Non-Linear Growth

A glimpse around the next corner; mind the curves.

September 1, 2011 • 9:59 am 0

One Surefire Way to Screw up Your Lifestyle Business

Some businesses are designed – maybe even destined – to be owner operated. Industry parlance often refers to these businesses as lifestyle businesses. Wikipedia has a nice definition. They are typically small, profitable, generate cash and enable their owner-operator to sustain a well-above average lifestyle. In some circumstances, they may even make their owner-operator filthy rich over time.

Some people may think that the term lifestyle business is an insult. I couldn’t disagree more. Being the owner-operator of a lifestyle business should be a source of pride; a badge of honor.

As a growth stage investor, I see quite a few lifestyle businesses in our deal log. This type of opportunity finds us because they often meet our high-level screening criteria. They have paying customers, generate meaningful revenue and produce EBITDA and cash every year. They “fit the profile”.

But when I meet with an entrepreneur who is running a lifestyle business, I’m not shy about asking a most important question. It usually goes something like this:

I understand you wish to raise capital to grow your business. But if I’m hearing you correctly, today you own and control nearly 100% of your company. This enables you to lead a balanced life, generate meaningful personal wealth and take great satisfaction from your work. Why would you want to screw all of that up by raising capital?

I mean it too. Raising capital comes with loss of control, changes in lifestyle (read work flexibility) and other issues. More importantly, lifestyle businesses tend to lack one key ingredient that institutional equity investors (particularly growth equity investors) need to generate returns; rapid scalability. Bringing in institutional capital creates an incredible amount of pressure to generate top-line growth. In the context of most lifestyle businesses, that kind of top-line growth is either not achievable or if it is, will so fundamentally alter the character of the business that it will be unrecognizable to the entrepreneur at the end of the process. In short, that pressure will probably do more damage than good from the owner-operators point of view.

So if you are an entrepreneur seeking capital from me and I say something like “You own a great lifestyle business; why on earth would you want to raise capital and screw it up?”, please know I’m coming from an honest place. I’m not insulting you.  I am, however, trying to get you to come to grips with the fact that raising capital may be a surefire way to screw up the good thing you have going.

Filed under: Growth Equity, Investment Selection, Lessons Learned, Raising Capital

August 25, 2011 • 3:54 pm 0

Ignore the Headline

I’m not here to make a statement about the press, although I might be all too happy to get on that soapbox. I’m talking about doing diligence.

We investor types juggle a lot of tasks on any given day and given that time is limited, we have limited time for any one task. This can be a real detriment during the diligence process, which requires concerted effort, open-mindedness and an awareness of our own biases. It is all to easy to pick up on a headline we hear and ignore the story behind it.

When we hear a headline delivered as a statement of fact, we are at risk of taking it as gospel truth, particularly if the statement comes from a trusted source. This is particularly true when the headline confirms our own bias or if the statement is delivered with overwhelming intensity. In either case, we may not take time to understand the story behind the headline. If the headline confirms our bias, human nature is move swiftly to the next task. Likewise, human nature overweights headlines delivered with gusto.

I view diligence as a process of gathering facts, filtering them and making sense of them by applying analytical thought models that I trust. I trust those models more than I trust myself, because I’m acutely aware of my own human biases enough to sequester those biases from the decision-making process. And I don’t trust headlines, because they are written by humans who have their own biases.

So ignore the headline; read the story. Give me the facts; I’ll write my own conclusion.

Filed under: Decision Making, Lessons Learned, , , ,

June 25, 2010 • 2:27 pm 3

Why I’m Contrary on Compensation

When I was a teenager, I spent two summers working in a furniture manufacturing factory. The company, Steelcase, was (and still is) one of the largest office furniture manufacturers in the world. I worked in the binder-bin plant – a binder-bin is the cabinet that mounts on the back of your desk at about eye-level. I assembled the damn things. It was physically demanding (binder bins are heavy) and repetitive work. There was absolutely nothing intrinsically rewarding about the work; suffice to say, I did not enjoy it.

I was well paid though. I received a base wage rate plus a piece-rate, where I was paid an additional amount for each binder bin that I completed. The piece-rate was set based on meticulous analysis of the manufacturing process which determined how many units I should be able to produce per hour. The full-time factory workers, who were lovingly referred to as “factory rats”, were paid under the same scheme. This scheme was intended to motivate higher output on the manufacturing line.

A couple of weeks into my first summer, I figured out that I could improve my output of binder bins, and therefore my compensation, with a couple of tweaks in the process.  During lunch, I shared with some of the factory rats what I had discovered. Their response was not what I expected. Essentially, I was told:

You don’t get it. If you improve the process, management will modify the piece-rate component of our comp scheme. We’ll have to make more units to get the same total compensation. You’ll only be here for the summer, but we’ll have to live with that change forever. Don’t do it. Don’t ruin it for us.

The factory rats didn’t want to help the Company figure out how to produce more, because they didn’t believe they would receive more compensation for identifying ways to produce more. This was my first experience with what compensation experts call “if-then” rewards. I have been skeptical of “if-then” compensation schemes ever since. If this kind of pay for performance scheme doesn’t work for a mundane repetitive task, imagine what happens when you apply “if-then” rewards to knowledge work.

Established management philosophy treats all employees like the factory rats – with carrots and sticks. That philosophy says “I can cause you to do more of what I want you to do if I pay you when you do it” and “If you don’t do what I want, I will withhold rewards or worse punish you”. This is tantamount to giving a mouse a piece of food for pushing the blue button and shocking it if you push the red one.  The only problem is we’re not mice (or rats for that matter). WE’RE HUMAN and that makes us complicated. Carrots and sticks don’t work.

The first book I read on this topic (many years ago now) was Edwards Deming’s The New Economics. Yes, that Deming, the American-borne manufacturing process guru who helped to usher in Japanese domination of manufacturing process. It turns out that Deming was also a management psychologist who was well ahead of his time. Deming believed that we should abolish performance reviews in the workplace and grades in school. He felt that those types of subjective measurements of performance wiped out the employee’s/student’s intrinsic motivation. The employee’s goal becomes to please management, rather than to do good work. The student’s motivation becomes to get a good grade, as opposed to learn. It turns out that we complicated humans like to do good work and we enjoy learning; we are intrinsically motivated beings; external rewards and punishments get in the way.

Many years later, I’m encouraged that there is finally a new management regime beginning to take hold. It is best summarized in my most recent reading on this topic. Written by Daniel Pink, Drive: The Surprising Truth About What Motivates Us gives a good overview of the roots of our antiquated management/compensation philosophy and the science (much of which has been around for many years) that shows how flawed it is. Pink also offers insight into what we can do to change. To sum it up; pay people what they are worth, give them autonomy in their work, provide them the opportunity to master their craft and create a sense of purpose in the workplace. It is not that hard.

My own experiences, my personal reaction to comp. schemes I’ve had imposed on me in the past and years of reading on this topic (Here are my favorites) make me contrary on compensation. I’m done with carrots and sticks. How about you?

Note: For a good summary of Drive, check out this RSA Animate sketch narrated by Pink.

Filed under: Books, Economics, Lessons Learned, Venture Capital, , , , , , ,

December 22, 2009 • 3:14 pm 0

The make or break fallacy

It seems inevitable that every startup hits an inflection point; a “make or break moment”. There is no path to success that doesn’t include these moments. You have to go through them; they are not optional.

The catalysts that create make or break moments vary. Sometimes the catalyst is external; perhaps the market meeting your product, an acquisition by one of your potential partner’s competitors. Sometimes the catalyst is internal; a great new product release, a partner deliverable. We all know what these moments look like; we’ve all described a moment in time as “make or break”.

The notion of “making” a business in a singular moment is alluring. But entrepreneurs rarely think about the execution risks they will face after they’ve “made the business”; and the fact that there are likely to be future “make or break” moments where they will also have to avoid breaking. For me, ”make or break” is a fallacy. You can absolutely break a business in a singular moment, but rarely can you make a business that way. The only way to truly “make” a business is to exit it, in which case, future execution risk and future “make or break” moments become irrelevant.

Perhaps we should rename ”make or break”. Lets call it a “don’t break” moment. ”Don’t break” moments comes with the recognition that by not breaking, you create opportunity to execute well in the future so that you can see future “make or break” moments where you must also “not break”. If you make it through the gauntlet of multiple “don’t break” moments, you might just have the opportunity to exit the business for a monumental value at some point in the future.

How would you rename the “make or break” moment?

Filed under: Lessons Learned, Venture Capital, , ,

November 16, 2009 • 5:29 pm 1

What is this “momentum” of which you speak?

A meeting with an entrepreneur last Friday reminded me of the most frustrating and overused feedback entrepreneurs receive from VCs:

Talk to me when you have “momentum”; or

I need to see some “traction” first.

With more and more VCs looking to make later stage investments, entrepreneurs are receiving this feedback more than ever. You can understand why an entrepreneur might find this feedback frustrating. If they had massive traction, they probably wouldn’t need VC money, or if they did, the deal should be priced at a much higher valuation. That said, the real issue with this feedback is that it triggers a conversation about the definition of momentum. Entrepreneurs complain (rightly so I might add) that the VC definition of momentum comes in the following forms: 1) VC defines momentum by saying; ”I know it when I see it”, 2) VC gives a milestone as a proxy for momentum that if achieved means that the entrepreneur will no longer need capital, or 3) VC gives a milestone but moves the goalposts once the milestone is achieved. Fundamentally, these are all non-answers and don’t serve the entrepreneur particularly well.

I’ve tried to take a different approach. I’m not smart enough to define momentum for every business, so I don’t bother trying. In-stead, I try to work with the entrepreneur to describe the value creation engine of the business; the mechanics through which value is created. With those mechanics defined, investors will get excited about just about any business for which the process of igniting that valuation creation engine is both replicable and scalable.  I lay it out as follows.

Identify the value creation engine for your business

Generically speaking, the value creation engine links the time, energy and capital you invest in the business to the measure of output that you think will be used to value the business at exit. The measure of output you choose depends on the type of business you are building. If your business is about aggregating eyeballs and monetizing them, then you will likely be valued based on unique visitors, users, user engagement, and the “potential” monetization of the audience. For more mundane businesses, your value creation engine may be revenue generation and eventually your ability to generate profits. If you can’t articulate the linkage between time, energy and capital and the value creating output of measure for your business, then you haven’t figured out your value creating engine. For example, wouldn’t it be great to say:

Based on experience thus far, a new account rep. will begin producing between $5k and $10 of incremental monthly recurring revenue within six months of their data of hire.

Make the value creation process replicable

Understanding your value creating engine implies that there is both a process in place to create value and a causal relationship between time, energy and capital and the desired measurable outcome. If there is causation, then the process for creating value is likely replicable; if I do X, then Y. If I do X again, then Y again.

When something is replicable, a measure of control is implied. For my part, I like businesses where the company is in control of X; more sales people, more marketing, more channels, etc. Businesses that rely on “viral” effects where the company has little control over the creation or velocity of the viral process are more difficult for me to get my head wrapped around. If I can’t control X, why should I believe X will continue to turn into Y?

Show that the process is scalable

Some value creation processes have rapidly diminishing productivity curves. The more input you give the process, the less productive the process is in generating output per unit of input. What I’m looking for is a value creation process where I can add a significant amount of additional time, effort and capital as raw material without diminishing the returns on investment; that is scalable. If I add five more sales people, I generate 5 times more leads, which turn into five times more sales, etc. You don’t have to prove this, but you should be able to make a compelling argument for why the process is scalable. A really big market with lots of customer prospects really helps. I’m more likely to believe your valuation creation engine scales in a big market than in a small one.

Entrepreneurs should not be deluded into thinking that there is some magic threshold number that once crossed will enable you to raise huge sums of money. Businesses that have a replicable and scalable value creation process make for attractive investments because additional capital is fuel on a fire that is already lit. In a market where investors are more risk averse than ever, these businesses are the ones most likely to capture the attention and imagination of investors.

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

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