Getting to "yes" in a world of "no"…

Archive for October, 2010

Entrepreneur Role Models…?

Who should entrepreneurs see as role models? When Microsoft @bizspark tweeted this general question a few days ago, my immediate thought was that there were plenty of bits of entrepreneurs I liked:-

  • Clive Sinclair’s mass manufacturing (but not much else)
  • James Dyson’s design (but building in the UK from the start was obviously a bad move)
  • Robin Saxby’s collaboration (how ARM can supply so many bitter rivals is frankly quite amazing)
  • Steve Jobs’ design aesthetic & marketing (coming soon, the iToilet, the iOven, the iMoped, etc)

However, one problem with this is the whole concept of success, because when you put successful businesses under the microscope, what you tend to find is just how arbitrary their success actually was, how perilously close they came to abject failure. And as for the entrepreneurs driving those companies – well, every time I see a list of character attributes entrepreneurs ought to have (such as this list from the Startup Professionals Musings blog – confidence/leadership, uniqueness, openness, respectfulness, roundedness, humility, charity), I have to say that they correspond only glancingly with the ones that successful entrepreneurs do present. Please correct me if I’m wrong!

In fact, if experience was any guide, you ought to see endless Internet lists describing an ideal entrepreneur as:-

  • pig-headed, arrogant, ruthless, unpleasant, driven
  • emotionally shallow, feigning humanity only to achieve their short-term ends
  • overconfident, relying too strongly on their own limited expertise
  • greedy, ambitious to the point of megalomania
  • etc

But then again, we all have a little bit of an angel and a demon in us, so I don’t think any of this helps much. The key characteristic shared by big stories about startups is that the people involved are on an emotional and financial rollercoaster, and such an extreme experience will naturally tend to bring out both the best and the worst in them – whichever side gets foregrounded will depend on who’s telling the story (and why).

Ultimately, I think the reason that there are so few “role model entrepreneurs” is that it is not their characters that make them rich, it is their customers. Maybe the trick is not so much good character, but good market rapport, good technical knowledge and an excellent sense of timing.

Honesty In (Startup) Advertising…

A topic that continues to vex my startup soul is that of honesty in presentation. Which is definitely not to say that startup pitches are dishonest as such (on the contrary, I’m pretty sure that almost all are done in very good faith); but rather that the tools we use to communicate and the cultural presumptions about business practice and presentations we share don’t really help us communicate transparently and clearly.

When it comes to pitching, we’re far too often building on sand, people.

Firstly, here’s what I think particularly sucks about the presentation tools we rely on so much.

Powerpoint itself is a lousy way to share complex information sharing, as it encourages unhelpful conceptual simplification, needlessly hierarchical presentation, visual compactness over clarity, and inappropriate layout tricks for capturing structure. Read Richard Feynman’s book “What Do You Care What Other People Think” on the bulletized flawed arguments (and engineer bullying) that contributed to the Challenger disaster, Edward Tufte on the Columbia disaster, let alone Peter Norvig’s hilarious Powerpoint re-presentation of the Gettysburg Address. Yet 95% of startup pitches use Powerpoint.

Excel, too, is a pretty lousy way of communicating complex data: is there any graph I could show an angel they’d honestly believe? I suspect the #1 reason angels look at cashflow forecasts is (a) to drill down the burn rate, and (b) to see how much the founders plan to pay themselves. Of course, the right reason for using spreadsheets is to model different growth paths based on different sets of assumptions: but all most angels would ever do is follow the curve for the most pessimistic models, which would rather defeat the object of modelling.

Secondly, here are some of the many faulty business presumptions we use when trying to construct pitches.

  1. Progressivist narratives. Both pitcher and pitchee(s) tacitly agree to marginalize the whole iterative, fail-several-times-but-keep-trying nature of startup life, preferring instead to pretend that product development and customer development will both run smoothly from start to finish (if perhaps a little late). Of course, life almost never runs in a straight line: the only constant in development is a need to persist against the odds, to drive over the world’s arbitrary speed humps. Whenever I’ve hired programmers, the key quality I’ve looked for is an ability to push through to the next milestone: when you take on difficult tasks, coding is less about beauty than about a mix of willpower and solid engineering. But have you ever seen a pitch that emphasizes this?
  2. Numbers never lie. Actually, anyone who has done any accounting knows that, sorry, they usually do. The only real issue is by how much they are off. As my MBA forecasting lecturer used to say, “forecasting is hard, particularly about the future“.
  3. Graphs never lie. See point #2 (and multiply it by ten).

As an exercise, I took my current startup presentation deck and did everything I could to make it as transparent and honestly communicative as possible. This involved taking out almost all of the Powerpoint structuring (which only got in the way), throwing away the eye-candy, adding in a diagram, and adding in customer videos. Here are my comments on each slide in turn (note that I also tried to upload it to Slideshare, but it got the header formatting completely wrong):-

Slide #1: nobody cares much about the startup’s name or logo (mainly because these very often change on the way to market), but contact information at the bottom is always going to be handy. Following the journalism rule (tell the whole story in a single sentence, then iteratively expand), I included what the company does, its USP, and a simple business diagram. I dramatized the USP and placed it centre stage:-

Slide #2: it’s probably true that investors invest more in people than in projects, so the second slide focuses on the team aspects. But (following Feynman) rather than bulletizing it, I turned all the points into sentences – much more readable and non-Powerpointy! I also alluded to our Lean Startup iteration / Customer Development ‘mojo’:-

Slide #3: this is a tricky one. Ultimately, the core problem with presentations is probably their inability to engage – you don’t want McLuhan-esque ‘cool media’, you want ‘hot media’ to excite your audience, and to raise their financial heartbeat. And your set of customers is one of those things talking about will always be rather unsatisfactory. Angel bloggers like to talk about ‘social proof‘, but probably nothing short of a slo-mo video of Ron Conway signing a cheque would beat seeing actual customers enthusing about your company’s products or services.

Slide #4: in my opinion, a startup pitch without discussing burn rate and your exit strategy would be a 100% non-pitch. In my particular industry (security), companies get acquired all the time, but I would be fairly surprised if many investors happened to know that. In this last slide, I’ve finally succumbed to Powerpoint’s wiles and used some hierarchical structuring, basically because it was a good fit to the actual structure:-

OK, nobody is ever going to fit everything relevant in four slides: but a pitch should never be complete anyway.

As an entrepreneur, the key issue here is whether your pitch uses Powerpoint, or whether it is a slave to Powerpoint. Edward Tufte advises us to think about the structure of the information we are trying to present, and to make sure that our desire to lay it out nicely does not lead us to compromise the message we are trying to give. How does your pitch presentation rate? Could it be more honest?

“Cash Is More Important Than Your Mother”…

…A.K.A. “CIMITYM“. Even though I first heard this phrase from Paul Dawalibi’s “The VC Whisperer” blog, I didn’t realise it was from Al Shugart, the colourful disk drive innovator who cofounded Seagate Technology in 1979. He also helped his dog Ernest run for Congress in 1996 (as a protest), but apparently didn’t realize that only poodles are allowed in. 😉

Anyhoo, it’s a great phrase for entrepreneurs to bear in mind, because I’ve heard so many of them outline their world domination business plan solely in terms of growth through hiring people – we’ll hire two developers immediately, then a marketeer, then we’ll buy X & Y and rent an office in Z (etc etc).

In the real world, spending money is all too easy: probably the biggest skill a startup can have is not spending money. The basic equation goes that each $ going into a startup is worth ~10$ in two years’ time, so startups should spend each seed dollar as if it is printed on gold leaf. This is the core reason why investors often fixate (and rightly so!) on an investee company’s burn rate: probably their #1 fear is for all their hot investments to burn out in six months, leaving only a singed, empty smell in their once-full wallet.

The full quote from Shugart goes: “It is important to remember when starting and growing a new company that cash is more important than your mother” – hence you can also see why many current angels focus on prospective startups’ cashflow projections, because looking at them is often an effective way of bringing faulty assumptions to the surface. Really, if your company can survive 18 months without running out of cash and still make good progress to market, then it’s in the top 10% of startups, surely? A thoroughly good place to be!

The Enterprise Investment Scheme: stepping stone or millstone?

For many years, a key landmark on the UK startup funding landscape has been the Enterprise Investment Scheme (‘EIS’ for short). This is a wonderful piece of tax legislation wizardry that gives tax breaks to angels investing into qualifying startups both on downside outcomes (i.e. if the company fails) and on upside outcomes (i.e. if the company succeeds). As I recall, the figure I saw quoted for 2009 said that 76% of UK angel investments into UK companies went through EIS, which makes it a pretty popular scheme.

All the same, when I started structuring my own company (Nanodome Ltd) pitch to make it angel-ready, I priced up all kinds of non-obvious corporate structures (options, debt, convertible debt, etc), but honestly – the EIS makes everything else so second-best that it was kind of embarrassing. Hence the EIS is something I’ve long told other entrepreneurs is the only sensible way to go forward: it’s pretty much gold-plated.

However, funding is changing. Paul Graham (of Y Combinator fame) put up an essay last month about what he calls High Resolution Funding, by which he means startups’ selling convertible notes at different prices to different people (and at different times). Convertible notes are a kind of debt equity that can be converted to common stock at a future round (though you have to be careful that you’re not effectively trading insolvently and that you will still have access to overdrafts / factoring / etc). ‘Capped convertible notes’ refine this further (so that seed round angels’ investments don’t get diluted down to nothing on big up rounds). Graham’s finesse on capped convertible notes is that startups can choose to give earlier or particularly-useful angels a better price than later or not-so-useful angels, which makes a lot of sense to me – as he says, few angels nowadays want to lead. But for him, the #1 attraction of this ‘high resolution funding’ is that it means startups don’t have to pre-decide how big a round to raise – instead, you can size it up based on how well angels react.

Of course, you’ve probably already worked out that this is precisely the kind of non-obvious financing trickery the EIS was designed to discourage: to be precise, only common shares held for at least three years in an all-common round qualify (though of course this is not legal advice, read the HMRC guide for yourself), so EIS and Paul Graham’s brave new entrepreneur-centric investment world don’t easily overlap.

And that is where the core problem lies here. While funding is rapidly changing in the US, the EIS supplies a strong disincentive to change in the UK, even though the UK funding picture has changed dramatically over the last few years:-

  • no realistic bank funding (whatever our banker chums say to Vince Cable)
  • hardly any local grants (unless you live in a deprived area)
  • hardly any national grants (unless you happen to be female)
  • unwieldy, overspecialized, glacially slow EU grants (where the size can be exceeded by the bureaucratic effort needed to gain it)
  • regional development funds being dismantled

Hence, R&D tax credits (which are great if your enterprise is just the right size, and with enough PAYE employees) and the EIS are just about the only two bright lights in an otherwise uniformly dark sky. So, it may initially seem somewhat ungrateful of me to say that I think the EIS may currently be turning from a stepping stone into a millstone round startups’ necks. However, it is true insofar as it serves to accentuate the increasing funding gap between the UK angel scene and the US angel scene. In Thomas Homer-Dixon’s phrase, there’s a funding structure “ingenuity gap” here which I think the EIS disincentivizes anyone from filling.

What nobody in the UK government seems to grasp is that things like AngelList (and other routes opening international startup dealflow to US angels) are not ‘high concept theoretical conceits that may possibly become practical in a decade’. They are happening right now, and frankly you don’t have to engage with them for very long to see that they make the UK’s attitude to financing look utterly parochial, utterly dead in its own stagnant water. UK entrepreneurs are now able to jump on a plane and – for much the same cost as, you guessed it, presenting to a single UK angel network – pitch to US angels who they’ve probably already networked with via Twitter, LinkedIn, Facebook, email, etc. And any guesses as to which side of the Atlantic they’d find funding first?

Much as I love the EIS, and much as I understand exactly why the taxman wants to reward equitable investing practices, I can’t help but conclude that the EIS has become one of the things impeding UK startup financing innovation, simply because the startup financing world around it is moving so rapidly. I hate having to say such heresy, but it’s true, every word of it.

Really, if the EIS is the best we can do, what kind of madness would have to take hold of my mind for me to advise a UK entrepreneur in the current climate to pitch to UK angels at all? If you’re building a world-beating company (and you’ve gone just about as far as self-financed bootstrapping will take you), surely your most rational next step would be to hone your pitch until it can slice through a telephone directory at forty paces, network with US angels like crazy, and get on that plane? But then… if the top 10% of UK startups all do this, where next for UK plc?

PS: up until a few days ago, I wondered whether my heresy was just some personal ‘reality distortion field’ affecting my judgment: but chewing the far with other entrepreneurs after Eric Ries’ talk at TechHub helped me realise that no, this is exactly how a lot of other UK startups also read the funding situation. Just so you know!

“Series A, R.I.P.”…?

Doubtless VCs will find some way to disagree (please leave your comments below, I really don’t mind), but I believe that fast growth startupsyou know, the kind VCs are so desperate to get a slice of – should now avoid Series A completely. The Big Things that are So Very Wrong with Series A…

  1. VCs get preference shares, i.e. where everyone who was in before takes a big hit and comes second in any future liquidity event
  2. The process takes so long and costs so much (legals, due diligence, etc) that it has to be for an obscene amount to be worthwhile.
  3. VC funding is hugely expensive, with service charges and top-table directors’ fees to add to your monthly cash outgoings

…have long been believed to be balanced by the sheer weight of the money pile. If your only exposure to business was TechCrunch, you’d be certain that a Series A round sounds like the company has hit a key growth / credibility milestone. But… I think the world has changed so much over recent years that Series A is (almost by definition) redundant. I’ll show you what Wikipedia says about Series A and I think you’ll see why:-

“A typical Series A round is in the range of $2 million to $10 million and is intended to capitalize a company for 6 months to 2 years as it develops its products, performs initial marketing and branding, hires its initial employees, and otherwise undertakes early stage business operations.”

Hence even at the slow end of this model, such startups are looking for (say) $4m to last them 24 months of early stage operations, i.e. burning $167K per month. Circa 2010, the problem with this is that in all but a few cases, product development & customer development are just not that expensive any more.

So on the one hand, thanks to trailblazers such as Steve Blank and Eric Ries, lots of dev people are busy building and bouncing stuff off their customers, pivoting fast to try to fail fast, and persisting down their long-term road to product/market fit nirvana. After all, everyone makes mistakes, but there’s a technical name for people who keep on learning from their mistakes: winners.

While on the other hand, you have an entire VC industry (regardless of whether or not you happen to think it’s moribund etc) dangling big valuations and multi-zero cheques in front of startup execs’ eyes to convince them to build big, go big, stay big: their model of winning is to use money to build a market fortress at speed and get to #1 (or maybe #2 behind Microsoft, if it’s a big enough market and MS is in an acquisitive mood).

So… how can ‘win through learning’ and ‘win through sheer size’ ever be properly reconciled with each other? Personally, I don’t think they can.

I suspect that the new growth path will come from startups building a financial firewall around their IP (specifically their patents) and securitizing it about 18-24 months after their seed round – basically, leveraging a non-VC debt round against market-proven IP. OK, it’s completely true that hardly any Euro bank securitizes intellectual property at the moment: but then again, hardly anybody does IPOs any more either – and both of these are probably just fashions that will change before very long.

Here in Europe, the other big funding angle to watch is what the European Investment Bank is doing, because it is one of those institutions with an awfully big pot of money and a long strategic reach that will probably never scale down to seed level… but mezzanine-level support from it may well be possible.

Finally: here in the UK, unless Vince Cable can quickly devise a way of bribing encouraging more angels to write more (and larger) cheques, there currently seems to be too few active angels to support any substantial UK startup scene (whether seed or early-stage), even with EIS relief (for both downside and upside), and even with Wired going ra-ra-ra about the sector in the current issue. Oh well!

“Funding pivots”…?

Following my post on the absence of a Lean Funding Movement, I thought I ought to at least try to come up with some lean funding concepts, put a bit of thought in. After all, high-concept business models are what MBAs are supposed to be good at devising, right?

The primary constraint on the solution is obvious: sufficient money needs to come into the startup basically before the startup needs it – but the issue is about whether it should all come in while the startup is iterating and learning. After all, it usually takes some time (in Mike Maples’ Jr’s terminology) to carry out “business model discovery”, and so the notion that the startup must have already identified the correct opportunity at the start (as well as its achievable share of that opportunity and its optimal path to achieve that share) in its business plan (Lord ‘elp us all!) goes against the grain of actual startup experience. It’s typically an 80-20 thing: even though knowing 80% is normally enough to take action, it doesn’t mean that you have the other jelly-like 20% nailed to the wall yet (if indeed you ever do manage this).

So, as a startup builds, tests and develops, it zigzags (and occasionally leaps) towards its product/market fit and its market position, both of which it knows only imperfectly at the start: conversely, the problem with business plans is that they almost always gloss over this zigzagging – after all, a typical startup narrative (i.e. repeated failure and delays tempered only by persistence and bloodymindedness) would not be hugely helpful in a business plan, which (after all) is an idealised process towards an idealized end line. So, the question is: how can the contract between angels and startups be made more honest to reflect this?

Firstly, because raising a single round is hard enough in the real world (whatever anyone tells you), let’s try to base a first attempt at a corporate structure for Lean Funding around a single round but with a modified shareholder agreement and modified shareholder behaviour. For the sake of argument, let’s consider a Lean Startup that thinks it needs to raise $500K. But (of course), it doesn’t really know that: for all its spreadsheets, plans and timelines, $500K is still no more than an educated guess – let’s say the figure is broken down into $250K for development, $100K for marketing and $150K of ‘sh*t-happens‘ contingency fund, all based on a post-money valuation at $2M (just because it puts the equity at an easy-to-work-with 25%).

As it develops, however, the startup’s knowledge of what it needs should iteratively converge on more realistic numbers as it moves towards product/market fit: however, what also changes is its “company/angels fit”, i.e. how well the company’s situation sits with its angel backers. It is surely rare to have a Borg-style level of accord amongst your backers – a pivot from (say) a niche strategy to a mass market strategy may leave one or more backers in an uncomfortable place, even if other backers think that it’s a good move.

Let’s say the round raises $500K, but the company puts $300K of it in some kind of escrow – as a ‘lean startup’, it wants to use the first $200K for product development and customer development, and to then give itself the option of making a pivot based on what it has learnt. My suggestion is that the company should then make a matching funding pivot. But what would a ‘funding pivot’ look like? Here are the five basic options I can see:-

  1. “Abandon ship”. If it becomes clear that it’s never going to work, the whole lean startup idea of “Fail Fast” should be backed out to the angels. At least they’ve collectively only lost $200K and 8 months rather than $500K and 24 months: as losses go, this is a big win.
  2. “Stay on course”. Of course, sometimes it so happens that customers really like what you’re doing. So, just carry on as planned. And why not? Release 50%-100% of the cash in the escrow account and take it to the end line.
  3. “Slow down”. OK, this is for when there’s turbulence ahead. Development is going OK, but other confounding market factors are in play. Release (say) $100K to get to the next pivot (renegotiating where possible), and we’ll see how it develops.
  4. “Speed up”. The startup’s big development risks are passed, and the market opportunity is significantly larger than we thought. The startup now clearly needs (say) $800K to go big, whereas there is only $300K in the escrow account. The startup needs a new funding round, but having $300K in the bank is surely a much better point to be looking for more money than if you have $0K in the bank.
  5. “Change direction”. The hardest situation of all – but probably the most honest, because it’s based on much more information than the initial funding round could ever have been. Some backers might want out, others might want to double up, while some might want their share converted from equity to some kind of debt. You can think of all this as a ‘lean’ internal re-funding round, to try to find a better company/angel fit in light of what has been learned.

(…I’ll leave the issue of how such decisions should be made to another post entirely…)

Note that I don’t have all the answers, these proposed “funding pivots” are just my tentative reachings towards a better (and arguably more transparent and financially honest) way for angels and entrepreneurs to do business. If startups iterate, why doesn’t startup funding iterate too?

“The Lean Funding Movement”…

After Eric Ries’ recent talk at TechHub in London, I queued up to ask him the Lean-related question burning on my lips, which is this: because startup guys like me ‘get’ the whole point of Lean Startups, shouldn’t he be giving talks to audiences of angels instead? Without a corresponding Lean Financing Movement to work with inside the angel community, isn’t Lean Startups just a typical technical solution to a social problem (and as such doomed to failure)?

My immediate concern was that of all the 120+ UK angels I’ve talked over the past year, I’d be fairly surprised if more than 3 or 4 knew enough about the Lean Startup methodology to know whether it was a good or bad thing in an investment. All the same, Eric told me that a number of US angels were now actively looking at startups with a Lean eye, and that the number of such angels was growing all the time over there. OK, thanks but… pretty lean pickings as answers go, and not hugely helpful for us in the UK. 😦

I suspect the core problem here is that because the startup funding process has for so long been constructed around the slamdunk / the set-piece goal / the home run / (insert your favourite sport metaphor here), the Lean Startup principle of “tactical pivoting to iteratively learn from customers how to get to product/market fit” is a financial model mismatch. You know – for decades, startup funding has been based around The Big Bet, the build-your-Frankenputer-and-let’s-get-to-the-end-line… in fact, the whole concept of the end line. Startups were essentially mini-casinos for angels, with each table holding an MBA whose (business) plan claimed to have some inside track on the dealer’s (i.e. the market’s) cards.

But take away the MBAs, take away the business plan, and indeed take away the whole concept of an end line, and what should the conceptual basis of lean funding be? Never mind product/market fit as the end-point of the lean learning, what about the angel / lean startup fit at the start-point? What would The Lean Funding Movement look like?

Much as you’d expect, the issue seems to be that we have become so accustomed to big seed rounds driven by lead angels or Series A/B rounds driven by super-angels / syndicates / VCs, we have no practical conceptual model for small rounds driven by entrepreneurs. Yet if startups are iterating in £50K / $75K increments, shouldn’t funding be at this sort of level too? But isn’t that a kind of tranche funding (which everyone sneers at)?

Alas, I don’t have an easy set of answers to cut and paste here: but I do think that this is the right questions to be asking. For me, this is actually the cutting edge side of the Lean Startup Movement – for without any real conception of Lean Funding, what’s the point, what’s it all for?