Entrepreneurs, Drummers, and Merry Christmas

On my way home from driving my daughter to school last week a particularly beautiful rendition of “The Little Drummer Boy” came on the radio. The song has always has always touched me deeply, portraying that one with seemingly nothing to offer could offer so much.   A new thought struck me on this hearing—the message of the Drummer Boy is also the message of the entrepreneur.

From the great wise men of distant lands to the poorest of the local village, they came to the manger to honor the promised newborn King.

Our finest gifts we bring, pa rum pa pum pum
To lay before the King, pa rum pa pum pum

The little boy was invited to join.  The opportunity to contribute was open to all who would come. Knowing he had not the gifts of the world to offer, certainly no gold or frankincense or myrrh, the boy combined hand, head, heart, and talent to give his very best.  Joining with such as were available, the boy played his drum for Him as the ox and lamb kept time. The result was simple and profound.

Then He smiled at me, pa rum pa pum pum
Me and my drum
When we come

The story of the Drummer Boy is not scriptural or historical.  And the message behind it is probably not meant to apply to commercial activities like a startup. But this Christmas season I’m reminded of the beauty and dignity of entrepreneurship. You apply talents, toil, creativity and heart to create something innovative and sometimes even profound in the broad, open and beautiful spectrum that startup entrepreneurship is.

Whatever your faith or creed, I hope you’ll accept my Merry Christmas wishes in the spirit of respect for those who innovate and reverence for traditions that inspire us to create. Keep moving your mountains and may the coming New Year bring fruition to your efforts and dreams.

No Permission Required

The new book, Startup Communities: Building an Entrepreneurial Ecosystem in Your City is a great read on an important topic.  My favorite line came on the last page:

“My favorite thing about startups is that they don’t require anyone’s permission.”

-Brad Feld

This just captures what makes entrepreneurship awesome.  It’s about doing something worthwhile simply because you decide it needs done.  More than any other aspect of the business economy, startups operate outside the bounds of bureaucracy, politics, and harmful regulation.

Good public policy has a role in building the national infrastructure of startup communities.  Paraphrasing the popular Einstein quote, we need to make it as simple as possible to launch, operate, and scale a startup, but no simpler.  Along with taxes and death, some regulatory overhead is inevitable.  The World Bank currently ranks the U.S. 13th globally for ease of starting a business and falling.  We can do better.

On the list of startup barriers that concern and disturb me, crony capitalism is the worst.  Entrenched interests sometimes gain enough power to manipulate the political system to bar competition and restrict innovation.  We have an example right now in my home state as the Colorado PUC is proposing a new set of rules that would shut down transportation startup, Uber, in the state.  Make your voice heard on crimes against entrepreneurship like this.

Other regulations are less egregious but arguably more damaging because of their wet blanket effect.  The most significant in my mind involve equity compensation.  Take the standard practice of equity vesting, for example.  It’s internally aligning, not to mention essential for raising venture capital, to give a startup the right to buy back a portion of founder’s shares for a team member  who leaves the company early on.  But what if you put these standard vesting provisions into place and don’t know the IRS requires filing an 83(b) election (who comes up with these names, anyway?) declaring the tax basis of your equity stake?   Answer: if the company is successful, you owe taxes on the increase in value each time additional shares vest.  Say you bought 1 million shares of stock for a penny a share and over the next year the company knocks it out of the park.   If a year later the stock is worth $1.00 a share and 25% of your shares vest, the IRS can come after you for taxes on the paper gain of $990,000.  Never mind the stock isn’t liquid and you’re still not taking a salary.  The sin of not being able to afford a decent startup attorney who can help you and your co-founders file the one page 83(b) election puts you in a tax trap.  This is shameful policy.

Almost as bad are the requirements of Internal Revenue Code 409A.  In clamping down on some overreaching compensation and tax avoidance tactics of Exxon a decade ago, Congress passed legislation that caught startups, requiring companies to follow a rigorous process in valuing their equity grants.  Issue stock options or stock grants without an independent 409A valuation report (which costs $5,000 to $20,000 four times a year) and the IRS can challenge your valuation.  If you’ve issued stock options with a $0.25 strike price and the IRS asserts that $0.55 was the fair market value, you’re on the hook for back taxes, penalty, and interest on the $0.30 per share difference times the number of options granted.  To date the IRS has rarely if ever challenged startup company valuations.  But the existence of 409A regulations greatly increases the cost, time, and uncertainty of operating a startup.

Other examples include the hoops of employment laws.  In a financial technology startup I co-founded I vividly remember trying to figure out what employee notification posters we were required to post in the break room, the dilemma of how to post in a virtual company operating out of three states, and the regulatory warnings about the steep fines we faced if we got it wrong.   It wasn’t the largest hurdle in the world, but for a startup CEO to take a day out of his or her life to figure out posters in the critical first months is a big deal.  Minimum wage requirements of the engineer who leaves a six-figure income job to work for equity is another regulatory issue that creates friction.  Another I recall from my startup, was receiving notice of a near doubling of our state unemployment insurance tax rate.  While I was taking no salary and investing everything in building a company, congress was extending unemployment benefits from 13 weeks to 33 weeks to 53 weeks.  I understood there was a policy issue involved, but I’ll never understand why my startup was being taxed at dramatically higher rates because I was trying to build a new business and hire good workers.

Happily, startups will continue to be awesome and do awesome things.  How much more cool can you get than the StartupWeekend that some of the folks at Startup Colorado Springs are bringing to the community in April.  This three day hackathon epitomizes the light, lean, building culture of startup entrepreneurship.

We need to lower the hurdles and decrease the headwind as part of an effort to dramatically alter the startup success rate.  I have a feeling the ‘no permission required’ culture of innovation and creation is going to prevail.

Unfair Entrepreneurship in Utah

Entrepreneurs and entrepreneurial communities good at startup ‘discovery’ win

After two trips out to Utah in October, I’ve concluded the state is building an unfair entrepreneurial advantage.    It’s scary how well they’re doing at startup and startup community building.

Utah’s secret is extreme focus on first principles of building successful startups—on what they call discovery.  Their well-developed distinction between the discovery stage and the execution stage of startup building—and organized efforts to embed discovery capability into the DNA of its entrepreneurial community—is having profound results.

Here’s the background.  When visiting Utah in early October I hit the local pitch night event, LaunchUp.  The director of University of Utah’s startup incubator, the Foundry, gave the amp session and threw my world a little off balance with his data.  Accelerator programs on average lower the success rates of their startups.  Incubators that provide deep business infrastructure to startups waste resources.  Lean startup methodologies may or may not be efficacious.  These are serious challenges to the conventional wisdom.

But then it got worse.  One of the program graduates took the stage.

Gary Jense, founder of Zeniick, described his virtual launch of a mid-priced wristwatch line, hitting 1,000 web pre-orders and raising funds for initial production through Kickstarter . . . all during Christmas break 2011 his senior year at the U.  He then described identifying a uniquely cost effective overseas supply strategy, gaining brand identification and loyalty within a large yet tightly defined target customer segment, securing retail distribution channels, attracting a senior designer from Skullcandy, and building on each wave of customer acceptance to find he was hitting some serious sales volume . . . all in the past ten months.  I regularly see entrepreneurs asking “How do I raise capital?” when their product hasn’t yet met its first user.  How do these startups compete with a Zeniick?

Of course I considered a call for legislation to stop this unfair competition.  But I had another trip to Utah last week, so I decided instead to reach out to the Foundry to see if they could fill me in on what they’re doing.  The result was a sit down with Bill Schulze, department chair at the U of U’s Eccles School of Business, and Rob Wuebker, Foundry director.  A combined mix of engineer, PhD-academics, strategist, entrepreneurs, department chair, scientist, economist, biker, and pony tail, they were a fire hose of highly relevant insights.  (I consider 2 ‘double asterisk’ take-aways in my notes as an awesome conversation.  This one yielded 8.)  The most significant insight took the form of this diagram which they penned out on a napkin.

Here’s the Foundry’s secret.  They define startup creation as simply as possible—business model discovery and business model execution.  Then they facilitate the process of entrepreneurs mentoring each other in real world case studies as each seeks to discover a viable business model.  The only entry criteria are bringing an idea and an attitude of being coachable to the group.  By helping entrepreneurs help each other understand how to discover a viable business model, a surprisingly high portion are able to simply, rapidly, cheaply prove they have a business model worth executing.  What struck me is just how much the focus on discovery and putting first things first enables the rest to fall into place.

Startups that focus first on discovery don’t build highly polished products to find they have inadequate market demand.  When they verify the market wants their solution, they put great focus on identifying sales channels to reach customers in scalable and cost effective ways.  They don’t spend their time and energy raising capital before they’ll be received by investors or with investors that are not a good fit for their business model.  They understand when and why they might need to bring in professional management when they’re ready to scale their discovered business model.

It’s not that the execution stage is easy.  Quite the opposite.  But business schools and corporate America have been training people to scale companies for many decades.  The rare skill is discovery.  I’d venture that more than 90% of entrepreneurs, mentors, and entrepreneurial communities don’t differentiate between identifying versus executing a workable business model.  In teaching discovery the Foundry instills the easiest and lowest cost—but also the most rare and most enabling—aspects of startup building.

I think of discovery as:

Identifying and validating

through significant real world product contact

with real world customers

that you have a solution to a problem

that is deeply held

by many people

who will pay significantly more for your solution than it costs

and can be reached through a repeatable & scalable sales process.

The delightful thing is, a business model can be discovered or validated for a tiny fraction of the cost of executing or scaling one.  The resources required to execute need not, should not, be raised before the evidence is in that the startup is on target.  Columbus makes an apt analogy.  He was seeking to discover a trading business model through the innovation of westward travel.  He could have approached Queen Isabella with an execution funding request–capital for a fleet of trade ships.  Instead he focused on discovery and asked for just enough to find out if the westward route worked.

As Wuebker pointed out to me, there are many discovery models.  Scientific experiment, drilling a hole in the ground, and focus groups are examples.  The lean startup methodology is a particularly well developed discovery model.  Another model is the “build it and they’ll come” route espoused by some Iowa farmers as well as WebVan.  WebVan built a national warehouse/truck fleet/online logistics system to deliver web-ordered groceries to consumers.  $1.2 billion and an IPO later, they discovered consumers don’t want to do their grocery shopping online and went bankrupt.  I’ll take Zeniick’s wristwatch-Christmas break-Kickstarter discovery model every time.

Radical focus on discovery before execution turns out to be powerful.  Following the scientific method, entrepreneurs make a hypothesis about each interconnected element of their business model and then set out to test each assumption in as simple a manner as possible.  Some hypotheses can be tested at a resource cost of $10 (NetFlix’ founder reportedly mailed a dozen DVDs to himself to test if they’d survive the USPS); others $1,000; and others $1 million.  The point is, a massive amount of risk can be taken out of the equation by tackling (validating) the low cost but critical assumptions first.  If an entrepreneur has already validated six of eight key assumptions and the next experiment will cost $50,000—say, manufacturing the first run of wristwatches to fill pre-orders or building a working software prototype to deliver to an enterprise customer who’s signed an LOI expressing volume interest—the company is an excellent candidate for Angel financing.  There’s risk, but there’s also clarity.

How much risk and uncertainty has the entrepreneur eliminated from his startup when he’s validated his business model?  Think about the third university campus Facebook launched to.  They had another thousand campuses (and a billion users) still in front of them.  But by about number three, they knew they’d discovered a powerful business model—and so did their VC backers.

Most entrepreneurs seek to execute their business model simultaneous with discovery.  Not knowing a better way, it feels pragmatic and purposeful to dig in.  So they build as much of a scaled down version of traditional big company infrastructure as they can.  A sales force, a marketing department, manufacturing, distribution, PR, and full product development teams.  Focusing instead on business model discovery without trying to execute or scale that model until one has truly validated it has powerful economics.  I estimate the discovery first route will typically knock between one and three zeroes and the same number of years off your startup budget.  Entrepreneur-thinkers like Steve Blank, Eric Ries, Nathan Furr, the folks at StartupCompass, and Sean Ellis have shown the world this better way.  But the message isn’t being distilled.  I love how Utah is changing that, one group of entrepreneurs at a time.

* * * *

With Utah’s Foundry cranking out a couple hundred entrepreneurs a year who understand discovery and putting first things first, and I’d guess dozens who understand it deeply and really do it well, the state is racking up a significant entrepreneurial advantage.  This clarity will enable them to approach the level of top tier entrepreneurial ecosystems like Silicon Valley and Boston.

Fortunately, startup communities are all about sharing and the Foundry is no exception.  I sat down to ask Schulze and Wuebker what’s working for them so we can apply it within my community.  Their return challenge: “Don’t replicate the Foundry.  Build something ten times better.”

Ultimately the challenge is about finding better ways to instill discovery into the entrepreneurial ecosystem and to then give a path for entrepreneurs with discovered business models to execute and scale.  I suspect that how well communities rise to this challenge will determine whether they join the fabric of vibrant entrepreneurial communities of the next decade or enter a silicon rust belt of lost potential.

________________

This blog post is being simultaneously published on Startup Finance and the blog of CFOwise, the outsourced  CFO solutions company.  The author works as a startup CFO with CFOwise serving startup companies throughout the country.

The Paradox of Lean: Perfectionist vs. Minimalist

A startup CFO wears several hats.  With my accounting or legal hats on, my rule is DIRTFT.  Do it right the first time.  In contrast, when coaching Lean Startup and with my product manager hat on, the rule is MVP—minimum viable product.  With emphasis on minimum.

Perfectionist or minimalist—which is right?

The central principle of Lean—“don’t waste”—unifies this paradox.  The way to not waste is to take the “right action at the right time.”  In accounting and legal entity setup, one rarely knows more about the issue in question than at the outset.  Apply the DIRTFT rule and you never have to revisit booking a transaction or setting up founders’ vesting again for example.  This yields a foundation the company can grow on.  But in product development, you rarely know less about what the market needs than at the outset.  Developing the minimum (often just a mockup, drawing, or landing page) lets you get outside the building and engage real customers with your product.  In doing so, you learn things unlearnable inside the building and can create a better product and company.

MVP is a really big idea that means you approach the startup with substantial humility.  Knowing how much you don’t know, you build:

that version of a new product which allows a team to collect the maximum amount of validated learning about customers with the least effort”

-Eric Ries

Act when you have the information to act.  For accounting and most legal matters, DIRTFT will keep costs down and timeliness and accuracy high.  But as is pertinent to so much of startup innovation, definitely put off until tomorrow what you don’t know enough to do well today.  Make the smallest possible meaningful start and go learn in the meantime.

. . .

This blog post is simultaneously published on Startup Finance and CFOwise, the outsourced CFO solutions company.

Department-Level Reporting—A More Meaningful P&L

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Free Resources:
Startup Chart of Accounts (Excel file)
Startup Chart of Accounts (.IIF file) (importable into QuickBooks from File|Utilities|Import)
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It’s important that financial reporting meet the IMPACT standard:  Insightful. Meaningful. Precise. Accessible. Comparable. Timely.  A pile of numbers just doesn’t cut it.  One useful way to make the Profit & Loss statement (P&L or Income Statement) more meaningful is to show expenses by department, such as Customer Support, Development, and Sales.

Here are two examples, first a standard and then a department-level P&L:

A default QuickBooks P&L groups expenses together, making it impossible to see how much was spent by department.

Organized to show expenses by department, this P&L gives management and board members more insight, meaning, and comparability.

 

The P&L on top is QuickBooks-default, which organizes more for income tax reporting than managerial insight.  That can work.  But for a startup preparing for or experiencing rapid growth, breaking out costs by department, as done in the lower P&L, yields more insightful, meaningful, and comparable information.  CEOs and board members often find this breakout valuable.  It borrows from the department reporting of GAAP financial statements while still including some detail.  The lower P&L also includes growth rate and normalized percent-of-revenue ratios to further enhance the insight and comparability of the statement.

Ask yourself this question to see if department-level reporting makes sense for your circumstances:  Will it be useful for my CEO to see that compensation expense was $74,183 in September; or to see that compensation cost $24,200 for Sales including commissions, and $39,983 for Development?

I view a startup CFO’s job as being all about company scalability.  Understanding, managing, and communicating scalability is much more clear if costs are broken out by, for example, Research & Development (an investment in scalability) versus General & Administrative (overhead costs that need to grow more slowly than revenue if the company is to successfully and profitably grow).

For CFOs and Accountants Only . . .

Department level reporting requires some careful organization of your chart of accounts.  The links at the top of this post provide you with a downloadable resource for getting started.  You can edit the chart of accounts .IIF file in Excel.  Just download the file to your hard drive, right-click in file manager, choose ‘open with’ and then select Excel.  Edit and then resave, keeping it a .IIF file.  You can import directly into QuickBooks after editing using File|Utilities|Import.  Experiment first using a dummy company Quickbooks file.

The other way of creating department-level reporting in QuickBooks is to use class tracking.  However, I find class to be a cumbersome tool for department-level reporting.  Save class tracking for other company dimensions such as product line or geographic reporting.

Here are some tips I find valuable in department level reporting:

  • If an account has a sub-account, classify expenses ONLY to the sub-account.  Parent account are for organizing the sub-accounts only.
  • To keep things simple, don’t go more than three layers deep in sub-accounts.
  • For the final version going to the executive team and board of directors, export the P&L to Excel and hide detail rows that don’t matter to the users.  For example, you may want to track sales travel expenses by transportation, meals, and lodging for tax and reimbursement purposes.  But the board rarely wants to see more than total travel costs.
  • Be slightly militant about keeping your chart of accounts lean. Consolidate small dollar accounts by merging with similar accounts.  Deactivate accounts you’ve not used in over 18 months.  And ask your bookkeeper to never create a new account without your OK.

Department-level reporting adds a bit of complexity and length to the P&L.  For growth companies, the benefits in insight, meaning, and comparability make it well worth the effort.

 This blog post is being simultaneously published on Startup Finance and CFOwise, the outsourced CFO solutions company.

Startup or Small Business — The Other Chasm

There’s a world of difference between a scalable technology startup and a small business.  Decide which you are.

Crossing the Chasm is a startup classic written in 1991 about the challenge of going mainstream with a technology product.  I see an earlier mindset-based chasm with startups.  It’s summed in this question:  Are you a startup or a small business? 

The terms are sometimes used interchangeably, but the confusion on this point tends to be cataclysmic.  There’s alignment that comes from meaning the same thing when founders, investors, and employees talk about these organizations in the same way.  Using a bit of the mindset and vernacular of Silicon Valley, let’s explore the difference and the implications of the chasm between startups and small businesses. 

Steve Blank showed the world that startups are not just small versions of large companies.  Applying big company management within startups leads to frustration and failure.  A similarly critical distinction separates startups from small businesses.  Silicon Valley thinks of startups as organizations that are designed to become very big (my rule of thumb is $20 mil. in 5 years and $100 mil. in 10) and are characterized by extreme uncertainty because they seek to do something very new.  In contrast, small businesses are designed to meet the income, lifestyle, and other needs of their founders and are characterized by execution risk within known business models (dental practice, restaurant, building contractor, etc). 

Small businesses can be awesome.  But they are different from highly scalable technology startups.  The disaster lies in trying to operate as both.  At the core, startups have so much business model risk that they need to eliminate all the unnecessary risks and uncertainties of their structure so they can focus on validating their business model.  Here are some differences I’ve observed in how startups vs. small businesses organize and operate themselves. 

. . .

Legal Entity – Startups are C-Corporations (usually Delaware C-Corps), small businesses are LLCs organized in their home state.  Startups intentionally pick a more expensive state to incorporate in and an entity type with big tax disadvantages, because you can scale a C-Corporation dramatically easier than an LLC. 

Shares vs. Percentages – Startup stake-holders think in terms of shares, then calculate their percentage ownership.  Small businesses just think in terms of percentage ownership—which is often 100%, as in “I own this business.”  Percentage matters second in a startup because the value in the end can be so dramatically higher by making smart decisions to trade percentage ownership for key resources like talent, advice, and capital. 

Key Personnel Exits – Startups take a portion of ownership back when key personnel exit.  Without meaningful compensation.  Small businesses buy that ownership back at a profit to the departing partner.  That’s because the early value of the organization is nill in a startup, and everyone needs to sign on to make that value huge.  If you leave before the company’s had time to do that, vesting agreements come into play in which players agreed at the outset to give up the unvested portion of their equity.  In contrast, small businesses have buy-sell agreements in which the parties agree at the outset as to the value of their stake on exit.  This works great with a dental practice or law firm.  In contrast, the presence of a buy-sell agreement in a startup makes it unfundable.

Eccentrics and OTJ – Startups have room for approximately one less than fully baked executive.  Sometimes brilliance can outshine eccentricities (Steve Jobs) and inexperience (Mark Zuckerberg) to create real magic.  But more than one only creates real problems.  Small businesses, by contrast, can have room for the slower pace and unnecessary missteps that accompany nepotism, dysfunctional habits, and inexperience.  There are limits either way, but those limits hit much earlier in a startup.  The corollary to this rule is that startups can have little tolerance for drama while a small business can have as much tolerance as its founders have patience for.

Employment Agreements – Startups use ‘At-will’ employment agreements.  Because business model uncertainties are so extreme, a startup has to have full flexibility to separate when things don’t work out.  There’s precious little room for fixed term employment and generous severance.  In contrast, a small business can structure its agreements to give maximum protection to founders and key internal partners. 

IP Ownership – In a startup, the company owns the intellectual property.  Founders and employees sign all rights to all past, present, and future IP related to the company’s business that they have developed or will develop so long as they are with the company.  There’s zero room for less than full clarity on this point as operational execution and funding prospects both rely on the company fully controlling its IP.  In a small business, IP ownership disputes can be equally devastating but there’s more latitude for informal understandings and ambiguity.

Control – I was once considering investing in a semiconductor startup.  When we asked the CEO if he needed to remain CEO forever, he replied “I’d rather be rich than king.”  That’s the startup mindset.  Startup founders are willing to intelligently trade off control such as board seats, dilution, voting rights, and executive positions to enable the company to maximize its success.  Small business founders, by contrast, may prefer to maintain full and final control.  That’s ok, but it doesn’t work with high potential startups.  A few wildly and instantly successful startups like Google and Facebook are the exceptions that prove the rule.

Capital Sources – Startups are self- and friends and family funded, then angel and venture capital funded.  Small businesses start on the same self- and F&F sources but quickly diverge to funding through retained earnings and bank loans.  Startups have too much business risk, too little history, too negative profitability levels, and too few tangible assets to be candidates for bank financing.  In contrast, small businesses have too little scalability and the wrong governance and control structures to be candidates for venture capital.

Copernicus —  What is the central focus your company revolves around?  In the sixteenth century, the Copernican Revolution established that our planet revolves around the sun, not the other way around.  Startups establish their own Copernican Revolution by deciding their company revolves around customers or users and shareholders.  In that order.  Small businesses share a central customer focus, but are also all about their founder.  This will be controversial, but I believe even a team focus is wrong for a startup.  Successful companies often outgrow their founders’ abilities.  That’s success!  At some point, a commitment to keeping team members in place for the duration will run counter to building the best company that delivers the most value to its customers.

Customers or Profits – Do customers or profits come first?  Here’s one where small businesses ofttimes have the edge.  Apple last week set the record for the highest market value of any company in the U.S.  Paradoxically, its mantra of “insanely great” products got it there while a mantra of profits and stock options would have prevented it.  It takes some balance, but startups are well advised to let vision and passion for delivering to customers carry the day.

. . .

The distinction between startups and small businesses is well understood, but hasn’t sunk into the common business vernacular in most parts of the country.  Refer to The Founder’s Dilemmas and the book’s excellent discussion of the “high-potential startup” vs. the small business, and this talk by ‘super angel’ investor Mike Maples for some of the thought leadership on the subject.  In Silicon Valley, the culture and advisors preclude confusion.  It’s difficult to overstate the competitive advantage this brings the Valley’s startup ecosystem.  In the rest of the country, it’s crucial that advisors, investors, entrepreneurs, and community leaders understand and articulate the differences.  Helping companies intelligently choose to be on one side of the startup-small business chasm or the other will dramatically increase successful business outcomes with both.  Stuck and struggling deep inside that chasm is no place from which to be running any business.

This blog post is being simultaneously published on Startup Finance and CFOwise, the outsourced CFO solutions company.

Funding Fit

Understand what financing sources are a good fit for your company . . . and vice versa

From a family loan to a bank loan to venture capital, different types of financing are appropriate for different types of companies and stages of their development.  The ‘funding fit’ is everything.  Here’s how I look at the match-up.

Source Criteria Fit
Self-funding Vision and ability you believe in The best way to get started if you can swing it
Friends & Family Vision and ability they believe in The time-honored startup seed funding route
Customer-sponsored Reputation with customers Persuading customers to pay for development provides built-in validation of what you’re doing.  Works best b2b situations where you’re solving a critical customer need and providing them with first access to a competitive advantage.
Angel Investors Reputation and common vision Angels are wealthy private investors.  It’s best to work with someone who knows your space well or invests in startups regularly and has a great reputation with other entrepreneurs.
Bank Loan Two ways to repay Borrowing from a bank is easy, they say.  Just show you don’t need it.  In other words, show that you have the income to service the debt payments and assets you can pledge that can be liquidated to repay should something go wrong.
Venture Capital Awesome team and validated, highly scalable business model VCs invest in startups, not small businesses.  There’s a world of difference.  You need to show traction in a business model that can scale to at least $20 million of revenue in 5 years and $100 million in 10 years.
Private Equity Proven team and business model The P.E. guys and gals are looking for proven businesses that yield predictable revenue growth, profit margins, and free cash flow . . . or that can be quickly turned around to produce such.

This blog post is being simultaneously published on Startup Finance and CFOwise, the outsourced CFO solutions company.

Startup infrastructure: Revenue model

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Startup revenue model (Excel.xls download)

Customer conversion model (PowerPoint.ppt download)

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The revenue model is the keystone of the business model.  It goes in last but holds the entire structure together.

Like all things startup, your revenue model is nothing more than a hypothesis to be tested.  Start right and you’ll have more focused product and customer development and stronger engagement in the capital raise.

Here’s how to do it.

1. Price x Volume = Revenue.  That equation gives your base.  Wait until you know roughly where you’re aiming the business, then grab your team, head to a white board and start answering basic questions.  Who is our target customer?  What is our product or service solution?  How much can we charge?  Who pays, our users or someone else (such as advertisers)?  What units drive revenues (clicks, page views, downloads, widgets shipped)? How many units are feasible?

2. How does volume scale?  Still at the white board, start exploring feasible volume growth dynamics across time.  By month, at what pace can you increase unit sales?  What are the limits?  What’s the total market?  What segment of the market do you address?  How much share can you keep or take?

3. “What are the physics?”  Specifically, what are the physical customer touch points through which you’ll directly reach target customers?  That’s the best question I’ve been asked about crafting a revenue model.  No surprise since it came from Lyle Wallis, President of Decisio, which gives big companies a bit of a crystal ball on how to optimally launch products and services like GM’s OnStar.  The action here is to brainstorm the ways you’ll reach customers and they’ll reach you.  Radio ads?  Direct sales calls?  TV spots?  Banner ads and Google AdWords? Referral?  Search?  Customers walking in a physical door?  List the possibilities then bring it down to a short list of the best.

4. Visually connect.  Now put it together visually.  Draw on the board your target customers, your channels for reaching them, and what happens between first touch and revenue.  It’s often helpful to reduce this to PowerPoint for future discussions, both internal and with VCs.   The PowerPoint linked at top is Qbillion’s, with credit to Dave McClure whose brilliant “Startup Metrics for Pirates” pointed me down the right path.

5. Model the math.  Finally, convert the logical flow into formulas in a spreadsheet.  Just follow the logic you’ve already sketched out.  You’ll find that modeling in a spreadsheet dramatically tightens your business thinking.  Your aim is to capture how physical activities drive customer actions and at what rates.  For example, translated from Excel to English, a good revenue model may say,

For every $100 we spend on Google AdWords, we’ll gain I impressions and C clicks.  A percent of those who click will abandon within 30 seconds.  Of those not abandoning, H percent will have a happy first visit and S percent will sign up for our messaging.  U percent will become active users and P percent will become paying customers.  We’ll lose X percent per month to churn.” 

Contrast that bottom-up logic with rookie top-down logic of, “We’re in a $15 billion market and have such a great product we can conservatively take 35% share within three years, and will thus have over $5 billion in revenue.“  Which path gives you actionable detail to test, learn from and improve?  Which impresses a VC with your business thinking?  Embedded above is an Excel revenue model I created for Qbillion (assumptions generalized for confidentiality).  It reflects a freemium type revenue model of free base usage and subscription premium usage, with plumbing for an ad revenue model included but zeroed.  The PowerPoint and Excel files are a revenue model partnership of the visual and the mathematical, both saying the same thing in a different medium.

Conclusion:  You’re not going to precisely nail the numbers, but that’s not the point.  What’s critical is that you become more directionally right with each iteration.  It’s about learning what channels work, what your true channel costs are, how to trade off and optimize those costs, how to increase customer referral activity and the impact this has on revenue and profits, etc.  With a good revenue model crafted, you’ve taken a leap towards being a learning organization that tests business model hypotheses, improves, and ultimately succeeds.

Startup Resources: The best blogs

For nearly two decades I considered Harvard Business Review my best source of business thinking.  My subscription lapses this month.  Engaged in a startup, the best blogs are simply a better use of my learning time.  Here are the ones I’ve found most valuable in my startup journey.

  • Feld Thoughts by Brad Feld.  An ‘all things startup’ blog written by a VC and targeted to the startup community.  Always insightful, always enjoyable, usually irreverent, this is the best of several excellent VC-written blogs.  Brad runs early stage VC fund Foundry Group, is a co-founder of the TechStars incubator, and impresses me as a generous individual hugely committed to advancing both the Boulder and global startup community.
  • TechCrunch.  The New York Times of the startup world, TechCrunch is a blog form media site that will keep you in the loop on all things entrepreneur, startup, and tech.
  • Steve Blank.  Steve showed the way for turning startup building from black art to art with elegant, science-based process behind it.  He did this in his seminal book Four Steps to the Epiphany.  His blog covers invaluable and insightful topics, much around customer development and lessons from startup war stories new and old.
  • Lessons Learned by Eric Reis.  Eric’s blog is about the Lean Startup methodology, building on Steve Blank’s thinking in a more down int the trenches way.
  • Ash Maurya.  Ash’s blog is customer development and lean startup thinking applied very specifically to web applications startups.  It’s never the same enjoyable but intense 2 minute read of Feld Thoughts.  It’s deep business thinking that requires you to think deeply about its application to your business.  Ash has crystallized more of my most valued entrepreneurial insights than any single other source.
  • A VC by Fred Wilson.  Another great VC-written blog on all things startup, this one from a New York locale, where Fred runs Union Square Ventures.
  • Ask-the-VC.  Here Brad Feld and Foundry have organized answers to a host of great questions founders have for venture capitalists.

Those are the sites high on my RSS home page and that I find myself learning . . . a lot . . . from every week.  Others I also visit frequently include:

Both Sides of the Table;   Ben’s Blog;   Information ArbitrageSeth LevineBryce-dot-VC;   For Entrepreneurs;   How to Change the World;   Startup Marketing Blog

What startup blogs do you gain the most from?

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Next up:   Startup Infrastructure: Revenue Model

What’s a Startup? (2 of 2)

As we covered in part 1, a startup knows for sure neither the customer problem it is solving nor the product or service solution.  It forms hypotheses about both, tests them in the simplest ways possible, and iterates its way to increasingly solid and validated hypotheses.

Steve Blank (the man who made customer development co-preeminent with product development in startups) adds an important dimension.  He says a startup is about the search for a “repeatable and scalable business model” (“What’s a Startup?  First Principles.”  2010).

Startups, as the term is used in Silicon Valley and by VCs, need to solve a big problem with a competitive solution.  To me the threshold feels like $20 million in revenues within 5 years and $100 million within 10 years.  To be a startup, you need a business model that can profitably scale to those levels.  A $10 million or $250k revenue opportunity can make for a great business.  But venture financing is going to make little sense for either the entrepreneur or the VC.

So putting things together, your entire and only purpose as a startup entrepreneur is to discover a “repeatable and scalable business model” by treading some very new and innovative paths that result in “conditions of extreme uncertainty.”  In other words, startups are about following the most efficient path to a big and worthwhile goal.

This definition lays the groundwork for some great discussions about startups, startup operations, and finance.

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Next up . . .

Startup Resources:  The best blogs