Non-Linear Growth

A glimpse around the next corner; mind the curves.

November 12, 2009 • 4:04 pm 1

A fun (and potentially infuriating) mental exercise

Every couple of years, I run into this probability puzzle that reminds me just how bad humans are at assessing probabilistic outcomes. Its called the Monty Hall problem, named after Monty Hall, the host of the famous gameshow, Lets Make a Deal.

The puzzle goes something like this.

Suppose you are given the opportunity to choose between three doors. Behind one door is a prize of significant value; say $1 million. Between the other two doors are near valueless prizes. Pick a door, any door.

Now that you have picked a door, the host, Monty, opens one of the two remaining doors, revealing that there is a pile of coal behind the door. The $1 million is clearly still behind one of the doors that remains closed; perhaps the door you originally selected. To make things interesting, Monty gives you the opportunity to switch doors; you can keep the door you selected originally, or switch to the other door that remains closed.

So, do you want to switch doors? Are you better off keeping the door you originally selected or switching to the other closed door. I know what you are thinking; it doesn’t matter right. There is a 50% chance the price is behind the door you picked and a 50% chance it is behind the other door. After all, there are only two doors remaining and you get to pick one. You might as well keep the door you originally picked.

What if I told you that your instincts are wrong and that the prize is two times more likely to be behind the other closed door than the door you originally selected. You’re thinking “Derek is crazy; this non-linear stuff has eroded his ability to think logically.”

Lets start over and try the exercise with 100 doors. You picked 1 of 100 doors; you have a 1 in 100 chance of picking the door with the prize on the first try. Now the game show host opens 98 of the other 99 doors, revealing that there is nothing behind them and leaving only the door you selected and 1 other door closed. Remember, you had a 1 in 100 chance of getting the door right on the first try. That means that there was a 99 in 100 chance the the prize was behind one of the other 99 doors. But 98 of them have been opened with nothing behind them.

Do you see now, there is a 99 in 100 chance that the other door contains the prize and only a 1 in 100 chance that the door you originally selected contains the prize. In the three door example, there is a 1 in three chance the prize is in the door you originally selected and a 2 in 3 chance the prize is behind the other door that remains closed.

Still don’t believe me, this Wikipedia post has a lengthy explanation here.

Our brains just aren’t very good at dealing with probabilities; or the randomness we face in the world. I get a kick out of that and try to keep that in mind whenever I’m making a big decision.

Filed under: Random

November 10, 2009 • 2:22 pm 1

Managing your Board; Give ‘em a job!

In a post last week, I addressed the notion that everyone needs someone to report to. After all, you can’t report to yourself.  The reporting relationship between a CEO and a Board is critical for a Company’s success. That relationship must be based on trust, candor, and transparency.

While that hierarchical reporting relationship is necessary and constructive, it is far from sufficient for a company to succeed in a dynamic, ever-changing emerging growth environment. My view has always been that venture investors (and Boards more generally) need to get “on the same side of the table” with entrepreneurs and work with entrepreneurs (shoulder to shoulder) to create value. The burden of making this work is clearly on Board members, but there is much a CEO can do as well. As my Partner Jack Tankersley is fond of saying,

The CEO has to give each Board member a job.

It is my experience that Boards are often left unmanaged by CEOs and that an unmanaged Board is a dangerous Board. When smart people (the kind you typically find on venture-backed boards) are left unmanaged, they manufacture activity, because they don’t know what else to do. They create their own “job definition” whether it is aligned with the needs of the company or not. The risk for a CEO is that an unmanaged board can run roughshod over an entrepreneur. What is a CEO to do?

First, a CEO must view his/her Board as a set of tools to utilize. This starts with understanding the skills, capabilities, and relationships your Board has. Identify the strengths and weaknesses of each board member and figure out how to use their strengths to the Company’s advantage.

With an understanding of those resources in mind, a CEO can then give each Board member a job. In other words, define the Board members job and make it a job that they are both likely to enjoy and succeed at on your behalf. Here are a couple of examples:

  • A Board member with a deep Rolodex with potential strategic partners can be assigned to work with the Company’s business development team to generate new biz dev activity.
  • A Board member with a penchant for strategy and planning can be given the responsibility to help the Company prepare for an annual strategic planning exercise.
  • A Board member with a skill in shaping discussion might be assigned to facilitating Board level discussion.

Think about it this way; would you hire an employee without telling them what their job responsibilities are? Of course not! So apply the same management discipline you apply to your employees to your Board. The effects can be really constructive. By assigning tasks, Board members become accountable to the Company. They are forced to work with and for the CEO to help accomplish a task, ensuring alignment. This also sets boundaries for each Board member. By signaling what you want to them to work on, you also signal what you don’t want them to work on.

So if you are a CEO having a difficult time managing your Board, take this simple advice: Give each Board member a job. Your Board will be much more productive as a result, your Board members will be happier because they will know how to contribute, and your Company will be better off.

Filed under: Boards, Lessons Learned, Venture Capital, ,

November 10, 2009 • 12:48 am 2

The math of SaaS revenue growth

A conversation with the CEO of a SaaS company today reminded me of the importance of the rule of 78s. What is this “rule”, you ask. If you run a recurring revenue business, it is the most important number you have never heard of.

Back to my conversation with the CEO. We were talking about the use of proceeds for the financing she is trying to raise. In her case, the business is break-even, but has the opportunity to grow into some oncoming market demand. So I asked a classic VC question; “Assuming you close the financing in Q4, 2009, what will your 2010 revenues be?” Simple question right?

Lets say that this company ended 2009 with $3 million in run-rate revenue and that the Company has two sales reps. Each sales rep. has a quota of $10,000 of incremental monthly recurring revenue (“MRR”) bookings per month. Sales reps. historically produce at 75% of quota in this company, so the incremental new bookings per month, per rep is $7,500. At its current level of sales and marketing resource and productivity, this business can expect to generate $1.17 million more in revenue in 2010 than it generated in ’09. To get there, just multiple the $15k per month of incremental revenue the two sales reps. will generate by 78. Why 78? Because 78 is the ”sum of the digits” for revenue producing months in a year. Incremental revenue added in January will produce revenue for 12 months; incremental revenue added in February will produce revenue for 11 months; …; incremental revenue added in December will produce revenue for 1 month. The sum of digits for 12 is: 12 + 11 + 10 + … + 2 + 1 = 78. So the baseline revenue projection for 2010 should be about $4.17 million.

Now lets talk about the enhanced growth opportunity. The Company wants to hire two additional sales reps. who can be expected to produce at the same $7,500 of MRR as the two existing reps. For purposes of the example it will take a quarter to recruit and hire the two new reps and another quarter for them to build a sales pipeline given the sales cycle. Conservatively, these two new reps. won’t begin generating MRR bookings until June. Lets say there is a one-month install cycle so that June bookings convert to revenue in July. So what kind of incremental growth will these reps. generate in 2010? We don’t get to use the rule of 78 this time; no, because these reps. will produce for only six months during 2010, we use the sum of digits of 6, which is 21. That is a lot less than 78; that six month delay between making the decision to hire two new reps and getting them on board and productive really hurts. In 2010, the two new reps. will generate only $315k of incremental revenue. The business can be expected to generate $4.485 million of revenue in 2010; not meaningfully more than the base scenario without additional investment.

While this looks like meager growth, it doesn’t tell the whole story. Remember, this business came into the year with a $3 million run-rate. Without hiring the two new reps, the business should end 2010 with a run-rate of $5.16 million. By hiring the two new reps. that can be increased to $6.24 million, even though the two new reps. are productive for only six months. That incremental run-rate of over $1 million makes a huge difference and sure makes hiring the two new reps. look a whole lot more attractive than the meager incremental revenue they will generate in 2010.

Here are the key takeaways:

1) Get the Base Right: Recurring-revenue businesses are great because they are highly predictable. Applying the rule of 78s and with a little understanding of your sales resources and their productivity, you should be able to estimate your baseline next year revenue with a high degree of confidence.

2) Scaling Takes Time: The most common mistake I see recurring-revenue entrepreneurs make it to underestimate the time it takes for increased sales and marketing resource to impact the top-line. Hiring new sales people today probably won’t move the needle on your next twelve month revenue. More likely, an investment in sales and marketing won’t have meaningful impact until the following fiscal year.

3) Run-Rate Matters: You will see the impact of an investment in sales and marketing in run-rate much faster than in top-line GAAP revenues. If you are asked about what your revenues will be next year, answer the question directly, but also include a description of the difference in the run-rate you expect to end the year with under the no-growth and growth scenarios. The run-rate difference will impress much more than the top-line difference.

By the way, the CEO of the SaaS company I was speaking with got this analysis dead-right. Well done!

Filed under: Economics, Lessons Learned, SaaS, Uncategorized, Venture Capital, ,

November 6, 2009 • 1:38 pm 4

You Can’t Report to Yourself

Everyone needs someone to report to; even VCs.

This may sound strange coming from a VC. Some entrepreneurs who choose to raise venture capital have great disdain for the necessary evil of reporting to their investors. That disdain is appropriate to the extent investors are asking for mundane information that creates a reporting burden and does not add information necessary for critical board decision-making. But entrepreneurs that cross the line and don’t like to report because, well, they don’t want to report to anyone, are making a great mistake. There is no excuse for not wanting to stand and be counted; no excuse for not wanting to answer difficult questions; no excuse for not wanting your thinking challenged. I once interacted with an entrepreneur who chose another investor over us because, “we understood the business too well”. Apparently this entrepreneur thought my understanding of his business would be a “burden”.

VCs have someone to report to; Limited Partners and Advisory Boards. Yesterday, my Partners and I reported on our progress here at Meritage Funds to our “bosses”, our Limited Partners and Advisory Board, at our Annual Meeting. In a series of sessions, we stood and were counted; we answered difficult questions; our thinking was challenged. In presenting our progress, we strive for transparency and to give a balanced view to our Limited Partners. We talked about the elephant in the room - the difficult macro-economic environment and the difficult fundraising landscape for venture capital funds. We shared our enthusiasm for the opportunity to invest the capital we have raised in our Fund III and the excitement over the opportunities we are currently evaluating. We talked about our failures and the lessons learned. We talked about the challenging spots in our portfolio as well as the upside opportunities. And most importantly, we told our bosses what we were doing to capture the opportunities we’ve created and what we are doing to minimize the risks we see. The picture we drew was not all rosy and bright, nor dark and depressing; it was balanced. In addition to the annual in person meeting, we send written quarterly reports, have quarterly Advisory Board meetings, and a semi-annual conference call that all Limited Partners are free to attend.

We don’t report to our Limited Partners and Advisory Board because we have to, although we do. We do it because it is a good and valuable discipline. If we could convince our investors to gather quarterly, we would be thrilled. The process provides us with the opportunity to record and contend with the facts; to deal with harsh reality; to account for decisions we have made in the past, and to explain and justify what we are going to do next. For us, this is a valuable exercise; one we cherish. The feedback we receive is invaluable and helps to shape and reframe our thinking in constructive and positive ways.

Many entrepreneurs share this view. Such entrepeneurs use their Boards of Directors as sounding boards. They report with transparency and share not only what they have accomplished, but also where they have failed. These entrepreneurs cherish the opportunity to stand and be counted. I like this kind of entrepreneur. They understand that you need someone to report to; and that you can’t report to yourself.

Filed under: Boards, Lessons Learned, Venture Capital, , ,

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