the office when they are not networking or meeting with prospects, customers, or partners.
  • Keep a repository of new ideas so that people have an outlet for new ideas that are not within the current focal point (perhaps using a Wiki). This should increase focus AND give you some good ideas when you decide to expand. Encourage the use of the repository for the current focal point.

You hear about focus all the time. But if you apply it, you will, like the magnifying glass and the sun, be capable of “burning through? your niche! Need more energy given the available resources? Just make the focal point smaller!

Next time: Strategy #4: Create the Scale Advantage!

endnote: I modified my original posting to incorporate more detail in the fifth point.

November 13, 2005

How Can David Beat Goliath?- Strategy #2: Create the Time Advantage!

Posted in David vs. Goliath, management at 6:51 pm by scottmaxwell

The big company disadvantage…

I used the concept of large companies being like a large snowball in my last post, when I was writing about the insulation that large companies have with the outside world. Another angle using the same snowball concept is from an internal perspective. Imagine that each of the people in the company is a snowflake in the snowball. If you have perfect communication in the company, each snowflake should get to know and share ideas with every other snowflake. So, what happens when the snowball grows?

  • 2 snowflakes- If you have two people (person A and person B) in the company, there is one possible conversation between them (person A can talk to person B).
  • 3 snowflakes- If you have three people (person A, person B, and person C) in the company, there are three possible conversations (A can talk to B, as before, and now C can talk to A and, separately B). Wow, we added one person and got two extra conversations!
  • 4 snowflakes- If you have four people in a company, there are 6 possible conversations (person D can talk to A, B, and C, which adds 3 conversations to the prior number).
  • 1000 snowflakes- You have probably figured out the pattern here. If a large company has 999 people in the company and added a person, they would have an additional 999 possible conversations and the total number of conversations in the company would be 499,500! That is an average of roughly 500 conversations per person…when we had two people, the average was 1/2 a conversation per person!!


So large companies have a problem! If they try to have perfect communication, they spend their entire day communicating internally rather than doing customer-related work. To solve this problem, they break their large snowball into a set of much smaller snowballs (which they call departments) and then they communicate and share ideas at the snowball (department) level rather than at the individual snowflake level. These communication vehicles include phone calls, meetings, e-mails, business process software, blogs, wikis, content/information management systems, videoconferencing and a host of other approaches in order to discuss, review, and approve plans, review progress against plans, adjust plans, review people (and a lot of other verbs, adjectives, and adverbs that describe the communications)

Even with these organization and communication systems, and as companies get even larger, the snowballs (departments) still have the problem of communication between snowballs (adding a snowball when there are 99 existing snowballs adds 99 new communications paths between snowballs, and 4950 total communication paths!).

This is generally resolved by the snowballs (departments) getting organized into groups of snowballs (divisions) and then the snowball groups (divisions) communicating with each other, generally through a low-bandwidth communication pipe called Corporate VPs (or division VPs, SVPs, EVPs, or Presidents) along with all of the other communication vehicles described above (although the most important communications go through the senior people and the most important decisions are made in-person at meetings…the ultimate bottleneck for large companies).

What are the implications?

  • Filtered information- the snowballs and snowball groups pass information with their own interpretation added (note, this is generally not malicious, it is just the grand version of the “telephone game?). Also, because large companies have a harder time of getting external information into the company (see my last post as an example), the bad information tends to be self-reinforced into “internal truths? that become embedded into the company.
  • Priority information flow- The communication bandwidth between the snowballs is still constrained relative to the traffic need (think about trying to download a movie on a dial-up internet connection), which reduced the communication down to the most important elements. A lot of details and nuance does not pass to each snowball, let alone each snowflake. Communication tends to favor the “more important? issues as well as the larger products and markets, rather than the small, emerging products and markets.
  • Stale information- The information that does get through is stale because of communication latency and information queues as it passes from snowball-group-to-snowball-group, snowball-to-snowball, and snowflake-to-snowflake.
  • Internal issues consume the senior managers’ time. The most important people to each snowball end up in meeting lock (endless days of meetings) and inbox lock (endless days of e-mail) trying to communicate, which does not help build product, sell product, or support customers.
  • Lack of decision-making on the issues considered less important like smaller products and newer markets. The senior management just does not have enough time.
  • Bad short-term decision-making due to internal politics. Because of the lack of senior snowflake ability to really determine the best snowflakes, snowballs, and snowball groups because of their inability to know everything, the snowballs and snowflakes start competing in an internal “market? for major projects, bonus pools, titles, additional resources, etc. (The internal market is not generally aligned with the needs of the customers!)
  • Even when part of the organization figures out the “right? answer, the large companies have difficulty changing. Think of all the (two way) communication necessary to agree on the right course of action and then get all the snowball groups, snowballs, and snowflakes moving in the “right? direction!

The result of all these issues is that planning horizons tend to be in years, rather than days, weeks, or even months. It is the only way to keep the snowball groups, snowballs, and snowflakes in rough alignment.

Note that these problems have nothing to do with the quality of the people. The well-run large companies have some of the great, grade “A? people. The problem is simply the geometry of the situation (or the fact that we can’t do a Vulcan mind meld, at least yet, so the methods of communication that we have limit the communication bandwidth).

Bottom line, the time scale for a large company getting something important done is significant and change is very difficult, even for the best companies. The only answer to completely solve the problems outlined above is for large companies to break themselves up into a series of smaller companies, which is essentially competing with small companies by becoming a series of small companies. Lots of other approaches have been or are being tried, but nothing works that well, at least as far as I can tell. The net effect is that large companies could have a time-based disadvantage if your emerging growth company capitalizes on the opportunity.

Creating the Time Advantage

Emerging growth companies can benefit from these observations by creating a time advantage. Some ideas:

  1. Pick a product market that is rapidly evolving or has dynamic needs or tastes. Markets with dynamic needs (needs that change quickly) or tastes (interests that change quickly) are perfect for the small company. A great example a dynamic market is the gaming market, which has rapidly evolving customer “tastes? as new games come out and fulfill older “tastes? and gamers want MORE. These market characteristics are perfect for the company looking for a time advantage, as it is exceedingly difficult for the large company to move at the pace of change of these markets.
  2. Pick a product market that has significant long-term innovation potential. This is really important to the time advantage, as the innovations that can take place between a large company’s release cycles are tremendous. The large company essentially designs and launches its missiles, but by the time they hit, the innovation has moved significantly beyond where they aimed! If there is enough innovation left, you can do this again and again.
  3. Build your market before the large companies know what hit them. The extreme approach here would be staying in stealth mode until all the release details are worked out, and then explode into the market. (Note, this is much easier said than done, but thematically the idea is to build your early market quickly before the large companies have time to act).
  4. Use newer technologies and business model components. You are probably aiming at the early adopters, at least initially, so this approach will be advantageous, or at least somewhat expected, for a smaller company. Also, both you and the large company have to go “up the learning curve? on the new technology, and you should be able to do it more quickly due to the problems outlined above. (The effects of this approach are amplified when the newer technologies and business model components are evolving rapidly.)
  5. Package your “whole product offering? so that the package includes innovations in product, marketing, sales, and service all at once. When the large company must create change in multiple snowballs (departments) and multiple snowball groups (divisions), the time-based advantage is amplified (due to the communication and decision-making issues).
  6. Rapidly evolve all aspects of your business. Use your information advantage and the observations that large companies must have long time horizons to rapidly evolve all aspects of your business, such as your product, your marketing messages, your distribution approach, and your customer service. Again the key is to not be there when the large company missiles land!
  7. Put your senior management, particularly your CEO, out in the field as much as possible. Your senior management team will have much more time available than the senior management of the large company. Get outside the company and meet with customers, prospects, the press, industry analysts, and others. It will give you better information and will give you the edge relative to the large companies.

Time is an important strategy to have on your side. The large companies have a natural disadvantage with respect to time. You can have a large impact on your strategic position by exploiting the opportunity!
My next post: Strategy #3: Create a Scope Advantage!

How Can David Beat Goliath?- Strategy #1: Create an Information Advantage!

Posted in David vs. Goliath, management at 12:10 pm by scottmaxwell

When I invest in emerging growth companies, I spend a lot of time understanding what the large companies are doing and to determine how the emerging growth (read “small and growing”) technology company will win against the large companies.

Well-run large companies have several advantages relative to emerging growth companies. These advantages can include a brand name, significant customer relationships, a “platform” of some kind in place that customers are using that they can “extend,” a significant set of functional experts in many different specialties, great senior management, and superior financial resources.

Better from the perspective of the small company, there are several advantages that the emerging growth companies have over the large companies. If emerging growth companies exploit these advantages while taking steps to minimize the large company advantages, the emerging growth companies are at a net advantage to the larger companies!

This series is intended to point out the opportunities and how emerging growth companies can take actions that allow them to win against their large competitors (note: while I put numbers against them, the priority order will depend on the particular product market of the specific emerging growth company).

The first Strategy is to create an information advantage:

 

The large company has a natural disadvantage…

What melts more slowly, a small snowball or a large snowball? All else being equal, the large snowball melts more slowly. Why? The outer layer of snow on the large snowball insulates the inner snow. The snow in the small snowball is better exposed to the outside world than the snow in the large snowball and, therefore, reacts to the outside environment more quickly.

A large company has the same basic geometry as the large snowball. Most of the company has much more difficulty getting a true feel for its “outside world” (for example, customers, the market, or the competition) than a small company. This has nothing to do with the quality of the people or the company. It is just a natural disadvantage that large companies have relative to small companies.

Small companies can benefit by exploiting this natural advantage…

Small companies could benefit if you execute to create and then exploit this advantage. The two major tactics that you need to execute against are:

  1. Create the advantage by maximizing the information you generate from the outside world, which includes all the information that you can get from customers, non-customers, competitors, suppliers, and others that are outside the company “walls.” (Note that I say information, not data. The key is to maximize the true useful information without overwhelming amounts of extra data!)
  2. Exploit the advantage by using this information to make adjustments to ALL aspects of your business. The information is important for all aspects of your business, including product feature/function, pricing approaches, specific technologies that you are using, your customer service process, your marketing messages, your distributions approaches, and every other “impression? that your company makes on your customers or prospects.

Below, I discuss some ideas for addressing the first tactic, which is all about creating the information advantage. Later posts will describe some of the ways to use the information advantage to exploit the information advantage.

…But they need to start by creating the information advantage

Emerging growth companies tend to be relatively customer centric by nature, as they need to understand the customer in order to get the first customer purchases (they also have the basic geometric features of the small snowball, which is helpful). Unfortunately, as companies evolve, they naturally lose touch with their customers, very similarly to the larger snowball. EVERY company has the opportunity to improve the information flowing into the company, and if you address the issue early in the company’s life, you will have a HUGE advantage against the larger companies as well as your smaller competitors. I list some ideas below, but all of the ideas should be tuned to the specific situation that you, as an emerging growth company, finds yourself in:

  1. Expose all employees to the customer! This is probably the most important activity that you can employ. The basic fact is that all your employees walk around with “mental models” of your customers, including their needs, the technology that will best meet their needs, how they interact with your product, the best approaches to helping them resolve issues, and the marketing messages that will best resonate with them. Your employees use this “mental model” in order to help them make ALL of their decisions including product feature/function, customer service approaches, and sales and marketing approaches. It should be pretty clear that the better their “mental model” aligns with the reality of the customer situations, the better their decision-making! It is HIGHLY important that all of your key decision-makers get the opportunity to interact with customers. If you are too large for all employees to interact directly, you should build some tools (written summaries, videos, audio interviews, etc.) that will give the remaining employees the exposure, as all employees need to walk around with the right understanding of your customer!
  2. Ask your salespeople. To the extent that you have salespeople in your company, “asking the salesforce” is a great vehicle for gathering information from their prospect and customer interactions. Good salespeople are talking and meeting with prospects and customers all day, and generally have a very good view on how the prospects and customers perceive your company, its products, messages, position in the market, customer service, management team, and etc. (note: you will need to put some filters on the feedback from the salesforce, as I have never met a good salesperson that does not want more feature/function, lower price, better customer service, or more resources to help them sell. That said, the salespeople can generally give you a laundry list of feedback and generally rank the feedback in level of importance. You will need to speak to several of them to help separate the overarching themes from the “one-off” situations.) The best activities are pipeline reviews, where you can get a very good understanding of each prospect situation and the outside-in views on your company (as well as where you stand in the process) and, even more importantly, Loss Reviews (essentially calling or visiting the prospect and nicely asking for feedback on “why did you choose the company you chose?” and “Can you give us feedback on what we can do better?” I would ask as in-depth questions as they are willing to answer!). Most loss reviews come from the eyes of the salesperson. My view is that loss reviews should be done by someone else, probably the CEO until the company outgrows the CEOs available time, as the loss reviews are probably the single best activity for getting feedback from the market.
  3. Utilize your customer service interactions. The other area that you can easily get a lot of data is by using your customer service interactions. Even if the interaction is highly automated, trouble tickets tracking is one of the best ways to determine how your customers are doing with your product and how you are servicing them. If you have customer service reps, listen to the phone calls, ask them about their interaction, and give them a small number of questions to ask your customers (and then gather the feedback). Also, once a trouble ticket is closed, ask your customer for some feedback on the process (Rackspace does this very well via e-mail).
  4. Monitor the Internet forums, message boards, blogs, and other sites. There is a tremendous amount of information available online these days. Most people reading this post already know what to do (if you don’t, start by entering your company then product name into Google and start reading!). The key is to do it!
  5. Ask your customers. Once customers have “purchased” your product (btw, I consider the ongoing use of a website with advertising as the payment method a “purchase”), you will find that most are more that willing to do what they can to give you as much information as you want, as they want you to continue getting better. User conferences, user advisory board, and user surveys can be great vehicles for getting great data. Another easy, short-term approach is to sit down with the customers periodically (and for an extended period of time) and really get to know them in depth. While it takes time and resource, there is nothing better to gather really useful customer information!
  6. Ask the industry analysts. Some product markets will have industry analysts (for example, Gartner, Jupiter, AMR) covering the industry, including the providers, the customers, and the prospects. The good analysts tend to have a good pulse on the perceptions in the market. (Note: you need to be careful here, however, as the industry analysts tend to have a large company bias.)
  7. Utilize your website. Another great vehicle for gathering information is incorporating data gathering, called web analytics, into your website and then mining the data for useful information. Beyond building better usability and conversion into your website, the web data can be very useful for improving various functions. For example, visitor interaction with your product pages can tell you a lot about their interests and interaction with your customer self service pages can tell you a lot about their issues with your products. Much has been written about how to go about executing web analytics, and I continue to be surprised how few emerging growth companies are making use of this information!
  8. Utilize your product. Another great vehicle for gathering information is incorporating data gathering into the product and then mining that data for useful information. When the product is browser-based, this is a pretty straightforward process of instrumenting you web interactions with the customer through the use of web analytic systems. When the product is on the customer site, the issues become somewhat trickier because privacy issues are more amplified and many customers do not want information flowing out of their computer systems. That said, many customers will still allow the information sharing if you ask them, if you have policies to restrict the actual information flow, and if you are legally and ethically “squeaky clean” with the approach (these concepts should be part of a browser-based approach as well). Two large examples of this approach are Google’s systems for browser-based information gathering and Microsoft’s Watson system for installed software (these are probably two of the largest product/customer information gathering systems in the world).
  9. Find out what the competitors are doing. Write down the list of things that you would like to know about your competitors and then get creative about how you are going to (legally and ethically) get the information. Some of the activities above can help you get started. You can also study their websites, visit their booths at conferences (if they market this way), and use Hitwise to determine where their Internet traffic is coming from (full disclosure, my VC firm is an investor in Hitwise).
  10. Find out what related companies are doing. Understanding the best practices of related companies can also help you. Do the same activities as if they are a competitor, but also call the person that is functionally similar to your position in that company and invite them to lunch to “share ideas.” You can probably get some good ideas and give some good ideas, as both sides will be more open given you are not competitors.
  11. Work the activities and results into your management systems. You probably have some level of formal management approaches at your company (if not, you should). Work this feedback into the management meetings, your company wiki, your e-mail, your management reports, your employee feedback systems, and all the other vehicles that you have to manage, monitor progress and communicate internally. You are gathering valuable information. You need to get better at it every day as well as share it!
  12. Finally, DO NOT DO EVERYTHING ON THIS LIST AT ONCE! This list is intended to be an idea generator, not a list of things that you need to do. If you try to do too much, you will actually be watering down your efforts and will actually get less useful information (remember it is the information, NOT the data, that you are looking for. Also, you need to spend the vast majority of your time building great product and then selling and servicing it! Start with the easy steps, and increase the activities as you grow!

 

A natural question is “why can’t large companies execute against the same tactics?” The answer is that they can, and some do. But, even if they do, they still have the natural disadvantage of the large snowball. If the large company and the small company execute these tactics equally well, the small company will have the edge!

Some companies may read the above ideas and either believe that they are already doing the activities or, perhaps, even go through the motions of performing a number of activities. The companies that truly execute against this strategy will really push to understand the customer and market issues and how they are changing and then do something extremely useful with the information (by adapting their product, customer service, sales, marketing, to exploit the information)!

My next post: Strategy #2: Create the Time Advantage!

November 8, 2005

Extreme Funnel Economics- Aiming Toward the Economic Singularity

Posted in Economic Model, management, marketing, Product Development, Sales at 7:12 pm by scottmaxwell

As I have been working on trying to frame out some of the strategies related to Funnel Economics over the last few years, my favorite is the strategy of companies putting much more energy into building better, simpler products (from the user perspective), charging less for them, and using very efficient sales and marketing approaches (rather than building an acceptable product and trying to have as high a price as possible through a value-based sale and aggressive sales and marketing efforts).

The Strategy Has Help Shape Many Success Stories…

Some notable example companies deploying the strategy are Microsoft and Intuit, which have been successful for a long time, and Google, Skype, Salesforce.com (and many others) more recently (the internet has been an important recent enabler).

How it Relates to the Funnel

Funnel Economics is essentially the (inflowing) cash flow generated by “sales and marketing” activity divided by the “sales and marketing” expenses. If you shrink the denominator faster than the numerator, the limit is a singularity (the singularity is actually zero in the denominator, but try dividing a really small number by a really really small number on your calculator and you will see that you get a large number). From a business standpoint, if you aim for this economic singularity in a very large market, it could be a formula for a very successful company and huge wealth creation (i.e., take the previous number on your calculator and multiply it by a very large number and you get an even larger very large number).

The strategy has some really basic, but powerful elements

  1. Make something useful and make it really, really, really easy to install, configure, use, and update. This approach increases the value to the user base, increases use, and reduces product abandonment. (The idea works with all technology products including, but not limited to, appliances, server applications and both browser applications and rich client applications so long as they follow the “really easy” principle)
  2. Constantly make the product better with rapid development cycles. Economically, this continues to increase the value to the user base (by better meeting their needs), gives the users something to “sing” about, and reduces the cost of customer service (the customers don’t need service, as the product works and is easy to figure out!).
  3. Design into the package one or more “features” that will compel users to tell people about it and influential people to write and talk about it. The most prevalent approaches either build in the network effect or have unbelievable usability or other characteristics that make people want to talk about them (see Jeremy Levine’s posting for a pretty amusing extreme example of this). If you can’t come up with any ideas here for your product, focus on points 1 and 2 (above) even harder. Economically, this leads to very low sales and marketing expenses, as others are doing the selling for you!
  4. Give it away free for beta and trial purposes, and price it competitively once the free period ends. No one wants to be oversold these days. Give it to the users and let them see if it is worth using, and make sure that they feel they are getting a great deal when you actually charge them for it (note that looking at advertising counts as payment here)! This approach increases conversion rates of prospects to customers (assuming the product works!).
  5. Make the “purchase” transaction as simple and easy as possible. For consumers, the extreme version of this seems to be the “micropayment” vehicle called “advertising” (at this point in time), although SkypeOut allows you to make a single credit card purchase that will last for a very long time and Amazon.com has one-click purchases, both of which are very simple and easy. For business customers, the credit card model or simple contract/billing model seems to be acceptable, although it would be great if something better came along. (Perhaps my friends at IPCommerce will create something to address this issue better for both consumers and businesses!). Economically, this approach increases value to the user and conversion rates of prospects to customers.
  6. Keep the sales and marketing expenses (the denominator) as low as possible, and put your resources toward the first five elements of the strategy, which should drive customer adoption. Economically, bringing this cost to zero creates the singularity! (Note: I expect that most B2B and many B2C companies will still need sales and marketing, at least in the current environment. The key is to keep pushing for the efficiency and to keep this cost as low as possible relative to the gross profit generated by the activity).

Don’t confuse this approach with just eliminating sales and marketing and calling it a day. If a company sets the right operating point in the right market situation, the company should still be growing, possibly explosively, just growing for reasons other than a purely aggressive sales and marketing effort.

To perfect the execution, you need to determine the optimal operating point…

I am a strong believer in the six themes outlined above, but there are four major issues that every company needs to address:

  1. The larger the market, the better the strategy works. Companies that sell to consumers and the universe of small/midsized businesses will have a better outcome than companies that only have a few hundred (or fewer) possible customers.
  2. Each company needs to find its optimal “operating point.” The best way to think about this is that each of the six elements above have knobs controlling them that company management can rotate to set the “level” for each element. The optimal set point for each element has to do with how sensitive user response is to that element (this gets more complex when you build in the issue of path dependent outcomes, which I won’t cover here). The ultimate goal is to have the right set points for each of the knobs. The core assumption that needs to be tested is that you can improve your results by decrease sales and marketing resources, increase resources spent on the product, and reducing the price (or eliminating it for a period of time).
  3. Once you set your initial operating point, it is easier to move away from the singularity than toward it. That is, it is easier to move from a simple product to a complex product than a complex product to a simple product and it is easier to add sales and marketing activities and expenses than it is to subtract them! As an example of an extreme starting point, the concepts around Web 2.0 are essentially the extreme version of the strategy aimed at consumers. (I particularly liked Charles O’Donnell’s posting “10 Steps to a Hugely Successful Web 2.0 Company” as an example of the web 2.0 themes). In my view this is a great starting point for these types of companies, as it is the extreme from which to start turning the dials to tune in the optimal operating point.
  4. You can use this strategy against your competitors (and they can use it against you). Some people say that Google is out-Microsofting Microsoft. Essentially, the point is that Google has set its operating point closer to the singularity and it will be difficult for Microsoft to respond (harder to move toward the singularity!)…It will be interesting to see what happens. It will also be interesting to see if someone eventually out-Googles Google (perhaps Microsoft?)!

    I have seen these themes in place in companies selling to consumers, small businesses, and large enterprises in all areas of information technology (infrastructure, applications, software as a service, etc.) and entertainment (particularly gaming). The strategy can be deployed in different forms at different operating points by every company selling to any customer segment (so long as it is a large enough segment!)…All you need to do is focus on aiming toward the economic singularity (also, make sure that you start closer to it than your competitors do)!

November 7, 2005

Recruiting Best Practices- Summary

Posted in culture, management, recruiting at 8:31 pm by scottmaxwell

I just completed three very long posts that describe what I believe are best practices to

  1. Determine what characteristics to recruit for if you are seeking “A” caliber employees,
  2. Manage the process of recruiting them, and
  3. Ensure that you are set up to attract, retain, and motivate them.

please send me comments if you have suggestions for improvement on any of them.

Recruiting Top Candidates- What Does “A” Caliber Mean?

Posted in culture, management, recruiting at 10:57 am by scottmaxwell

I received a question on a recent posting about what constitutes an “A” caliber person from a recruiting point of view. In my view, this is one of the toughest questions faced by management teams. I had been thinking about the issue when I read Friday’s New York Times article on Tiger Woods, “Tinkering With Success.” The basic theme of the article is that Tiger has been an excellent golfer for a very long period of time (winning eight major championships through 2002), but has spent the last 20 months changing his swing (and his coach). The results have been tremendous this year…he has won two major championships and six tournaments. Tiger is an “A” caliber person!

The problems with this observation in the context of recruiting into your company (besides the fact that it is obvious) are:

  1. It does not (by itself) help predict if other people will be “A” caliber at golf as it is describes the result rather than points out characteristics that help predict the result.
  2. Even if it did point out predictive characteristics, the predictive “algorithm” would only work for golf (i.e., While he is “A” caliber at golf, Tiger probably is not an “A” caliber engineer!).

My involvement on the issue of finding “A” caliber people over the years has led me to the following “best practice” approach:

  1. Focus your attention on only one or two positions at a time. This is extremely important, as the effort required to do the job right is considerable. If you do get it right, you will significantly improve your company (I continue to be amazed at how the addition of one key person to an emerging growth company has had such a significant effect on the companies that I am involved in). Given that you want to get the “biggest bang for the buck,” I would suggest that the possible focal points are:
    • a position that is currently a significant hole in the team,
    • senior level positions (C-level/VP level), or
    • a function that you intend to hire a large number of people into over the next year or two (probably a specific sales or service function if you are at the expansion stage).
  2. Determine what “A” caliber OUTPUT “looks” like. Some thoughts:
    • Output has an “efficiency” angle and an “effectiveness” angle. Efficiency is all about pure input/output productivity (how many sales calls per week does a salesperson make, how many lines of code does a developer make), while effectiveness is all about quality (how many sales per sales call does a salesperson make, how many errors per line of code does a developer make. I know, the examples that I give are really simple and not the only measure of output for the functions mentioned, but hopefully they serve to get the point across. Also, don’t confuse these simplistic examples with Taylorism. The intent is to get you thinking on the topic, not pulling out a stopwatch!)
    • It is relatively easy (at least conceptually) in an individual sport like golf to determine “A” level output. From an efficiency point of view, you can look at the number of tournaments/top tournaments that a player enters for a given season. From an effectiveness point of view, you can look at tournament wins or wins against top competitors as a couple of high-level metrics. You could also disaggregate the measures of the game into some components like length and accuracy of drive, pitch accuracy, putting accuracy, ability to recover from tough situations. You could also disaggregate each of these components further. For example, for the drive swing, you could look at club speed at impact, body speed, arm speed, form etc.). I have not read (or looked for) a book on disaggregating golf, a great read on the use of statistics in baseball is “MoneyBall: The Art of Winning an Unfair Game” by Michael Lewis.
    • When you move to a team sport, like basketball, the issue of determining “A” level output gets more complex for a few reasons. First, basketball involves specialist roles (e.g., Point Guard, Center, Forward), and you need to make sure that you have defined the “A” level output for each of the roles separately. Second, each basketball program has a somewhat different strategy (fast-break running game, outside shooting game, inside shooting game, pressure defense, etc.), and you need to make sure that you have defined the “A” level output in the context of this strategy (or planned new strategy!). Third, teamwork matters. The capabilities and style of the other players already on the team will help determine what “A” level output of the player/position in question. If the new player does not “fit in” with the rest of the team, the output of the entire team could suffer.
    • When you move the issue to an emerging growth business, determining “A” level output gets even more complex. You not only have the same role/position specification, strategy, and teamwork issues as the team sport example, but also have additional burdens of constantly changing need to move from generalists to specialists as the organization grows, as well as very dynamic changes in markets, competition, and regulatory issues as markets and companies evolve (think about changing the rules of basketball and adding new players on the other team WHILE the game is in progress). Finally, you do not have the benefit of transparency, where you can gather up all of the output data from all of the other companies that have similar functions…you only have your own data to work with!
    • So how do you determine the right “A” level output for a given position, given the dynamic nature of the business? This is part art, part science, but to the extent that you have people already in the position/role, you need to “tease out” the output from the best relative to the rest (assuming that you have one or more people performing at the “A” level). You should also reach out to your network and advisors to get as much information and as many viewpoints as you can from them, especially if this is a new position (if you have a good VC, this is easier, as you will generally have access to other companies in the VC’s portfolio as well as the experience of the VC. Also, really good professional recruiters can be helpful in all stages of the process, including this stage.). Take all of the data and ideas that you can, and distill it down to what output that you think constitutes the “A” for the role/position in question (and what is the priority for the output that you are looking for…conceptually similar to a “hierarchy of needs” for the position in question). This is important, as you may decide at some point to “back off” your original criteria (for now). If you do, you will want to know what you “must have” vs. what is “nice to have” for your current stage of development.
  3. Determine what “defining characteristics” help to predict that an individual will have the “A” caliber output. Some thoughts:
    • Try to make sure that the characteristics are “causal” in nature. This is the toughest step, in my view, as you need to separate correlation (things that move in similar ways) from causality (things moving that cause other things to move). An example of this (from my college statistics course) is that someone once figured out that as the number of Bishops in England went up, the number of fires in England went up. Cause for alarm if the Bishops CAUSED the fires! But it is only correlation (the two things moved in similar ways). The cause of both the Bishops increasing and the Fires increasing was that the population of England was increasing (the population increase led to an increasing need for Bishops and increasing accidental fires). More relevant to golf, (from Tiger Wood’s fun facts), the fact that Tiger wears red on the last day of a tournament is less causal in nature (at least in my view) than the fact that he first started swinging a golf club at 11 months (note: neither are probably the best criteria to use for predicting golf success, but the latter is probably more predictive!)
    • You need to determine the time scale for the predictive characteristics. For example, do you need someone to “hit the ground running” (in which case, you need characteristics that predict the person’s output today) or are you hiring less experienced people that you want to grow over time (in which case, you need characteristics that predict that a person will develop into having the “A” caliber output over time). For example, getting a “plug and play” salesperson to sell advertising may suggest characteristics such as “currently selling advertising to the same advertisers for the same type of media,” “sells a lot,” and “works well with others.” Getting a less experienced person right out of college for the same type of role might be characteristics such as “leadership,” “aggressive,” “outgoing/extroverted,” “team oriented,” and “passionate for this job.”
    • Make the characteristics comprehensive. You need to make sure that you encompass the role.
    • Keep it as simple as possible. No need to get overly complex here. Boil the characteristics down to the minimum necessary. (This point is not in conflict with the prior point.)
    • Turn the characteristics into useful screening criteria. For example, you can measure “sells a lot” by the salespersons W2 (that is, what (s)he got paid last year) and the written compensation plan for the position, “works well with others” through personal reference checks, the college graduate’s “leadership” through extra curricular activity leadership in college, etc. The key is that you can get the facts that help determine if the person has the characteristics that you want. (Btw, you need to do real work here when you are doing diligence!)
    • Once you start interviewing, revisit and refine these criteria. I find that the process of interviewing helps to both identify the “land of the possible” and is also quite useful at improving your thinking on ingoing criteria.
    • Note1: You can make these activities more comprehensive, and possibly more accurate, with activities like psychological and behavioral testing, but I have not seen it “up close and personal.” My sense is that it is probably better suited for large scale hiring efforts that can not put the time into a deep understanding of the candidates and may be better suited for finding “minimum competency” rather than “maximum competency” of hiring “A”s as I discuss here; therefore, I believe the activity is better suited for the large companies.
    • Note2: I have used an organizational psychologist to help with the defining characteristics and interviewing periodically. His high emotional IQ and different angle on the issues has been quite helpful.
    • Note3: When companies have the luxury of lots of data and resources to analyze the data, this approach can (an has) been taken to the extreme through regression modeling. I have not, however, been in a position with any of my emerging growth companies where we have done (or even considered) this. It is really more of a large company activity.
  4. Build diversity into your criteria…there are lots of ways to define the “A”. When you have the opportunity to hire multiple people into a function (like with a growing development group, sales group, or services group), make it as diverse as possible (education, experience, geographical location of childhood, gender, culture, language, socio-economic, life experiences, race, etc.) while still maintaining the bar of hiring “A” caliber people. It makes great business sense (doing this has a side effect of being politically correct, but it is the business result that I am interested in here). There are three major business reasons for creating diversity in your functional unit:
    • You will want to have a broad enough sample of different input characteristics so that over time you can tune the characteristics that make an “A” caliber person in the function. Since there are a lot of factors other than “population” that determine the “number of fires” in England, there are most likely a number of more idiosyncratic factors that define your optimal job candidates for a particular position.
    • Diversity will help you over time as your business and its needs change (think about Charles Darwin’s ideas!).
    • Diverse people also have diverse interests and motivations. With diversity, you essentially are allowing the business to run along its efficient frontier, which essentially means that it allows you to maximize your overall output (through increased “intelligence” and “network” of your company) while it averages out the hills and valleys in individual motivation and performance.

That is it in a nutshell. This process should help you determine what constitutes an “A” caliber person for a given role in your company. One last thought on setting the “A” criteria. Tom Watson says, “Tiger has raised the bar to a level that only he can jump.” There is not another Tiger Woods, so if you set the bar at that level, you will not be successful. Set a bar that is realistic for your situation and gets you the top candidates that you can find. The key is to “raise the bar to a level that only a few can jump!”

Also, once you have the criteria for the ideal candidate, make sure that you are doing the work necessary to turn the paper candidate into the productive employee, including:

  • Put a Process in place that “screens” for the right characteristics. See my post on “Recruiting Best Practices” for some thoughts on the screening process.
  • Set up the “environment” so that the individual can thrive. (See my post on “attracting, motivating and retaining” for some thoughts on setting up the right environment.) If you do this right, you will get all your staff, not just the “A” caliber staff, working above their natural level.

This process works well, and it should work well for you.

November 3, 2005

Choosing a VC- You need to squeeze the avocado!

Posted in finance, management, VC Roles at 2:44 pm by scottmaxwell

I wrote a post the other day on whether the need for capital is changing among emerging growth companies. As I read the comments and looked at some of the other postings on the topic (MikePK has a write-up and some good links to others, so I won’t repeat them here), I realized that another issue is that some (many?) companies might be more happy not having a VC (for them, it wasn’t that they were happy not to need the money, but rather they were happy not to need the VC that came along with the money).

My view is that with all of the different types of VC firms and individuals that make up the industry and with all the different companies, products, and situations that companies find themselves in, the range of possible outcomes is extremely large. When there is a solid fit between the management team, the VC, and the situation, the outcome is generally good (that is, the market opportunity is maximized and everyone feels good that they worked well together to optimize the outcome). When the fit isn’t right, many things can (and do) go wrong and/or the process and results do not meet the ingoing expectations.

Determine the fit before the deal closes!

I am a strong believer in making sure the fit is right for both sides in any VC/management team relationship. As an expansion-stage VC (that is, I invest in companies once they have a product and some customers), I learn as much as possible about the market, the company, the products, the distribution approach, the customer relationships, and the team. I also spend enough personal time with the senior team so that we can build a working relationship and to make sure that we share similar views on how to build a great company.

From the company’s view, I am a huge believer in having the management teams “turn the table” by doing due diligence on both my firm and me to make sure that they understand how we work and how we compare to others. (It actually worries me when they don’t do their work, as I start to wonder if all they want is the money, which is not the basis for great relationships!)

No two VCs are alike…

VCs are diverse, as are the firms that they work for. There are several major differences that are relatively straightforward to determine prior to closing an investment that can help you determine if you have the right fit.

The best due diligence that the senior management of a company can do is to call several of the CEOs that have current or former investments from the VC (the VC will give you a list or you can look them up online and cold call them) and ask them a number of questions (note: most, if not all, of them will say they are happy with the VC and that the VC is great. In order to truly get something out of the interview, you need to ask them much more specific and fact-based questions…see some suggestions below). Also, take the time to understand the individual VC and the firm. Ask to speak with other partners and members of the “value-add” team. Ask them all the same questions. It is a great exercise and you will have additional relationships to call upon once your investment closes!

The Differences- What to look for…

  • Market Focus- What is the market focus for the VC? The more closely the VC’s market focus matches your company, the better the fit. Also, the more focused the VC on particular markets (or business/economic models), the better the VC will understand the market. You can easily determine market focus by looking through the VC’s portfolio and asking the VC what interests them (note: You should not depend solely on the portfolio here, as it is a “rear view” mirror of the VC’s interest in particular markets. Talking through the issue with the VC should help you understand current interests…some VCs study a new market for a long time and gain some level of expertise prior to making an investment in that market and many markets are new, so no VC will have the direct experience.)
  • “Stage” Focus- What situations are the VCs most familiar with? The skills and network necessary to help very early companies are different than the skills necessary to help companies at the expansion or later stages. Also, while most VCs are growth investors, some investors are extremely good with turnaround situations or other special situations. Again, examining the VC’s portfolio and asking the questions to the VC will help here.
  • Past and Current Investments- Understanding the VC’s portfolio is another great way to understand the VC. Most VCs portfolio investments are online, but you might want to ask the VC for the entire list or visit the wayback machine to make sure that you have captured all of the VC’s past portfolio companies (this is also a great vehicle to find out how consistent the VC has positioned itself over time). Call (or, better yet, visit) several of the CEOs of these companies and ask as many questions as you need to get the detailed information.
  • Culture and Reputation of the VC Firm- Is the VC firm/individual engineering oriented, distribution oriented, financially oriented or some mixture of skills? Is the firm focused on adding value or more passive in nature (almost everyone says they are “value add,” so you need to dig deeper to truly understand what they mean by it)? Do the partners help out on each other’s deals in a true team manner, or are there silos? Do people in the industry want to work with the VC’s portfolio companies or do they shy away from them? Lots of good questions to ask here!
  • Background, Skill, Intellect, Personality, Current Interests and Passion of the individual VC- The partner involved with the deal, who will most likely be sitting on your board, is the most important individual to evaluate fit with and get to know. Some firms, including mine, assign a full team to a portfolio company. When this is the case, evaluated each of the team members and make sure that the fit works and that you are going to enjoy working together (at least as important as money in my view). Ask the portfolio companies about the individuals and spend as much time with the team as possible before the investment. Also, ask each team member individually the same questions. It is always good to see the consistency of the answers.
  • Engagement Approach- How does the VC work with its portfolio companies? Does (s)he show up daily, weekly, monthly, Quarterly? Are they formal or informal? Is there a team of experts behind the VC that helps on various functionally specific issues? How do they work with the companies? What is the relationship between the VC and the company (do they partner well or does the VC expect to be the “boss”)? Do they engage when asked?
  • Philosophy/Values- This is not a throw away touchy-feely point, as mismatched expectations are important to identify up front. Is the VC conservative or aggressive when it comes to deploying capital? What is the “right” level of profitability? What is the “right” growth rate? How does the VC think about the “operating points” for the “dials” of product development, sales/marketing, and customer service? Is the VC looking for “control”, to set up a multiparty governance structure, just a “seat at the table”, or some other approach to the control issues? Does the VC want to replace senior staff, work with current staff, or see how the individuals and company evolve? What is the “exit” philosophy (“reasonable exit” or go for the grand slam, sale or IPO)?
  • Available time- Most VCs are extremely busy people. They are trying to digest a huge amount of information every day to stay on top of the “news”, build their networks (that are extremely helpful to the portfolio companies), build relationships with the large technology companies (again to help their portfolio), work directly with their portfolio companies, and find new investment opportunities. Just how much time are they going to spend with you? There are a few approaches that I would recommend to get a basic understanding. First, find out how many companies the VC is personally involved in and/or sits on the board of. Second, take the full staff of the VC and divide it into the number of portfolio companies (to get a staff per company calculation). Third, take the full staff and divide it into the new portfolio companies over the last 12 months (to get a staff per new company…this is important because the VC is generally the most intensive the first 18-24 months of an investment). These three stats can give you a basic idea of what to expect, especially if you are evaluating relative to other VCs. Also, ask the current portfolio company CEOs for the details on how much time they get with the partner and the team in general (again, ask for the details!). Finally, ask the VC directly and get his/her commitment early on of the amount of time (s)he will be spending with you…setting expectations early is good!
  • Level and type of Value Add (most important)- All of the points above add up to the value add (or value minus) that you can expect to get from the VC, but there are two more questions to ask both the VC and the VC’s CEOs to get the most detailed understanding possible:
  1. Can you give me a detailed list of the value add that the (current portfolio) company has received from the VC in the last week, month, quarter, and year?
  2. Can you give me one or more difficult issues involving the portfolio company and VC and how you worked through those issues?

I believe that you will find that most good VCs will accept, even encourage, your due diligence effort. I encourage the effort for every company I talk to, as I believe the fit is a truly important vehicle for success. I know some truly amazing Venture Capitalists and I believe the process that I outline above will help you determine the right one for you…

Additional thoughts on the process

I can’t help but point out two other relatively obvious points on how emerging growth companies can set up for the most favorable outcome in working with VCs:

  • Don’t get your company in the situation that you “need” the money (I know, easier said than done in some circumstances). This will allow you plenty of time to determine if you have the best VC partner.
  • Get yourself the best deal lawyer with the best experience that you can find. A good lawyer will be in a position to help you understand the terms (it is just math and logic, but the words are unfamiliar and the lawyer can point out where terms are “off market”). From the VC perspective, it makes the legal documentation process a lot easier as well.

Take the time to do your work!

Choosing a VC is similar to going to the supermarket to get an avocado (I hate overripe avocados and am too impatient to wait for an avocado to ripen). I have only figured out one way to tell if an avocado is ripe (not too soft or too hard)…You need to squeeze the avocado!

November 2, 2005

Very Timely!

Posted in Exit Strategies, management at 8:08 am by scottmaxwell

As the interests of the large companies and banker employment levels swell for acquisitions, many emerging growth companies are starting to get inbound interest from acquirers. Ed Sim has a great new posting on the topic that is full of great advice!

November 1, 2005

Is the Need for Venture Capital Changing?

Posted in Economic Model, finance, management, VC Roles at 5:29 pm by scottmaxwell

I met with Jan Hichert, CEO of Astaro, over breakfast yesterday morning. As we were catching up on industry gossip, he asked me the question if VCs were becoming unecessary for internet start-ups. We had a good discussion on the topic and then I came back from breakfast and read Rebecca Buckman’s article, Many Internet Start-Ups Are Telling Venture Capitalists: ‘We Don’t Need You,’ in today’s Wall Street Journal (October 31, page C1).

The article was about Venture Capital effectively becoming superfluous. The basic argument of the article, and the question posed by Jan, was that the cost of getting to “product” release in an internet start-up has gone down considerably over the last decade (which it has by at least an order of magnitude) and many companies, therefore, do not need Venture Capital. It cites Flickr as an example (which was sold to Yahoo for an estimated $25 million). Clearly a good payoff for the management of the company and it looks like a wise purchase for Yahoo. Everyone involved won. And no VCs involved…cased closed. Right?

Some Good Points…

The article (rightly) points out that the current issue is at least true for a subset of companies that, perhaps, focus on the consumer market. We also have seen many B2B companies bootstrap themselves with services revenue or low cost product downloads and get to a level of revenue and profitability with very little capital consumption before we invested in them.

But…

My view on this issue is that it all depends on the goal for the company. If your goal is to build something useful (a feature that belongs in another company’s hands, for example) and make a reasonable amount of money from a sale (or create a lifestyle business), then clearly partnering with a VC is not for you (it is also not for the VC). But if your goal is to build a meaningful long-term enterprise, I would surround myself with as many smart, helpful, networked people as I can (good VCs fit in this category), and you will most likely need and/or want outside capital.

Expanding a Company- Uses of Capital

If you want to build a meaningful long-term enterprise, there are several uses of capital, even for profitable companies (yes, there are extreme outliers, but the following simple math is generally true):

1. As your revenues grow, your receivables grow, creating the need for working capital (cash turns into receivables). This point is generally true, but not true in certain consumer businesses that take credit cards and receive customer payments prior to paying suppliers (the negative working capital companies such as Amazon.com). If you run a financial model on your business including the balance sheet, you will get a good idea of the relationship.
2. As you grow your Sales and Marketing, the expenses are generally paid before the revenue/gross profit is received. Most great companies have the opportunity to grow (with a positive Net Present Value using a high discount rate) their companies faster than they can self-fund (that is, using the free cash flow of the business to fund this expense) sales and marketing. Again, the credit-card payment model is less sensitive to this point (due to days receivable outstanding being 3-5 days), but it still exists. On the other end of the spectrum, the B2B Software as a Service (A.K.A. On-Demand or ASP) “subscription” model (Salesforce.com is my best example), uses a lot of capital as the sales and marketing ramps up, as the timing for cash flowing out is much earlier than the timing for cash flowing in (btw, this is an extremely attractive business and economic model as Salesforce has been demonstrating in the public markets…my point is that it used capital to grow).
3. Experiments and “mistakes” use capital. Generally, as companies build-out, there are two major areas of expansion, one on the product development side and one on the product distribution side. I think of these build-outs as “grand experiments,” as you can do all of the up-front analysis that you can, but it is all theory until you put it into practice and see the results. Long-term sustainable businesses need to continue evolving their products’ feature/functions, build new products, and build out their channels of distribution. All of this takes capital, as the uses come before the benefits…even more capital if you make a few “mistakes” (and everyone does).
4. Missed Quarters (sometimes) Use Capital. Most emerging growth companies miss their quarters at some point. You want to make sure that you have “rainy day” money on the balance sheet to be used in circumstances like this.
5. Acquisitions use Capital. Several companies that I have been involved in have made small “tuck in” acquisitions, mostly to expand their product footprint. Generally, these types of acquisition candidates want at least a portion of their consideration in cash.
6. Large Enterprises want to see Capital on the balance sheet. If you are selling to a large enterprise customer, they generally are spending a large chunk of change on your product and many times will be integrating your product with some of their systems. They do their analysis and want to make sure that you are going to be there to serve them several years from now. Once of the items that they ask about is your company’s capitalization (note: my sense is that this issue peaked about 18 months ago and is now on the decline. I do still here about the issue periodically, however).
7. Finally, Founder Liquidity uses Capital. Many founders of great companies find themselves in the situation where a significant portion of their net worth is tied up in the business. Some VCs (including my firm) will make investments in a company to partially/fully liquidated certain shareholders (the key is that all key employees have enough of a financial stake in the company post the transaction that they remain highly incented). These types of transactions are useful to founders, as it allows them to take more risk (that make business sense) without worrying about their nest eggs.

I believe I have captured the major uses of capital as companies grow. I did not get into things like the company being subscale, but this implies that a company is unprofitable, which clearly requires capital.

I am actually a strong believer that VC is more about the help than the money, but given the question of capital need was raised, I thought I would direct my comments in that direction.

Is the need for venture capital changing? My answer for companies that want to build meaningful businesses over time, regardless of sector, is “no”…

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