Category: Entrepreneurship

EntrepreneurshipVenture Capital

On performance based earnouts

Posted on by Ed Sim

I am sure you remember the ebay-Skype deal where ebay coughed up $2.6b upfront for Skype and offered an earnout of up to another $1.7b for hitting performance numbers.  Besides the value of the deal, what struck me most was that 40% of the total potential deal size was based on performance-based milestones.  Fast forward 2 years later and in the day of reckoning it seems that eBay is only going to pay $530mm of the $1.7bb earnout (see Eric Savitz from Barrons post and press release).  I am not going to comment here on whether or not the Skype deal was a complete failure for eBay, but rather I thought I would more importantly share my thoughts on earnouts in M&A transactions.

Quite simply, be wary of performance based earnouts unless you get significant value upfront.  Many times an acquiring company may say that they can’t pay higher than a certain value for your business but if you perform they can pay alot more.  In other words, they want you to put your skin on the line and also incent you to stick around.  That is fine as long as you get more than enough upfront for your business so that any dollar from earnouts is just pure upside.  If you feel that you are not selling for enough and that too much is tied in the earnout, then trust your gut and either rework the deal or walk away. 

Earnouts in theory sound great – the better you perform the more you get.  However in practice it doesn’t always work out well.  First, earnouts could potentially put the acquiring and target company at odds by creating potential perverse incentives for the acquiring company.  Hmm, the company I just bought is doing great but I don’t really want them to hit it out of the park just yet so I may delay giving them their marketing dollars?  You can obviously think of a bunch more examples on this front.  More importantly, though, I feel that unlike a startup, you have relatively little control of your own destiny.  In any M&A with performance numbers, the acquiring company will say it is offering all of these resources and distribution and therefore the revenue, profit, and customer targets should be quite high yet attainable.  In a startup, if you fail it is your fault.  As part of an operating business or larger entity that isn’t always the case as you are most likely dependent on the acquiring company for resources, distribution, and cash to grow and deliver on your promises.  Big companies move slow and you are more likely to not get the support you need in a timely manner meaning that realizing your earnout becomes a very tough proposition.  Even thinking about the ebay-Skype saga, I can remember reading the countless news items and stories about how the 2 cultures clashed, how ebay did not understand the Skype business, and the management changes and reorgs that took place.  All that being said, I am sure the investors are bummed about leaving another $1.2b on the table in earnouts but at the same time they are still ecstatic about the initial $2.6b they received upfront.

Entrepreneurship

Too many chiefs, not enough indians

Posted on by Ed Sim

Before I dive into this post, I want to apologize to those who may be sensitive to the non-PC nature of this. Anyway, as always, I have met and spoken with a number of startups during the past week.  There are obviously all different types of companies with different funding needs but the ones that have stood out negatively for me are the startups that come in with a pre-baked senior management team and no product.  In other words, I have major concerns when I see SVP of this and SVP of that and I wonder to myself who is going to do all the work if everyone is a Senior VP.  When there are too many chiefs and not enough indians, I worry about how decisions get made and wonder if egos and titles are more important versus getting product out and customers on board.  Sure, some of these teams were quite impressive but in a startup environment keeping your burn low until you get your product in the market and refined is imperative.  In addition, more often than not, business models may change slightly or drastically and what you initially set out to build and deliver may not be the same in the future.  What that means is that your SVP of Marketing may not the be right person 12 months from now.  So do yourself one favor when starting a company-get the right people on board to get the product delivered and the first few customers and as you get feedback from the market and your team, figure out your next hiring needs.  Don’t worry about titles and focus on building an insanely great product.  Having too many chiefs and not enough indians can burn lots of dollars and also scare away potential investors.

Entrepreneurship

Board meeting advice

Posted on by Ed Sim

Over three years ago, I wrote a lengthy post on how to run a great board meeting.  And after having been at a few board meetings in the past couple of weeks, I was reminded again of one of the most important rules of running a great board meeting – be prepared and make sure there are no surprises for you and for the board members.

Here is an excerpt from that post:

1. Be prepared: Board meetings are like theater. Like any play, I expect the CEO to have a well thought out and scripted agenda for the meeting. The most efficient way to do so is to lay out an agenda and get feedback pre-meeting from the other board members to ensure that the board covers appropriate topics and allocates the right amount of time for each one. From an update and preparedness perspective, the CEO should always go into the meeting having a complete understanding of where the various board members stand in terms of any major decisions. There should be no surprises. This means that the CEO should have individual meetings and calls in advance of the board meeting to walk each director through any decisions that need to be made and the accompanying analyses behind them.

If all you do is follow this advice then I can guarantee you that your board meetings will run more smoothly.  As for my point on board meeting being like theater, my thought here is that I really believe that much of the work between active board member and CEO happen behind the scenes and not at a board meeting.  Regardless of your viewpoint, I suggest leaving ample time for pure discussion.  The best board meetings that I have attended are loaded with discussion on various key strategic issues and the worst are ones where we are expected to view powerpoint slide after powerpoint slide for simple updates.  If you are interested in hearing more about my thoughts on board meetings, I suggest reading my earlier post.

EntrepreneurshipVenture CapitalWireless

Learning lessons from Amp'd Mobile

Posted on by Ed Sim

I am not here to pile on the Amp’d Mobile situation, but I find it is always important to learn as much as you can from your mistakes and from other people’s mistakes.  Rafat Ali has a great interview with Peter Adderton, the former CEO of Amp’d Mobile.  Here are a couple of interesting points that Peter says helped to ultimately bring the company down:

— You don’t raise $400 million in 18 months by spending time inside the office. Trying to ambiguously raise that amount of money, while at the same time trying to create something new and different was a challenge that caught up with us in time.
— On the financing, we were learning as we went along. With the amount of cash that we required, it probably made more sense to go with one or two big pockets than a lot of smaller pockets.
— The biggest struggle I had [with the board] was agreement on where the company should go. We had way too many board members and then we had observers at top, and the any partner could dial in, to a point where it became very difficult for the management to manage.

Rather than dive into some of the operational or economic lessons like how a company that raises $400mm can’t get to profitability, I thought I would focus more on the financing side that Peter discussed with Rafat.  In short, some of the lessons learned from Peter include having too many investors and too many board members.  One VC once told me that having a great board did not guarantee success but having a bad board can almost certainly guarantee failure.  Speaking from personal experience, it is pretty easy to see how differences in strategic direction and plans combined with egos can get in the way of real productivity.  The more people you add to the mix and the more complicated and time consuming it can get.  In fact, I remember spending at least 3/4 of my time on one of the weak boards dealing with bickering between other board members instead of spending my time helping management and focusing on the important issues.  The CEO also had to spend just as much time massaging egos and different incentives to keep driving the company forward.  At times, It was close to impossible for the board to come to agreement on a budget, hiring plans, and strategy and ultimately the company missed many opportunities.  I can only imagine what Amp’d board meetings were like when you mix in a number of VCs, hedge funds, and strategics, all of whom invested in different rounds at different prices and with different preferences.  So one of the lessons to be learned is to choose your partners wisely and less is more.  Rather than try to spread out ownership of your business with lots of investors so one or two don’t have too much control, you are better off looking for a couple of investment partners who share the same vision of the business and who you believe will act rational through both good and bad times.  This is where references can help tremendously. 

One other point, every second you spend fundraising is another second you are not running your business.  Companies have to be well prepared and go through a number of meetings to raise $5mm let alone $400mm in 18 months. It is not hard to see how the CEO and management can get distracted and not spend enough time on operational issues when they are constantly raising capital. And of course, the more money you raise, the bigger the exit you need to get investors their 8-10x.  I am not saying this happened in the Amp’d situation, but when capital is abundant and the pressure to create significant returns exist, it can force companies to try to get big fast and try to spend their way to success instead of finding the right mix of organic and inorganic growth.  That is why I have always loved capital efficient business models.

Entrepreneurship

What kind of customer do you have?

Posted on by Ed Sim

I was in two board meetings recently, and I was shocked at myself when I seemingly gave contradictory advice to two companies.  On the one hand, I told the first company to do whatever it takes to land that big account for the quarter, and on the other hand, I told the second company to push harder for a higher price or to walk away.  Shouldn’t you always do whatever it takes to land a customer and continue building the pipeline?  Yes, in theory, but at the same time you have to understand what kind of customer you have: is it a good customer or a bad customer.  While there is no perfect definition for these two types of customers, let me give it a try.  In the first portfolio company’s case, the good customer we were going after was going to be a marquee win and great reference for future prospects down the line, would help us validate our technology and team in a head-to-head competition vs. the big incumbent, and finally would be a repeatable sale where we could take and package our software to many other prospects.  In that case, we told the company to be aggressive in order to land that customer, including giving it away for free for a short period of time to get that first big win.  The great news is that we landed that marquee customer and did not have to go the free route.  Ideally a good customer is also one that is profitable.  In this case, even though the first marquee win may not have been profitable in year 1, we were able to see future profitability down the line from expansion opportunities in the existing account and from that customer serving as a great reference and industry leader in helping us close other deals.

A bad customer is clearly the complete opposite of a good customer – one that requires too much one-off customization, is not a marquee account or potentially a great reference for future sales prospects, and ultimately an account that does not lead to repeatable sales.  In addition, bad customers for the most part will be highly unprofitable as you will probably spend way too much time on the account trying to make it referenceable.  So in the second portfolio company’s case, given that we had a bad customer, I told them that we should go back to them to charge more to at least make some money from the current deal or walk away.  Ideally, if it is a bad customer, you may just want to walk away altogether to go find that good customer which will lead you to many more great opportunities.  Starting your company with a handful of bad customers can kill your business so be ruthless with your time and carefully assess what kind of customer you are about to close.

EntrepreneurshipVenture Capital

Don't forget to look at venture debt when raising a new round

Posted on by Ed Sim

We all know the story – it is incredibly cheaper to start a web-based business versus 5 years ago with the rise of open source software and commodity servers.  However, while getting started with thousands of users is cheap, scaling to significant numbers will require some dollars.  The good news for you and for venture investors is that your buck can go alot further today versus yesterday not only because of the commoditization of infrastructure but also because the venture debt market is alive and kicking.  In the last six months, we have augmented some of our existing venture financing with venture debt as the market has become quite competitive which means pricing and terms are getting more attractive for  all of us.  In addition, while most associate venture debt with investments in companies with core technology, more and more venture debt firms  are back and willing to offer capital to earlier stage web-based companies with  no  financial covenants and MAC (material adverse change) clauses.   Of course the more flexibility you have with respect to uses of cash means that pricing will go up.  All I can say is when evaluating your company’s cash needs and potential runway, looking at the venture debt market is not a bad idea.

There is also another market metric that is driving a renewed interest in web-based companies for these lenders- they are getting funded by VCs (venture debt lenders mostly like to do deals with strong financial sponsors which increases their likelihood of getting paid back) and these startups are better able to manage their burn rates reducing risk and offering lots of upside.  Sure, while some of these venture debt firms recognize that web-based businesses may not have as much hard and true intellectual property, the fact that they are more capital efficient and can scale more rapidly means they can also generate pretty nice returns from the warrant portion of their deal.  Getting in earlier also allows these venture debt firms to buy more of the company from a warrant perspective than getting in on later rounds.  The trick for entrepreneurs is to look at bringing on debt concurrent or soon after your close of equity financing. 

Why can raising venture debt be great?  It is quite simple –  the dollars are relatively cheap compared to an equity financing  and extending your runway to hit more critical milestones means a potentially better valuation for your company down the road.  And of course if you exit before raising another round, there are more dollars available for the equity holders.  A typical structure for an early stage deal could be an equity raise of $3-5mm with another $1-2.5mm of debt.  From a pricing and terms perspective, you should look for capital which is flexible in terms of use for true  growth capital (growing your business) with no financial covenants or MAC (material adverse change clauses) which can put more risk into the debt equation.   Of course, the more flexibility you have, the higher the interest rate will be relative to other types of loans. Most venture debt deals will have an interest only portion for a short period of time before amortization (monthly payments of principal and interest kick in).  Typically you will see terms of 30-36 months where your lender will get paid his full portion of the loan and interest by that time frame.  In addition, lenders will ask for warrants equal to a percentage of the dollar amount raised (for example, depending on the deal, a 5% coverage for $1mm could be equal to $50k of equity to be purchased at the current share price).

All is not rosy as there are some potential and hazardous downsides to this model.  If you burn through your cash and can’t make the monthly principal and interest payments, your lender can take over your company as their debt is usually secured against your company and intellectual property.  Trust me, a number of companies got burned with this during the Internet boom when their businesses were based on wildly inflated revenue projections and unilimited capital resources.  Just when you needed another month or two to sign that strategic deal, the venture debt guys would come in and pull the rug from under you.  Granted it is not that bad as your lenders are your partners and will negotiate with you, but at the end of the day, if they see their ability to get paid in significant jeopardy, they will do what they have to do to recoup as much value as possible.  For some investors and entrepreneurs, this risk may not be worth the dollars.  For others who are confident in their execution and ability to raise another round, there is no better way to stretch your dollars in the company and create more value with minimal dilution.  So the next time you hear the word "debt," don’t be scared and keep an open mind as you may be able to stretch your resources further and achieve some additional critical milestones driving increased value in your business.  The interest in web-based businesses is there and the competitive market means that pricing and terms are pretty attractive now.

Entrepreneurship

Transitioning from startup to growth phase – don’t be afraid of process

Posted on by Ed Sim

As an early stage investor and board member of several companies, I am fortunate to get the opportunity to work with some great entrepreneurs and also pattern match and observe trends, both good and bad, in early stage companies.  I am not here to throw platitudes at you but simply to share an observation of the differences between some of the better run companies and the ones that have less than stellar execution.   In one portfolio company, we had some of the standard issues of coordinating product management with engineering and balancing sales requirements with engineering priorities.  Having a company operate solely in departmental silos is like having each body part with a different brain-sure it is your body but it is also hard to move fluidly if each body part is moving in a different direction.  As I spent time with management, I quickly recognized that there was no real communication of company goals and awareness of what each department’s priorities were.  This is a standard problem I have seen time and time again as companies transition from startup and initial product development to company growth and expansion.  There is no panacea for turning things around overnight, but I can assure you that layering the proper amount of structure and organization is an important element in improving cross-functional communication.

What makes a startup team great early on in terms of getting product out the door and rapidly refining and honing the product from live market feedback can also lead to issues down the road if companies and employees are managed on a similar basis.  What is easy to roll out in a 5 person company gets harder to manage in a 25 person and even harder in a 50 person company.  Take the test – ask your key executives what the 3 key company goals are for the month?  Are they the same or not?  How will they help contribute in each of their functions to delivering on the 3 key company goals?  If they are not on the same page and you have trouble getting them together, you may want to continue reading for some thoughts on how to improve communication and accountability.

Here are some simple steps you can take to create a more fluid organization.  First, institute a weekly management meeting.  Yes, like you, I have an allergic reaction to the word meeting, but believe it or not, simple processes can help tremendously.  It is a great way for the CEO to get input but also guide the team to focus on the same company goals for the month or quarter.  Secondly, have key team members provide a weekly dashboard report and list of key goals to accomplish for the following week.  At every weekly management meeting, have each team member discuss progress against his/her team’s goals and what they will be working on for the following week.  How does each of the departmental goals contribute to helping the company meet its goals?  Once again, this all may seem simplistic and a giant waste of time versus managing the next product release, but you will be amazed at the number of companies I meet that have not gotten to this point and consequently seem to have different ideas of what the business is and how to get there.  In addition, having weekly management meetings and clear weekly goals with simple yes/no criteria goes a long way towards creating an action-oriented culture of getting results.  If a VP doesn’t deliver consistently, all of the other executives know and they also know it is time to make a change.  No one wants to be the manager that is known to overpromise and not deliver.  There is also a real difference between a manager having weekly individual meetings with their CEO vs. openly discussing theirr priorities and completed tasks with their peers.  With respect to cross functional communication, rather than complaining about engineering, for example, sales and marketing can now understand engineering priorities and what it may take to adjust and rearrange some of them to meet the revenue targets for the quarter.  Trust me, there are many more factors to a company’s success and failure, but please don’t make an allergic reaction to scheduled meetings and a simple lack of organization your cause for execution problems.

EntrepreneurshipWeb/Tech

What a Microsoft-Yahoo deal would mean for startups

Posted on by Ed Sim

The rumors of a pending Microsoft-Yahoo deal are out in the market again today (see NYPost and Techmeme).  Who knows if it will happen but rest assured if it did, Microsoft would be in a pretty good position to take on Google with Yahoo’s user and advertising base combined with Microsoft’s strength in development tools and aggressive strategy to go grassroots and emerge as the platform of choice to build next generation web sites and applications.  All that being said, let’s take a moment to think about what this would mean for entrepreneurs.

It is pretty clear what is happening in the market today – Google is dominating and the Internet advertising game is a game of scale.  The bigger you are the more opportunities you have to increase your lead – more users equals more data equals better targeting equals more money per click.  In addition with lots of inventory and excellent targeting, it is easier to attract more advertisers.  And as we all know, much of this whole Web 2.0 (yeah-I hate that term) world is based on advertising, advertising from Google AdSense and other partners.  Why not outsource your whole ad sales team as you can get a pretty good deal from Google without any operating expenses?  If you do the math, startups really do need a fair amount of traffic to merit hiring its own internal ad sales team.  Consequently, we have seen tons of web startups launch over the years as it is really cheap to build a web-based product and costs no upfront capital to start generating revenue. 

I am not sure about your own analysis but based on a number of portfolio companies, I can tell you that Google Adsense delivers the best results bar none in terms of generating revenue.  In a world without a combined Microsoft-Yahoo, it is pretty clear that Google will only get stronger leaving it with a virtual monopoly in the online ad game.  And as you know, monopolies over time take advantage of their position by changing pricing in their favor.  I am sure every company that is generating money from Google Adsense worries about the day when the revenue splits could change.  So on the positive side, a combined Microsoft-Yahoo would hopefully give startups another real alternative to Google Adsense as the combined entity would have real scale like Google and therefore the ability to deliver Google like results.  On the negative side, a combination would mean that there is one less aggressive acquirer on the market. So if the Internet ad game is one of scale, you can bet that in the future there will be a high likelihood of further consolidation. What this means is that entrepreneurs who are starting companies to be acquired better think twice as their chances of winning the lottery will diminish with time.  What this also means is that entrepreneurs need to start companies for the right reason and focus on building a real business versus the quick flip.

EntrepreneurshipWeb/Tech

From Web 2.0 to Business 2.0 – MySpace pulls Photobucket videos

Posted on by Ed Sim

The alarm bells are ringing in the web world (see the Techmeme discussion) – one of the gorillas in the space is flexing its muscle and protecting its turf as MySpace is preventing Photobucket photos and videos from appearing on its site.  As Om Malik mentions, this happened once before and I am sure the MySpace folks have done some hard thinking about whether or not their users will vote with their feet and leave, and if they do, what kind of impact it will have on its business.  I guess they figure it won’t be too large of an impact for them.  Anyway, all of this is not a surprise as this is the way business works.  Forget about Web 2.0, this is Business 2.0 (ok, someone else already has the trademark).  The world of openness is only open so much because if you get to0 big and threaten someone’s turf and livelihood, guess what…they will fight back.  I put a timely post up two days ago titled "Why Startups Must Control Their Own Destiny."  The point is that the only person you can really rely on is yourself and in this world of mashups, widgets, and open APIs, distribution is easy…getting money is hard.  Well guess what-distribution via widgets on MySpace was relatively frictionless, but now that Photobucket is a serious player, the Gorilla is fighting back and that is just the way the world works.  I am not saying that you should not leverage free distribution, but that you should prepare yourself for the day that it may disappear.  In one of my portfolio companies we have a saying, "Google giveth and Google taketh away."  The point is you should take a hard look at your business, and if you are too dependent on any one partner or distribution method, you should stay awake every night thinking about how to diversify your business.  And for those who built their business off of one partner and think they are worth hundreds of millions or billions of dollars, I can assure you that if that one partner is not buying you, there will be appropriate discounts paid to your business based on the fact that the acquiring company’s competitor could shut your lifeline off tomorrow.  Yeah, this is nasty stuff, but this is business and companies need to make money.

Entrepreneurship

Why startups need to control their own destiny

Posted on by Ed Sim

I was in a board meeting last week, and as we reviewed the results one item quickly jumped off the page – the company did a great job signing up a couple of Tier 1 partners but a less than stellar job driving results.  This was not surprising as what happens more often than not is that we can get caught up in the thrill of the chase, signing a big deal for example, but forget that the real work begins after the deal is inked and the press release hits the wire.  Signing a deal in and of itself does not bring on any new customers and the more successful startups understand that.  The teams that can drive successful relationships keep pushing its larger partner, putting together a plan with expected goals, driving implementation, creating product literature for the new partnership, offering new ideas, asking for marketing dollars, and coming up with new innovative campaigns to drive adoption.  They just make things happen and are just as relentless after the deal as they were before the deal was signed.  The less successful teams will let the big partner move at its own pace, dictate the terms, and wait for them to take the next step.   

This brings up another interesting point.  Even if you follow the steps above, this does not guarantee success.  Big companies move slowly and often change their minds.  A relationship with a big company will surely take time and cost you money whether in upfront dollars or expenditures on resources.  And while we would all love to build our business off the back’s of other brands and distribution, at the end of the day, in order to create a big winner, it is imperative for startups to control their own destiny.  This means that your business has to be able to grow organically and not have its fate fully dependent on its partners.  What this means is that first and foremost you have to have a killer product, one that people love, can’t live without, and share with others.  In this new world of mashups, open APIs, and widgets, startups can easily get distribution.  Getting customers and revenue is a different story altogether.  Remember, distribution doesn’t matter if people don’t use your product or service so start with the basics and figure out how to make your product a must have that someone will pay for.