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Early Stage Startups

User Manual: The Early Stage Startups I Want To Hear About Most in 2016 and 2017

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Vasco da Gama Bridge - Lisbon, Portugal. Image Credit: Tasha S. K. Aoaeh (2010)
Vasco da Gama Bridge – Lisbon, Portugal. Image Credit: Tasha S. K. Aoaeh (2010)

At KEC Ventures, I have been largely focused on finding and meeting the founders that we can become most excited about and partner with. I will continue to maintain that focus over the course of 2016 and 2017.

Here are some notes for the founders of the startups I am most eager to meet.

About KEC Ventures

We are a team of early stage investors based in New York City. We invest in information technology startups that are pursuing business models with the potential to transform the way business is done in their market. In such startups, we generally invest in the first institutional Seed Round or, less frequently, we will invest in the Series A round of financing. Often, but not always, we act as the lead investor. On rare occasions, we might invest earlier than this when we meet a founder pursuing a vision that we believe in. Currently, we focus on investing in startups based in the United States or Canada.

Connecting With Me

If you know someone who knows me, an introduction would help. If you do not, never hesitate to communicate with me directly. I am easy to reach on the major social networking platforms. Also, I hold regular and frequent office hours at various co-working spaces in New York City. Some allow non-members to sign-up and attend.

The best time to start communicating with me is at least 6 – 9 months before you believe you will raise a round in which KEC Ventures might invest because I believe it is important to build trust before entering into the kind of working relationship that exists between startup founders and their early stage investors.

That also gives me sufficient time to understand the problem you are solving, so that if we invest, we are doing so with conviction. Time enables me to become a more effective advocate on the startup’s behalf when my colleagues and I have discussions about making an investment.

Communicating With Me 

If we are not meeting through an introduction, I will respond quickest to founders who get straight to the point, and explain why we should meet in 250 – 400 words in their first email to me. I try my best to respond. However, depending on what else I have going on, I may not respond if I feel the startup is outside KEC Ventures’ areas of interest and that the founder could have easily found that out before emailing me. Please follow up with me once or twice if you believe I have made a mistake.

If you are not connecting with me or anyone else at KEC ventures through a warm intro, you can email me at: pitch@kecventures.com. I’ll go through submissions to that email address every Friday.

Characteristics I Look For in Founders, and Teams 

I look for teams in which the founders have known one another for a considerable amount of time prior to launching their startup. I look for teams in which the level of trust and respect between the co-founders is high. I look for teams that will not have difficulty attracting other great people to join the startup. I look for founders who inspire confidence and loyalty from others because they are good at what they do, the kind of people I could picture myself working for.

I look for founders for whom solving the problem that their startup is solving has become their life’s mission and they plan to solve that problem with or without help from outside investors. I look for founders who have an unconventional opinion about the market opportunity they are pursuing, and can explain why their position is correct with evidence which investors can analyze independently.

At the outset I look for teams that can focus on building a simple product that their initial customers love, and who can focus on a niche within which to launch their product. I look for teams that are judicious and frugal in how they deploy the startup’s resources.

I look for founders who value teamwork, and who can become great leaders if they desire to do so. I value transparency, honesty, and openness. I value self-awareness. I like people who are determined and tenacious, who do not give up just because the going gets get uncomfortable and things seem bleak.

I look for founders who have a hard time doing something simply because it is what someone else expects them to do. I look for founders who are not afraid to be different.

Characteristics I Look For In Markets 

I look for large markets that could ultimately be served by the startup’s product, even though the initial target might be a small portion of the whole. I look for customers capable of and willing to pay for the product, and who are looking for and eager to find a solution to their problem.

I look for markets in which the pain is acute because the problem suppresses customers’ profits significantly, or because the problem makes users less happy than they could be.

If currently the addressable market is between $1B and $10B, I want to see evidence that it is growing quickly enough to support the startup’s future goals, and the competition that I assume will quickly follow if the team is successful.

Characteristics I look For In Business Models 

I look for products and business models that:

  • will benefit from network effects as time progresses,
  • can scale efficiently and quickly, and
  • can eventually benefit from an economic moat.

The Themes I Am Focused On

Notes:

  1. These themes cut across different industries and sectors. That is a deliberate choice.
  2. The technology sector evolves constantly. Accordingly, our team’s interests might ebb and flow in response. The themes I have described below should serve as a rough guide to how I think about the universe of startups in which we wish to invest.
  3. Ideally, a startup raising its first institutional seed round should have raised less than $1.5M – 2.0M or so prior to the round in which KEC Ventures would be investing.

I am currently interested in hearing about:

  • Marketplaces: Platforms that enable the participants in large, global markets to interact with one another in ways that reduce waste or create new, untapped opportunities.
  • Interconnectivity: Platforms that enable large numbers of different types of connected devices, machines, apps, and websites to communicate with one another and with the people managing or using them within a secure environment.
  • Data & Analytics: Platforms or applications that help people or other machines to manage, analyze, interpret, make decisions, and take actions based on vast and growing troves of centralized or decentralized data.
  • Effectiveness & Happiness: Products that enable people to accomplish more at work, or to become happier outside work. Products that help large enterprises and other types of businesses and organizations to grow or function more effectively.
  • Distribution: Products that make it easier to create, manage, distribute, and consume existing and emerging forms of digital media and content.
  • Asset Management: Technologies for managing different forms of enterprise, business, or individual assets. Technologies for managing different forms of enterprise, business, or individual risk.
  • Other: New, and as-yet unknown technologies and innovations founders are building to solve problems that exist only because no one else has developed a solution.

Things I am Not Interested In

  1. Exploding rounds: An exploding round comes with a caveat like “Seed round in ground-breaking tech startup closing in 1 week!” I do not like exploding rounds, not even exploding rounds that are being led by a name-brand VC. I need time to do my own homework.
  2. Meetings led by an advisor: I prefer my first few interactions with a startup to be with the team of co-founders, not with an advisor. It is okay for an introduction to come from an advisor, but I do not like to have advisors or mentors micro-manage my interactions with startup founders. That does not inspire confidence.
  3. Lack of control over core technologies: I try to avoid situations in which the startup has a product that has launched to the public, but the startup’s team has no primary responsibility for actually building the core product.
  4. Founders who will not share bad news: I only want to work with founders who will not hide bad news until it is too late for investors to do anything that might help the startup make a course-correction. I absolutely want to hear about difficulties, challenges, and problems. I expect the good news, but I think we have an obligation to try to fix the bad stuff before it becomes unfixable.

My Commitment to Startup Founders

Based on Gil Dibner’s VC Code of Conduct;

  1. I will be transparent.
  2. I will respect your time.
  3. I will not ask you for material I do not need.
  4. I will not string you along.
  5. I will let you know about any competitors in our portfolio.
  6. I will be transparent about conflicts of interest.
  7. I will not share any of your material without your permission.
  8. I will not speak with your customers without your permission.
  9. I will educate before I negotiate.
  10. I will be honest about what standard terms are.
  11. I will not issue a term sheet unless my firm has made a firm decision to invest.
  12. I will reflect the term sheet in the final legal documents.
  13. I will not seek an unreasonable equity stake.
  14. I will avoid surprises.
  15. I will always act in the best interests of the company.

Revisiting What I Know About Efficient Scale, Cost Advantages, & Early Stage Technology Startups

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This is the fourth post in my series of blog posts on economic moats. I have already written about Network Effects, Switching Costs, and Intangibles. In this post I will discuss how Cost Advantages and Efficient Scale might develop as an early stage startup travels through the discovery phase of its life-cycle. 1Any errors in appropriately citing my sources are entirely mine. Let me know what you object to, and how I might fix the problem. Any data in this post is only as reliable as the sources from which I obtained it.

My goal for writing this post is to provide one example of how I might think about this topic when I am studying an early stage startup that is raising a round of financing from institutional venture capitalists.

To ensure we are on the same page, I’ll start with some definitions. In the rest of this discussion I am primarily focused on early stage technology startups. If you by-chance have read the preceding posts in this series, you would have seen some of these definitions already.

Definition #1: What is a startup? A startup is a temporary organization built to search for the solution to a problem, and in the process to find a repeatable, scalable and profitable business model that is designed for incredibly fast growth. The defining characteristic of a startup is that of experimentation – in order to have a chance of survival every startup has to be good at performing the experiments that are necessary for the discovery of a successful business model. 2I am paraphrasing Steve Blank and Bob Dorf, and the definition they provide in their book The Startup Owner’s Manual: The Step-by-Step Guide for Building a Great Company. I have modified their definition with an element from a discussion in which Paul Graham, founder of Y Combinator discusses the startups that Y Combinator supports.

A company is what a startup becomes once it has successfully navigated the discovery phase of its lifecycle. As an early stage investor one of my responsibilities is to assist the startups in which I am an investor to successfully make the journey from being a startup to becoming a company.

Definition #2: What is an economic moat? An economic moat is a structural barrier that protects a company from competition. 

That definition of a moat is the one provided by Heather Brilliant, Elizabeth Collins, and their co-authors in Why Moats Matter: The Morningstar Approach To Stock Investing.

I take things a step further in thinking about startups and companies with business models that rely on technology and innovation. I think of a good moat as performing at least two functions; first, it provides a structural barrier that protects a company from competition. Second, it is an inbuilt feature of a company’s business model that enhances and strengthens its competitive position over time.

As a result I have arrived at the following definition of an economic moat pertaining specifically to early stage technology startups;

An economic moat is a structural feature of a startup’s business model that protects it from competition in the present but enhances its competitive position in the future.

Definition #3: What is a cost advantage? According to the authors of Why Moats Matter, a cost advantage arises when a company can sustainably lower its costs of doing business relative to its competitors. Such a reduction in costs can be due to process advantages, superior location, economies of scale, or access to a unique asset. In other words;

A cost advantage is a structural feature of a startup’s business model that enables it to maintain sustainably lower overall costs of doing business than its competitors while earning equal or higher margins over time.

Definition #4: What is efficient scale? According to the authors of Why Moats Matter, “efficient scale describes a dynamic in which a market of limited size is effectively served by one company or a small handful of companies. The incumbents generate economic profits, but a potential competitor is discouraged from entering because doing so would cause returns in the market to fall well below the cost of capital.” In other words, from my perspective as an early stage investor;

A startup can scale efficiently if doing so does not drive its customer or user acquisition costs to unsustainable levels over time, and if the startup’s decision to enter that market does not drive returns in the market to levels that are below the cost of capital for incumbent companies in that market over the short term.

Sources of Cost Advantage

For early stage technology startups, these are the most important sources from which a cost advantage may be derived. 3I do not include Materials and Supplies under this discussion because I do not think that is a sustainable source of cost advantage for an early stage technology startup.

People & Culture: This cost advantage arises when a startup develops a unique organizational culture, management processes, and organizational structures that enable and empower members of the team to consistently generate results for the startup’s business that are significantly better than the results of its direct competitors and that beat the adjusted-performance of more well-established incumbents in that market. This source of cost advantage is intimately connected to the intangibles of Management and Culture, and Research and Development.

Systems & Processes: This cost advantage arises when a startup develops unique organizational processes that enable it to consistently generate comparatively superior results. The key categories of such systems and processes are Marketing and Sales Processes, Operational Processes, Distribution Processes, and Support Processes.

Marketing and Sales Processes focus on the activities that the startup takes in order to create demand for its product or service, and subsequently to satisfy that demand by delivering the product to its users or customers.

Operational Processes focus on the activities in a startup that take inputs and turn them into the final product or service through which the startup’s value proposition is delivered to the market. These are the processes that enable the startup to turn tangible and intangible inputs and turn them into something the market is willing to pay for. I have previously discussed this in: Why Tech Startups Can Gain Competitive Advantage from Operations.

Distribution Processes focus on the channels through which the startup’s product or service will be delivered to its users or customers. A key consideration that has to be made here is the choice between direct distribution and indirect distribution channels, and how the startup’s choice in this respect will affect its ability to maintain an overall cost advantage over its competitors.

Support processes focus on all the activities that make everything else that the startup does possible; for example HR and Talent Management, and Financial Planning and Analysis fall under this category.

This source of cost advantage is intimately tied to People & Culture, since the two combine to create an environment in which unique tangible and intangible assets are developed consistently over time such that the startup’s competitive advantage over its peers increases, and evidence that this is happening is seen in the startup’s historical key performance indicators.

Facilities: This cost advantage is derived from the physical infrastructure that a startup needs in order to operate. For early stage tech startup the hard decisions related to this source of cost advantage begin to be necessary when the startup has scaled to a point at which off-the-shelf hardware products are no longer good enough for what the startup seeks to accomplish. This is often the point at startups must consider the advantages or disadvantages they may derive from building custom hardware instead of relying on what’s available from outside vendors or partners. It can also be tied to a geographic location which gives the startup unfair access to an input that is critical for what it does.

Capital: This cost advantage is determined by the startup management team’s ability to allocate capital in such a way that the startup successfully navigates the path it must travel between being a startup and becoming a company. Cost advantages due to capital are determined by external sources of capital – potential outside investors and sources of trade credit, and internal sources of capital – existing capital raised from investors, financial management of money the startup expects from its users or customers and money it owes to the vendors and business partners with whom it has a working relationship.

Key Considerations for Efficient Scale

Here I am assuming that the investor has determined that the startup’s customer or user acquisitions costs will most likely decline over time, or in the worst case scenario they will stay relatively flat.

How I think about efficient scale for an early stage startup is closely linked to the concept of product-market fit. An early stage startup is approaching the product-market fit milestone when demand for its product at a price that is profitable for the startup’s business model, begins to outstrip the demand that could have been explained by its marketing, sales, advertising, and PR efforts.

When I am chatting with startup founders and I am trying to explain this concept I use the analogy of a cyclist on a steep hill to represent the founder’s startup. It’s probably a poor analogy, but I think it gets the point across in a way that is easy for them to internalize.

Before Product-Market Fit (BPMF) everything takes a lot of effort. Every sale is tough, everything that can go wrong will go wrong, and most of the sales deals will fall apart for reasons that are hard to explain. The cyclist is pedaling very hard to get uphill, and even maintaining balance on the bike is quite a challenge. Every breath brings with it the possibility that the cyclist could fall off the bike. With luck, the cyclist makes it to the top of the hill. Then, there is that moment when the cyclist senses that it is possible to keep going without as much exertion as it required to get to the top of the hill. Now the downhill journey begins. Gravity kicks in. The bike is gaining momentum even as the cyclist is frantically trying not to careen off the path. The cyclist’s exertions are now focused on skillfully applying the brakes at sharp turns and corners on the way downhill, and speeding up when then the path is straight and clear of obstacles. If this is a race and there are other cyclists ahead, then our cyclist must also focus on overtaking then one after another, and must also avoid getting caught in crashes caused by other cyclists in the race. After Product-Market Fit (APMF) demand for the startup’s product threatens to outstrip the startup’s ability to meet that demand. This is when a startup must scale, and scale fast and efficiently. There are two reasons to scale at this point. The first and most important reason is that there is demand for the startup’s product and the startup should meet the demand from its users or customers. The second reason is that APMF is also the point at which copy-cat competition starts to materialize from new entrants, and possibly from incumbents too.

Efficient scale means different things at different points in the startup’s lifecycle: The way a team of 2 co-founders scales the startup’s business is much different than the way that same startup will scale its business when the team has grown to 20 people. In other words the way to pursue scale BPMF differs markedly from the way to pursue scale APMF.

Premature scaling seems great initially, until it leads to startup failure and death: The Startup Genome Report Extra on Premature Scaling reports that startups that scale prematurely tend to start scaling earlier than startups that do not scale prematurely, they often also raise 3x as much capital and have valuations 2x as high as startups that do not scale prematurely. This trend continues till they fail. Also, 74% of startups scale prematurely. I will not go into the details of that report in this post, because I covered that in Notes on Strategy; Where Does Disruption Come From?

The cadence of hiring is important: BPMF hiring should be slow, deliberate and methodical since it is not yet clear what new team members will be working on and if what they will be working on is relevant for the startup’s overall success and longevity. APMF the challenge is to hire the right people for the startup as quickly as is necessary to keep up with demand, and cope with competition. For this reason building sound and cost-advantageous systems & processes, and modifying them as the startup grows is important. Startups that scale prematurely, and then fail tend to hire more people sooner in their lifecycle than startups that do not scale prematurely.

Technology-enabled scaling wins: Whether a startup focused on consumers or enterprises, it is important for the founders to think about ways in which technology can be used to enable and support the scaling process. This should go beyond the obvious area of gaining new users or customers. Rather, as the startup scales thought should be given to how it ensures that:

  • Teams do not become too large to get critical work done quickly, and that they have the tools to promote communication and collaboration once the startups physical layout is taken into account.
  • Customer or user acquisition is not slowed unnecessarily by a failure to account for what customers are willing to do in order to get the product.
  • Sales and revenue generation is not hobbled by a failure to use tools that will make salespeople as effective as they can be, given other existing constraints.
  • Operations can seamlessly transition from one order of magnitude of scale to another without a deterioration in customer or user satisfaction.

Culture makes a difference: All things being equal, startups with a strong culture will scale more successfully than startups that do not. Why? Culture ensures that as the startup grows by hiring new people, the entire organization continues to solve the problem the startup set out to solve in a consistent manner.

Eventually, most founders must also become managers and coaches: It gets to a point where the founders job evolves into one of mainly facilitating and enabling the work of other people, setting strategy, nurturing a vision, and managing a team of executives. This is how founders gain managerial leverage. Not every founder is cut out for this. Some want to remain as close to building the product as possible because that is where their passion and drive comes from. I prefer founders who are self-aware enough to know if they want to remain close to building the product, or if they want to make the transition from building things to managing people, and setting strategy. Usually, this is not an issue at the Seed or Series A stage, where I am most involved. Still, I like to get a sense of what might happen. I’d rather not invest if this could become an intractable problem before the startup has reached escape velocity.

This wraps up my main posts about economic moats.

As a sector, technology is notorious for being one in which economic moats are hard to maintain. However, every tech startup that was able to build a wide moat around its business earned fantastical returns for its earliest investors. Many have also had a lasting impact on how people live life, and how the businesses that use their products get work done. You would recognize so-called “wide-moat” or “narrow-moat” tech companies if I mentioned names. You might also recognize the “no-moat” tech startups that initially seemed destined for great heights, but then were dragged back down to earth by a combination of market forces.

In either case, I will be thinking about economic moats almost daily.

Further Reading

  1. Scaling Up Excellence
  2. Traction: Get A Grip on Your Business
  3. Scaling Up: How A Few Companies Make It . . . and Why The Rest Don’t

References   [ + ]

1. ↩ Any errors in appropriately citing my sources are entirely mine. Let me know what you object to, and how I might fix the problem. Any data in this post is only as reliable as the sources from which I obtained it.
2. ↩ I am paraphrasing Steve Blank and Bob Dorf, and the definition they provide in their book The Startup Owner’s Manual: The Step-by-Step Guide for Building a Great Company. I have modified their definition with an element from a discussion in which Paul Graham, founder of Y Combinator discusses the startups that Y Combinator supports.
3. ↩ I do not include Materials and Supplies under this discussion because I do not think that is a sustainable source of cost advantage for an early stage technology startup.

Revisiting What I Know About Intangibles & Startups

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IMG_1050
My notebook and pencil. a book I was reading, and my headphones.

 

This is the third post in my series of blog posts on economic moats. I have already written about Network Effects and Switching Costs. The remaining three sources of an economic moat are Cost Advantages, Efficient Scale, and Intangibles. 1Any errors in appropriately citing my sources are entirely mine. Let me know what you object to, and how I might fix the problem. Any data in this post is only as reliable as the sources from which I obtained it.

In writing this post I am trying to consolidate what I have learned about intangibles & startups for myself.

I also hope that it is useful for first-time seed-stage technology startup founders who are trying to build a product, achieve product-market fit, and raise financing from venture capitalists. Often such founders are trying to accomplish all that while they also try to learn strategy, management and other subjects they perhaps had not been exposed to before they decided to build a startup. My goal in that sense is to provide one example of how an early stage venture capitalist might be thinking about these issues while assessing startups for a potential investment.

To ensure we are on the same page, I’ll start with some definitions. In the rest of this discussion I am primarily focused on early stage technology startups. If you by-chance have read the preceding posts in this series, you would have seen some of these definitions already.

Definition #1: What is a startup? A startup is a temporary organization built to search for the solution to a problem, and in the process to find a repeatable, scalable and profitable business model that is designed for incredibly fast growth. The defining characteristic of a startup is that of experimentation – in order to have a chance of survival every startup has to be good at performing the experiments that are necessary for the discovery of a successful business model. 2I am paraphrasing Steve Blank and Bob Dorf, and the definition they provide in their book The Startup Owner’s Manual: The Step-by-Step Guide for Building a Great Company. I have modified their definition with an element from a discussion in which Paul Graham, founder of Y Combinator discusses the startups that Y Combinator supports.

A company is what a startup becomes once it has successfully navigated the discovery phase of its lifecycle. As an early stage investor one of my responsibilities is to assist the startups in which I am an investor to successfully make the journey from being a startup to becoming a company.

Definition #2: What is an economic moat? An economic moat is a structural barrier that protects a company from competition. 

That definition of a moat is the one provided by Heather Brilliant, Elizabeth Collins, and their co-authors in Why Moats Matter: The Morningstar Approach To Stock Investing.

I take things a step further in thinking about startups and companies with business models that rely on technology and innovation. I think of a good moat as performing at least two functions; first, it provides a structural barrier that protects a company from competition. Second, it is an inbuilt feature of a company’s business model that enhances and strengthens its competitive position over time.

As a result I have arrived at the following definition of an economic moat pertaining specifically to early stage technology startups;

An economic moat is a structural feature of a startup’s business model that protects it from competition in the present but enhances its competitive position in the future.

Definition #3: What are Intangible Assets? An asset is a resource that is owned by a startup with the expectation that it will provide an economic benefit to the startup in the future. Intangible Assets are assets that are not physical in nature; intellectual property, brands, skill in research and development, regulatory environment, culture and management.

Baruch Lev explains why intangibles matter:

Intangible assets—a skilled workforce, patents and know-how, software, strong customer relationships, brands, unique organizational designs and processes, and the like—generate most of corporate growth and shareholder value. They account for well over half the market capitalization of public companies. They absorb a trillion dollars of corporate investment funds every year. In fact, these “soft” assets are what give today’s companies their hard competitive edge.

– Baruch Lev, Sharpening The Intangibles Edge, Harvard Business Review June 2004 Issue 3Baruch Lev taught me accounting while I was an MBA student at NYU Stern, his constant emphasis on intangibles increased my interest in getting better at assessing the connection between intangibles and competitive advantage from an investment analyst’s perspective.

In the remainder of this post I will discuss each broad category of intangibles from the perspective of an early stage startup and the issues such a startup’s founders ought to be aware of.

Intellectual Property

Bottom line: All things equal, a startup with a sophisticated understanding of the role that IP plays in creating value for customers and shareholders will be more attractive to shareholders than its peers.

According to the World Intellectual Property Organization: “Intellectual property (IP) refers to creations of the mind, such as inventions; literary and artistic works; designs; and symbols, names and images used in commerce.” As far as early stage technology startups are concerned I am mostly interested in copyrights, trademarks, patents, and trade secrets.

I am not an IP attorney, so please consult an IP attorney if you read this and have specific questions about how to protect your startups IP. The goal of this discussion is not to examine the intricate legal details and nuances of IP law, but rather to offer a broad view of the IP landscape with pointers about some of the issues to which first-time founders should pay attention.

Copyrights: This is a form of protection that is granted to the original author of any piece of work that can be stored in some form of fixed media. A copyright protects the original author’s work from indiscriminate copying by other people. Among other things, copyrights protect computer software, computer programs, blog posts, advertisements, marketing materials, videos, pictures etc etc. Merely creating the work in a form of fixed media establishes the copyright. In other words, an algorithm that exists in my mind is not protected by a copyright, but my copyright comes into existence the moment I commit it to software or document it some other tangible way – for example, in a notebook.  While it is not necessary to register the copyright in order for the right to exist, there is a benefit to copyright registration with the appropriate legal jurisdiction. In the United States, a copyright holder can not file a lawsuit for infringement if the copyright is not registered with the United States Copyright Office.

It is important for early stage startup founders who rely on outside vendors and other contractors to understand the “work for hire doctrine” and its implications on copyright ownership. According to the United States Copyright Office: “If a work is made for hire, an employer is considered the author even if an employee actually created the work. The employer can be a firm, an organization, or an individual” The parameters for determining who is an employee is not very straightforward in an environment within which the early stage startup; exerts little or no control over the how the work is done, exerts little or no control over the employee’s work schedule over the duration of the contract, or does not provide the employee with benefits or withhold income taxes from the employee’s pay. Due to these ambiguities, I think that early stage startup founders should make it a practice to protect some of the work done by contractors and vendors with work for hire agreements. A good work for hire agreement will state unambiguously that the work product covered by the agreement between the startup and the contractor is a work for hire to the benefit of the startup.

For  an individual, copyrights extend for the life of the original author and for an additional 70 years beyond the author’s death. For a startup, the copyright extends for 120 years from the date of creation or 95 years from the date of publication.

Trademarks: According to the US Patent and Trademark Office “A trademark is a brand name. A trademark or service mark includes any word, name, symbol, device, or any combination, used or intended to be used to identify and distinguish the goods/services of one seller or provider from those of others, and to indicate the source of the goods/services.”

Establishing a trademark is an important part of how an early stage startup begins to communicate its brand with its customers or users. Trademarks can take different forms, for example a distinctive sound can be used as a trademark.

Similar to copyright protection, merely using the mark in the course of doing business establishes the trademark right for the startup that owns the mark.

According to the International Trademark Association trademarks are:

  1. Fanciful Marks – coined (made-up) words that have no relation to the goods being described (e.g., EXXON for petroleum products).
  2. Arbitrary Marks – existing words that contribute no meaning to the goods being described (e.g., APPLE for computers).
  3. Suggestive Marks – words that suggest meaning or relation but that do not describe the goods themselves (e.g., COPPERTONE for suntan lotion).
  4. Descriptive Marks – marks that describe either the goods or a characteristic of the goods. Often it is very difficult to enforce trademark rights in a descriptive mark unless the mark has acquired a secondary meaning (e.g., SHOELAND for a shoe store).
  5. Generic Terms – words that are the accepted and recognized description of a class of goods or services (e.g., computer software, facial tissue).

A fanciful mark has the strongest trademark protection. A generic mark has the weakest protection. Over time, the protection afforded a fanciful mark can wane if that term becomes a generic term that is used to describe a category.

A startup founder seeking trademark protection should seek the advice of an IP attorney since this is a more complicated topic than copyright protection.

Patents: According to the World Intellectual Property Organization “A patent is an exclusive right granted for an invention. In other words, a patent is an exclusive right to a product or a process that generally provides a new way of doing something, or offers a new technical solution to a problem. To get a patent, technical information about the invention must be disclosed to the public in a patent application. The patent owner may give permission to, or license, other parties to use the invention on mutually agreed terms. The owner may also sell the right to the invention to someone else, who will then become the new owner of the patent. Once a patent expires, the protection ends, and an invention enters the public domain; that is, anyone can commercially exploit the invention without infringing the patent. A patent owner has the right to decide who may – or may not – use the patented invention for the period in which the invention is protected. In other words, patent protection means that the invention cannot be commercially made, used, distributed, imported, or sold by others without the patent owner’s consent.”

A utility patent is used to protect the functional features of an invention. Most of the patent applications made to the US Patent and Trademark Office are for utility patents. A design patent is used to protect the appearance of an invention. Utility patents generally provide broader protection than design patents, also it is easier to avoid infringing on a design patent. Utility patents are more expensive to obtain and take longer to obtain.

To receive patent protection an invention must be:

  1. Patentable,
  2. New, or novel,
  3. Useful,
  4. Non-obvious, and
  5. Adequately described.

Additionally, software and business process patent applications will likely be subjected to a “machine or transformation test.” The machine test means that software or business processes can not be patented unless they are combined with a machine of some sort – a computer. The transformation test means that software or business processes cannot be patented unless they transform one thing into another, different thing, or into a different state.

An invention is “adequately described” in a patent application if “someone of ordinary skill in the arts” can replicate the invention using nothing but prior background in that technical field along with the inventor’s description in the patent application.

An invention is non-obvious if someone of ordinary skill in the arts would not necessarily have reached the deductions made by the inventor on the basis of prior art in that technical field.

A theory will not receive patent protection, in and of itself it is not useful in a practical application.

There are two main patent award systems; first to invent, or first to file. In first to invent jurisdictions, the first person or group of people to conceive of an invention will be awarded patent protection if they go through the application process successfully and can demonstrate that they indeed conceived of the invention first. In a first to file jurisdiction the first person or group of people to file an application for patent protection will be awarded the patent irrespective of when they conceived of the invention relative to other inventors pursuing the same invention. The United States is a first to invent jurisdiction.

In the US, the clock starts ticking when an inventor first discloses the invention to the public – such disclosure could happen during a presentation to investors, a sales pitch to potential customers, or a presentation at an industry conference. Once public disclosure of the invention has occurred, the inventor has one year within which to file a patent application. If a year elapses without the inventor filing for patent application, that inventor then forfeits patent protection for that embodiment of the invention.

To avoid this, a provisional patent application can be filed with the USPTO to preserve a filing date. A final, or utility application has to be filed within 12 months of the provisional application. The utility application is what the USPTO examines in order to determine the merit of the inventors appeal for patent protection.

Outside the United States, inventors do not have the benefit of a grace period. As a result any international patent applications must be made as soon as possible, in order to preclude public disclosure by the inventor.

Public disclosure causes the invention to become part of the “prior art” in the field of the invention.

In 2009 I worked on an intellectual property audit with the management team at David Burke Group, that process culminated in the issuance of a patent, US 20100310736 A1 which describes a process for aging meat. The dry-aged steaks served at DBG restaurants are prepared using this process. That was my first experience securing intellectual property rights on behalf of a company.

In 2011 our team at KEC Holdings 4KEC Holdings is the parent company of KEC Ventures. invented a family of financial derivatives. I assumed responsibility for (1) ensuring that our valuation methodology was justifiable on the basis of widely accepted financial and economic principles, and (2) working with an IP attorney to attempt to obtain patent protection for the idea. Our electronic documentation of the idea came to 50+ pages of background, mathematical derivations and proofs, problems and worked solutions to demonstrate how the invention might be used in practice, valuation tables etc etc.

In 2012, I worked with a team of founders in Ghana who wanted to seek a patent for their idea. I was a volunteer mentor/advisor to the team. They worked with a patent agent in India. The working relationship was ineffective for reasons that were entirely preventable if the team had embraced some simple suggestions about how to work with a patent agent/attorney working on their behalf.

What have I learned about how to work with a patent attorney or patent agent?

Generally, a patent attorney or patent agent is unlikely to be an expert in the technical field of an invention even if they specialize in the legalities of obtaining a patent in that field; a software patent attorney is unlikely to understand the nuances of a software product as well as a software engineer. For that reason, it is the inventor’s responsibility to transfer as much background knowledge as possible about the technical field of the invention and specific nuances of the invention itself to the patent agent/attorney. First, this will help the attorney perform a more complete and comprehensive patentability search. Second. it will ensure that the patent application is drafted correctly from the outset. That has the benefit of minimizing rework. Third, it will also help the attorney answer questions and respond to objections during the period when the patent is being examined by patent examiners.

Here are some additional suggestions:

  1. Maintain “excruciatingly detailed” notes about the invention. You should describe the invention such that someone of considerably less expertise than you can understand the description. Also, keep pictures, drawings, figures, and any data that you create as you go through the invention process. It is a good idea to maintain a “lab-book” with numbered pages, dates, and handwritten notes about how you have tested your invention using theory, as well as the steps you have taken to test the output of what you have created. These can be supplemented by electronic notes created with MS Word, and also saved as PDF files as well as spreadsheets you have developed to test the idea further.
  2. Describe of prior attempts to do what your invention does, and keep notes about why those prior attempts did not work.
  3. Keep notes about the alternatives to your invention, and descriptions about how your invention is unique. You should describe the advantages of your invention over the prior art and alternative approaches.
  4. Keep records about any discussions you have had about the invention with people outside of the immediate team working on your startup’s product.

Assuming it makes sense, you should discuss the possibility of obtaining international patent protection with your IP attorney. In certain instances it is possible to speed up a patent application in the founders’ home jurisdiction by first obtaining a patent abroad using the Patent Cooperation Treaty (PCT) between different jurisdictions. You should ask your attorney about this, and come up with a strategy that works given your specific circumstances.

Here’s one illustrative example:

A startup founder in the United States must decide how to protect her idea with a patent. If she files in the US it will likely take 5 years or more before the patent is granted. If she files in the UK the wait is much shorter, 2 years or less before she may expect to be granted the UK patent. What should she do? She would like to obtain patent protection in the US and the UK since she believes these are her startup’s two most important markets. She should ask her patent attorney about using the PCT and Fast Track Examination under the Patent Prosecution Highway (PPH) to speed up the process.

What is the PPH? According to the USPTO: “The Patent Prosecution Highway (PPH) speeds up the examination process for corresponding applications filed in participating intellectual property offices. Under PPH, participating patent offices have agreed that when an applicant receives a final ruling from a first patent office that at least one claim is allowed, the applicant may request fast track examination of corresponding claim(s) in a corresponding patent application that is pending in a second patent office. PPH leverages fast-track examination procedures already in place among participating patent offices to allow applicants to reach final disposition of a patent application more quickly and efficiently than standard examination processing.”

In the scenario I painted above, our founder should apply for the UK patent and then use that as the basis for requesting fast track examination of her US patent application at the appropriate time. In which case she might obtain her UK patent as well as her US patent within 24 months of filing her patent application in the UK; 18 months to get her patent granted in the UK and 6 months under PPH to get her patent granted in the US. Remember, I am not a patent attorney. Discuss this with you lawyer.

Trade Secrets: A trade secret is any confidential and non-public information that confers a competitive advantage on the owner of that information because of it is not known to the public, and especially because it is not known to competitors in that market. The owner of the information must make demonstrable effort to keep the information secret.

Trade secrecy can be lost by legitimate means, such as reverse-engineering by a competitor. Also, trade secret protection lasts for as long as the information remains confidential and undisclosed to the public. Any kind of information can be designated as a trade secret by its owner.

The key to maintaining trade secrecy is the creation of internal practices and procedures that are designed to protect the information designated as “trade secrets” from being divulged to the public.

The mystique behind the formula for Coca Cola is one famous example of a trade secret.

Trade secrets have the following advantages, among others:

  1. It is cheaper to obtain IP protection through trade secrecy than by going through the process of obtaining a patent.
  2. A trade secret can cover subject matter that would not qualify for patent protection, for example; mathematical formulae, algorithms etc.
  3. Protection of IP through trade secrecy comes into effect almost instantaneously, and that protection can last indefinitely if appropriate processes, procedures and practices are put in place.

Trade secrets have the following disadvantages, among others:

  1. As previously stated, trade secrets can be reverse engineered by others.
  2. Information protected by one party (A) could legitimately be “independently invented” by another party (B) which then proceeds to seek and obtain patent protection for the invention. In that case A would be in violation of B’s rights as the patent holder. I do not understand how this works in “first-to-invent” jurisdictions, so it is worth speaking with an attorney if a choice has to be made between trade secrecy and patent protection.
  3. Once trade secrecy is lost, it is lost forever.
  4. Trade secrecy provides a significantly lower degree of protection than protection obtained from holding a patent.

Brand

Bottom line: To build a strong brand early stage startup founders must start by building a product that wins wide and sustained adoption by the market because the startup has intimate knowledge of its customers/users.

A startup’s brand develops primarily as its users and customers build an accumulation of experiences with its product or service over time. Ideally, these accumulated experiences should lead to customers and users having a positive affinity towards the product or service. The positive feelings that users or customers feel towards the startup and its product should be amplified through public relations, media and press commentary about the startup, community outreach, marketing, and advertising. Trademarks, copyrights, design, and iconography should all reinforce the positive emotions that the startup is accumulating within its users/customers towards itself. Lastly, knowledge that a startup has developed “trade secrets” which contribute to the pleasant experiences customers/users have each time they use the product/service can serve as a powerful source of implicit brand affinity and loyalty.

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Austin McGhie puts things succinctly in his book Brand is A Four Letter Word when he defines a brand as:

  1. “A brand is emotional shorthand for a wealth of accumulated or assumed information.” or
  2. “A brand is present when the value of what a product, service, or personality means to its audience is greater than the value of what it does for that audience.”

According to Heather Brilliant, Elizabeth Collins, and their co-authors in Why Moats Matter: “A brand creates an economic moat around a company’s profits if it increases the customer’s willingness to pay or increases customer captivity. A moatworthy brand manifests itself as pricing power or repeat business that translates into sustainable economic profits.”

Austin McGhie emphasizes throughout his book that a company’s brand embodies the market’s response to:

  1. The company’s product,
  2. The customer/user’s experience when they use the product, and
  3. The company’s marketing strategy, which should lead to a differentiated and valuable positioning of the company and its products relative to its competitors.

Early stage technology startup founders commonly treat marketing as an afterthought. That is a mistake. The excuse I have encountered when we discuss this topic is that there is insufficient capital for the startup to devote to marketing. The problem with that line of thinking is that it exposes a lack of imagination; marketing is not a one-size-fits-all proposition, nor does it always have to be expensive in order to be effective. Moreover, a startup’s founders are its most effective marketers in the very early days of its existence.

What should marketing look like during those early days when capital is scarce and the startup appears to lurch from one near-death experience to another? It should be a simple, uncomplicated strategy to:

Communicate to customers;

  1. What – What problem does the startup’s product solve for them?
  2. How – How is this better than the current alternative?
  3. Why – Why should they accept the risk that comes with trying a product from an early-stage startup? Why will they gain more than they stand to lose?

One complexity that early stage technology startup founders must contend with is that marketing in technology is multifaceted in the sense that there are numerous constituencies engaging with the startup’s marketing at any given time. Prospective customers want to know if they should switch to the new product/service. Investors want to know if they should make an investment. Potential distribution partners want to determine if there is a benefit for them in forming a partnership. Employees want to get a sense of how much job-security they can expect. Technology press and bloggers want to be first to scoop the next big thing. Regulators want to make sure that consumers are protected. Oh, and don’t forget competitors too. They’ll be paying rapt attention.

Research and Development

Bottom line: Research and development should purposely seek to strengthen the startup’s ability to win and retain customers, and increase profitability.

To understand why an early stage startup founder’s attitude towards research and development (R&D) matters, we first need to understand what it is.

Paraphrasing Investopedia, R&D is:

The set of systematic, investigative, and exploratory activities that a business chooses to conduct with the intention of making a discovery that can either lead to the development of new products or procedures, or that can lead to an improvement of existing products or procedures, and in the process create better ways of solving customers’ problems, creating new profit opportunities for the business.

Notice the key elements of R&D:

  1. It is systematic, investigative, and exploratory – it seeks to expand the boundaries of organizational knowhow and organizational capacity.
  2. It seeks to solve customers’ problems in a better way than the status quo.
  3. It seeks to create new opportunities for the startup to make profits.

For those reasons, R&D is one important means by which any organization that operates in a competitive market can create an enduring competitive advantage for itself.

There is only one valid definition of business purpose: to create a customer.

– Peter Drucker

If you agree with that definition, then it follows that activities that make a startup more likely to create and hold onto new customers must be pursued. Those activities are what we call R&D.

Research demonstrates the important role that R&D can play in investment returns:

In this paper, we examined the future excess returns of R&D intensive firms. Firms with R&D intensity measure greater than (lesser than or equal to) that of the industry are classified as Leaders (Followers). We show that Leaders have sustained future profitability. However, the future risk-adjusted excess returns are higher for Leaders than Followers, suggesting that the stock price does not incorporate the R&D relevant information in a timely fashion. We then directly examine the difference across Leaders and Followers of two risk measures: stock return volatility and future earnings variability. We find that Leaders have lower stock return volatility and earnings variability, ceteris paribus. We then examine whether the financial analysts’ help mitigate the apparent lack of information with respect to R&D, and find that even though the longterm earnings growth estimates for Leaders is high, they revise these estimates downwards perhaps as a reaction to short-term earnings. Overall, it appears that the stock market does not incorporate the Leaders’ potential for sustained future profits as argued in the strategy and economics literatures.

– Baruch Lev, Suresh Radhakrishnan, and Mustafa Ciftci. The Stock Market Valuation of R&D Leaders 5Lev, Baruch and Radhakrishnan , Suresh and Ciftci, Mustafa, The Stock Market Valuation of R&D Leaders (March 2006). NYU Working Paper No. BARUCH LEV-15. Available at SSRN:http://ssrn.com/abstract=1280696

So what does this mean for early stage investors? All else equal, invest in startup founders who show indications of being capable of building organizations that will become R&D leaders in the markets in which they have to compete.

How might one go about assessing this? How often in the past have the founders’ started with the same information as everyone one else, but examined it in a way that led to unexpected results that proved to be correct and so enabled them to exploit an opportunity others ignored or did not know existed?

Culture and Management

Bottom line: The early stage startup founders who excite me the most have convinced me that they know how to build an organization that will become exceedingly more valuable than the sum of its parts. They must inspire excellence from their co-founders, from other early team members they recruit to join the startup, and they must inspire devotion from their early customers.

Does the startup’s culture, and the assumptions that its founders make about the core assets it should acquire and how it should be structured as an organization lead to an overwhelmingly positive reaction from the market and from its customers?

One aspect of seed stage investing that I feel is not sufficiently discussed explicitly is how much of a bet seed-stage investors are taking on the founders’ decision-making skill as managers of entrepreneurial risk, and the assumptions that drive those decisions.

What are the kinds of decisions seed-stage investors are betting founders will make, and make correctly on a consistent enough basis to yield a return on the investors’ capital?

Below, I paraphrase some definitions of an entrepreneur to help highlight this idea.

Jean-Baptiste Say: An entrepreneur shifts resources out of an area of lower productivity and into another area of higher productivity and return. (1800)

Frank H. Knight: An entrepreneur is someone who confronts a business challenge and is confident enough to risk financial loss in order to overcome that challenge. (1921)

Joseph Schumpeter: An entrepreneur is someone who exploits market opportunities through technical and organizational innovation. (1965)

Peter Drucker: An entrepreneur is someone who always searches for change, responds to it and exploits it as a business opportunity. (1970)

Robert Hisrich: An entrepreneur is someone who takes the initiative to organize social and economic factors of production in order to create something unique that is of value to society, and accepts financial and social risk in the process. (1990)

In some cases, including the entrepreneurial context, uncertainty includes not only uncertainty about others’ actions, but also uncertainty regarding the courage and willingness of others to act.

– Ross B. Emmet, Frank H. Knight on the “Entrepreneur Function” in Modern Enterprise (PDF)

What are some of the decision-making pitfalls that can cause the failure of an otherwise promising seed-stage startup? I’ll list some examples I have encountered since 2010.

  1. Insufficient focus on the customer, too much focus on the technological innovation.
  2. Sub-par outcomes regarding recruiting great people, and empowering them to bring the founders’ vision into reality.
  3. Inability to think creatively about new organizational designs and structures that will yield better insights about shifts in the expectations of existing customers, the potential pockets of potential new customers, and opportunities that might be going unrecognized by competitors.
  4. Incongruities between what the startup needs to accomplish in order to satisfy its customers and achieve product-market fit, and the choices that the founders make. For example, relocating the startup and its team to a geographic region that makes it difficult to reach its most promising potential early customers and makes it difficult to recruit the people it needs.

There are many others.

One problem seed-stage investors face in trying to sort founders who go on to build successful companies from founders who fail to get past the startup phase is that it is very hard to differentiate between skill and luck at that stage because the financial ratios and metrics that one could use to make that determination do not yet exist. Managerial decision making skill only reveals itself over time.

So what is a seed-stage investor to do? Study the founders’ past accomplishments and try to determine which aspects of that track record result from decision-making skill. Isolate them from the other aspects of the founders’ past accomplishments that could be attributed to luck. Weigh those two things during the assessment of what that means for the startup. I try to provide sufficient time to observe founders’ decision-making skills and abilities before I have to make a final decision – individual skill matters just as much as collective skill. As a result I am interested in the role that each co-founder plays in the final outcome. For example, did the CTO fail to prevent the team from making an incorrect choice of the technology on which to build the product? If so, does the CTO take personal responsibility for that failing, or does the CTO attempt to pass blame and make excuses?

Culture is the way in which a group of people solves problems.

– Geert Hofstede

It is also important to remember that the culture of a startup is determined predominantly by the attitude, behavior, and personality of the founders. In trying to understand the kind of culture that will develop as an early stage startup evolves I am interested in trying to understand if the following things are true.

  1. The founders are self-aware, and understand how their behavior affects the startup through the response it elicits from members of their team, from their early customers/users, and from their early investors. Example: They hire strong performers who have complementary skills, and they empower those people to excel.
  2. The way the founders talk about themselves and the organization they are building is distinctive, it illuminates the founders’ beliefs about the world, and about the reality they will create as a result of those beliefs. Example: No one could confuse this startup with another startup because the distinction between the two is unambiguous.
  3. The founders understand what they need to do to build a winning team. They also know why they need to do those things if they want their team to succeed. Example: They communicate clearly. They hold themselves accountable. They are adept at reducing harmful internal conflict. They promote and moderate the types of internal debate and disagreements that will help their team make better decisions. They motivate people to work hard, and in exchange offer fair reward and recognition for the hard work it takes to build the startup. They encourage experimentation, and learning from failure. They are great teachers, and great students. They bring out the best in others by inspiring great performance.
  4. The founders understand that culture is not something they can ignore until things are falling apart, rather it has to be tended continually. Culture matters just as much as engineering, sales, and other organizational functions that are much easier to measure and manage. Example: They understand that an organization with a strong culture is easier to manage, and often will have a longer period of sustained excellence than an organization with a weak culture.

Culture is the collective programming of the mind which distinguishes the members of one group from another.

– Geert Hofstede

Regulatory Environment

Bottom line: If it is appropriate I want to see some evidence that founders have an understanding of the role that regulations might play; will they be a catalyst or an impediment? What can the startup do to make regulations work in favor of the business model that the startup has set out to create?

I have to admit that this is the most difficult intangible for me to discuss for a number of reasons. First, I have relatively less experience on this subject than on the preceding ones. Second, it is such a specialized subject that it is most likely a function that will largely be outsourced to a lobbyist, at least in the United States. Last, this is unlikely to be something a startup needs to worry about until it has grown considerably, which is likely to happen well beyond the seed stage.

The regulatory environment is the framework of rules, laws, and regulations that the startup and its competitors have to adhere as they go about their operations.

Startup founders who can play a role in shaping the regulatory environment that is developed to govern their activities have a better chance of influencing events in their favor than founders who demonstrate an inability to influence legislation.

In the United States there are many examples of regulators requesting comment from participants in an industry during the period when rules, laws, regulations are being crafted to govern the activities of organizations within a given market.

It’s worth observing that the benefits of this asset accrue to every entity that decides to enter that market after rules have been established by regulatory bodies. As a result, first-movers who bear the cost of creating a favorable regulatory environment might be at a relative disadvantage to other organizations that decide to enter the market after a regulatory framework has been established since the first-mover would have borne all the social, political, and financial risks of putting the regulatory environment in place. In comparison to the first-mover, fast-followers get a free-ride.

Concluding Thoughts

Assessing intangibles and their potential impact on the future of an early stage startup is hard work that can seem to rely on information that is even more qualitative and less data driven than other aspects of early-stage startup analysis. Nonetheless, it is important to think through the issues carefully since that work can lead to important conclusions that highlight potential risks, point to future areas of opportunity, and yield better decisions about when and where the investor should deploy scarce capital.

Collectively, intangibles are important because once a startup establishes them as an asset, it is impossible for that asset to be replicated in exactly the same way by a competitor.

Additional Reading

Blog Posts & Articles

  1. Most Company Culture Posts Are Fluffy Bullshit – Here’s What You Actually Need To Know
  2. 80% of Your Culture Is Your Founder
  3. The Ultimate Guide To a Startup Company Culture
  4. Netflix: Reference Guide on Our Freedom & Responsibility Culture (PDF)
  5. A Summary of Peter Drucker’s Innovation and Entrepreneurship
  6. Peter Drucker’s Life and Legacy – A Drucker Sampler

Books

  1. Reinventing Organizations
  2. Delivering Happiness
  3. Work Rules
  4. Setting The Table
  5. Small Giants
  6. Good To Great and Built to Last (See also: Was “Built To Last” Built to Last?)
  7. Innovation and Entrepreneurship

References   [ + ]

1. ↩ Any errors in appropriately citing my sources are entirely mine. Let me know what you object to, and how I might fix the problem. Any data in this post is only as reliable as the sources from which I obtained it.
2. ↩ I am paraphrasing Steve Blank and Bob Dorf, and the definition they provide in their book The Startup Owner’s Manual: The Step-by-Step Guide for Building a Great Company. I have modified their definition with an element from a discussion in which Paul Graham, founder of Y Combinator discusses the startups that Y Combinator supports.
3. ↩ Baruch Lev taught me accounting while I was an MBA student at NYU Stern, his constant emphasis on intangibles increased my interest in getting better at assessing the connection between intangibles and competitive advantage from an investment analyst’s perspective.
4. ↩ KEC Holdings is the parent company of KEC Ventures.
5. ↩ Lev, Baruch and Radhakrishnan , Suresh and Ciftci, Mustafa, The Stock Market Valuation of R&D Leaders (March 2006). NYU Working Paper No. BARUCH LEV-15. Available at SSRN:http://ssrn.com/abstract=1280696

Notes On Strategy; What Can We Learn From Religious Leaders About Building Early-Stage Startup Culture?

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Alternative Working Title: Notes On Strategy; Engineering Your Early Stage Startup’s Culture For Longevity

The topic of culture has been in the news quite a bit since the New York Times published an investigative piece describing what it is like to work for Amazon. While culture is something I think about all the time, that article got me thinking about religion and culture . . . and how that relates to the early stage startups in which we invest.

In this post I plan to:

  1. Examine what we mean when we say “culture” and tie that to the work that startup founding teams do during business model search and discovery.
  2. Examine the structural characteristics of religious communities; How do they maintain a sense of purpose, direction, and elicit devotion and commitment from members of the community?
  3. Provide some pointers about how first-time startup founders might get things off on the right footing as far as culture is concerned by making certain deliberate choices early in the lifecycle of their startup.

I am thinking specifically of startups raising their first institutional round from seed stage venture capitalists, or perhaps a Series A round of financing. These teams are usually small, often fewer than 10 people.

To get things started; What is Culture?

Culture is the learned and shared behavior of a community of people which distinguishes that community from other communities. 1J. Useem and R. Useem. (1963). Human Organizations, 22(3). Page 169. See: The Center for Advanced Research on Language Acquisition (CARLA) “What is Culture?” http://www.carla.umn.edu/culture/definitions.html. Accessed Aug 29, 2015.

Some of the things that distinguish a culture: 2Adapted from: Richard-Hooker.com; Clifford Geertz, Emphasizing Interpretation

  1. It embodies a way of life, an approach to thinking, feeling, and believing about the world.
  2. It endows the members of the cultural community with a social legacy from prior members of the same community.
  3. It provides a framework that enables members of the community to think abstractly about how they should behave;
    1. It provides lessons about how members of the community should react towards recurring problems by pooling the collective wisdom of past and present members of the community.
    2. It provides a guide for community members when they need to interact with the external environment.
  4. It is the process by which the history of the community is created and brought into permanent existence.

In this analysis I am most interested in religion as a cultural system.

According to Clifford Geertz religion is: 3Clifford Geertz, Religion As A Cultural System. In: The Interpretation of Cultures: Selected Essays. Pp. 87 – 125. Fontana Press, 1993.

  1. A system of symbols which acts to
  2. Establish powerful, pervasive, and long-lasting moods and motivations in people by
  3. Formulating conceptions of a general order of existence and
  4. Clothing these moods and motivations with such an aura of factuality that
  5. The moods and motivations seem uniquely realistic.

It is not difficult to see that a religion is in fact a specific type of culture and further, that every cultures is a kind of religion. In the rest of this post I will use the term “religion” and “culture” interchangeably. I also assume that a symbol may be tangible or intangible.

The structural characteristics of a religion are: 4William E. Paden, Religious Worlds: The Comparative Study of Religion. 2nd edition. Pp. 51 – 161. Beacon Press, 1994.

  1. A religion inhabits a unique world: Religions create, structure and propose a universe that is unique to adherents of that religion such that members of the community can explain, make sense of, and differentiate what is within their world from what is outside their world. This helps establish lines of commonality as well as lines of difference, and helps confront change and challenges.
  2. A religion is grounded on certain myths: Every religion possesses sacred myths that tell a story about something that happened during the genesis of the religion and that continues to have great influence on contemporary realities experienced by adherents of the religion. Myths:
    1. Help devotees of a religion make sense of the past, the present, and the future.
    2. Are a powerful means of engendering a certain mood and attitude within the devotees of a religion.
    3. Focus our attention on that which is sacred and important within a religion.
  3. A religion possesses rituals: Rituals help to focus the devotees of a religion on specific concepts or ideas at a specific point in time, also rituals enable the adherents of a religion to express their beliefs about the world in the form of a tangible display that appeals to the senses through action.
  4. A religion possesses gods: In the context of religious worlds, gods represent instances of language and behavior that is held up by the religious community as exemplary, worthy of emulation, and possessing interpretive power in terms of how that community understands the world.
  5. A religion possesses systems of purity: These systems of purity help to differentiate what is acceptable from what is unacceptable, right behavior from wrong behavior. This is a system that enables members of the community deal with negativity within the community.

What role do symbols play within a culture?

  1. Anat Rafaeli and Monica Worline: Symbols in Organizational Culture – A symbol is a visible and physical manifestation of an organization. It is an indication of organizational life that derives its meaning from the social and cultural conventions and interactions among the people who belong to the cultural organization. Symbols can be experienced through the senses. Symbols play the following functions:
    1. They reflect organizational culture: Symbols communicate information about what we think we know about an organization. They act as a bridge between our emotional and cognitive responses towards an organization.
    2. They trigger internalized values and norms: Symbols serve as a cue to trigger certain expected, desired, and acceptable behaviors once a person enters the physical environment of an organization or whenever the person is acting explicitly as a representative of the organization to the outside world.
    3. They frame conversations about experience: Symbols act as a frame of reference for guiding the communication that takes place between members of the same organization, or between members of a specific organization with people who do not belong to that organization.
    4. They integrate organizational systems of meaning: Symbols integrate the culture, norms and values, and shared experiences of members of an organization into a coherent whole within which members of the organization experience the world.
  2. Sherry Ortner: On Key Symbols – A key symbol is an element of a culture that is crucial and distinctly unique to the organization of that culture. They perform the function of carrying and conveying cultural meaning to people within the culture as well as to people outside the cultural community. Key symbols might be identified when:
    1. Members of the cultural group discuss the symbol’s cultural significance,
    2. Members of the cultural group are positively or negatively aroused by the symbol, and none are indifferent towards it,
    3. The symbol appears in many different settings and contexts,
    4. There is much elaboration around the symbol, and
    5. The group imposes numerous restrictions around the symbol. For example, misuse of the symbol can incur severe sanctions.

There are two distinct categories of key symbols. Summarizing symbols express meaning in an emotionally powerful way that is of uniform significance for all members of a given culture. They are generally accorded sacred status. Elaborating symbols make it possible for members of the religion or community to communicate ideas and feelings with one another, and to translate such feelings and ideas into tangible action. Elaborating symbols are generally analytic in nature and rarely attain sacred status.

What does this mean in the context of building an early-stage startup?

  1. Communicate a clear world view internally and externally. One question I ask myself when I meet with a founder is this; Why is this specific person uniquely suited to solve this problem in this market and why do I believe this team will succeed in its effort to accomplish this incredibly difficult task?
  2. Preserve and embellish important stories, particularly those that reflect qualities and themes that the founder wants to become aspects of the startup’s long-term culture and identity. I listen for founders who express enthusiasm for the work that the other people on the team are doing. Team cohesiveness matters.
  3. Create and maintain rituals:  For example, does every team member understand what would get existing customers/users to become more engaged with the product, and reduce churn? Does every team member know what needs to happen for the startup to increase its growth enough to get to the next funding milestone? Does the founder have a firm grasp on the startups key performance indicators? Has the team chosen the right indicators to focus on at this stage?
  4. Focus on finding product/market fit: A startup that fails to find product/market fit is doomed. Are the founders experimenting enough to find an ideal early market for the product, or are they stuck in a cycle of dogma regarding an initial point of market entry? What indications are there to help me ascertain the quality of their decision-making processes?
  5. Create systems of accountability: At the very early stage of a startup’s life the individuals on the team have an enormous impact on the organizational culture that eventually evolves. What steps are the founders taking to ensure that the early team has the right mix of people?
  6. Create a sales and marketing plan: What steps is the startup taking to create strong bonds with its earliest customers/users? Is anything being done to create a brand? Are the choices that have been made so far cost-effective and appropriate for the startup’s stage of maturity and its funding status?

Closing Thoughts The job of an early-stage technology startup founder is basically akin to that of a religious evangelist. The founder must recruit believers. Early team members join the cause because they believe in the founder and in the vision that the founder wishes to bring into reality. Early customers become believers because they have a problem they believe the startup’s envisioned product can solve. Early investors join the cause because they believe in the founder and believe that the startup can create the future reality that it describes during investment pitches. Basically, at the outset . . . Building a startup is exactly the same as creating a new religion.

 

References   [ + ]

1. ↩ J. Useem and R. Useem. (1963). Human Organizations, 22(3). Page 169. See: The Center for Advanced Research on Language Acquisition (CARLA) “What is Culture?” http://www.carla.umn.edu/culture/definitions.html. Accessed Aug 29, 2015.
2. ↩ Adapted from: Richard-Hooker.com; Clifford Geertz, Emphasizing Interpretation
3. ↩ Clifford Geertz, Religion As A Cultural System. In: The Interpretation of Cultures: Selected Essays. Pp. 87 – 125. Fontana Press, 1993.
4. ↩ William E. Paden, Religious Worlds: The Comparative Study of Religion. 2nd edition. Pp. 51 – 161. Beacon Press, 1994.

Notes on Strategy; Michael Porter’s Generic Competitive Strategies for Early Stage Tech Startups

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Vasco da Gama Bridge - Lisbon, Portugal. Image Credit: Tasha S. K. Aoaeh (2010)
Vasco da Gama Bridge – Lisbon, Portugal. Image Credit: Tasha S. K. Aoaeh (2010)

Running a business without a strategy is like breathing air without oxygen.

My post Notes on Strategy; For Early Stage Technology Startups led to follow up questions from a handful of readers who asked for additional posts with more explanations and examples. 1Let me know if you feel I have failed to attribute something appropriately. Tell me how to fix the error, and I will do so. I regret any mistakes in quoting from my sources.

In this post I will discuss Michael Porter’s 3 Generic Competitive Strategies. My goal in these posts is to provide concrete yet easy to use frameworks that founders of early stage startups can quickly learn and adapt as they work on moving their organizations through the discovery process that takes them from being a startup to becoming a company. 2My target audience is made up of  first-time startup founders who do not have any background in business, finance, economics, or strategy.

To ensure we are on the same page, and thinking about the issues from the same starting point . . . first, some definitions. You can skip past the definitions if you have already seen them in one of my previous posts.

Definition #1: What is a Startup? A startup is a temporary organization built to search for the solution to a problem, and in the process to find a repeatable, scalable and profitable business model that is designed for incredibly fast growth. The defining characteristic of a startup is that of experimentation – in order to have a chance of survival every startup has to be good at performing the experiments that are necessary for the discovery of a successful business model. 3I am paraphrasing Steve Blank and Bob Dorf, and the definition they provide in their book The Startup Owner’s Manual: The Step-by-Step Guide for Building a Great Company. I have modified their definition with an element from a discussion in which Paul Graham, founder of Y Combinator discusses the startups that Y Combinator supports. As an investor, I hope that each early stage startup in which I have made an investment matures into a company.

Strategy is about making choices, trade-offs; it’s about deliberately choosing to be different.

– Michael Porter 4Keith H. Hammond, Michael Porter’s Big Ideas. Accessed on Jun 20, 2015 at http://www.fastcompany.com/42485/michael-porters-big-ideas

Definition #2: What is Strategy? An early stage startup’s strategy is that deliberate set of integrated choices it makes in order to create a sustainable competitive advantage within its market relative to rival startups and market incumbents. It is the means by which a startup combines all the elements within its environment to create and deliver value for its customers, while simultaneously capturing some of that value for itself and its investors. Strategy answers questions about what the startup should do and what it should not do in order to find a repeatable, scalable and profitable business model.

In Competitive Strategy, Michael Porter describes The 5 Competitive Forces That Shape Strategy. Later on in the book he discusses 3 Generic Strategies that a business can apply in order to maintain its position relative to its competitors, and also to cope with the 5 forces affecting competition.

Before delving into the details of the generic strategies, one observation; Often, discussions about strategy get stuck in dogma – is it about creating a competitive position that a startup can defend, or is it about gaining market share? I do not think strategy can be an either/or proposition in that sense. It must be both. Good strategy protects a startup’s current market position, while attempting to reshape the competitive landscape such that it tilts overwhelmingly to that startup’s advantage.

Also, by definition a startup is still searching for a strategy . . . so many of the examples I will use are of companies, not startups. However, the idea is that this helps a founder go through the search and discovery phase of building a startup with these frameworks in mind.

The following generic strategies help a startup create a defensible position in its market, but they should also be thought of as a means for launching offensive moves to gain market share as market conditions evolve.

Overall Cost Leadership: A startup that has decided to pursue this strategy has chosen to maintain the lowest cost structure amongst its rivals.  One could think of “broad-based” cost leadership as a choice to become the cost leader amongst all a startup’s rivals in a given market. Alternatively, “narrow-based” cost leadership is a choice to become the cost leader among a select few rivals within the market.

A startup might choose a cost leadership strategy in order to cope with the threats posed by powerful buyers who can push prices down, but no further down than the cost leader in that market can bear. Also, cost leadership provides wiggle room for dealing with the threats posed by powerful suppliers who can increase the costs of inputs that the startup needs in order to develop its own products. Becoming the cost leader in a given market lowers the threat posed by new entrants to the market under the established rules of competition because the decision to enter the market under those conditions would be difficult to execute at a cost that is acceptable.

Startups exploring cost leadership as a strategy should consider making large upfront capital expenditure investments with an eye towards achieving economies of scale within a relatively short window of time. As they gain market share and scale, startups pursuing a cost leadership strategy will need to continue making relatively large CapEx investments that are aimed at keeping their overall costs low.

Additionally, cost leadership entails paying more attention to continuous process innovation, higher than normal labor-monitoring practices and pay-structures that might be described by outside observers as “below market”, and intense scrutiny of and discipline towards keeping overhead costs within a narrow band relative to revenues.

Examples:

  1. Walmart
  2. Toyota
  3. Amazon
  4. CraigsList

Risks: For technology startups as cost leadership strategy can be risky because of the pace of technological change and innovation. The pace of change requires ongoing CapEx investments in process improvements at a cadence that is higher than the alternative. As an example, think of all the different reports about the investments Amazon is making in trying to figure out how to get goods from its warehouses and shipping centres to its customers. Furthermore, blind focus on cost leadership can make startups inattentive to shifts in customer preferences that make cost leadership a losing strategy as time progresses. Lastly, cost leadership creates a competitive landscape in which there’s a constant race to the bottom and brand loyalty plays no significant role. Products and services become a commodity.

The image below, showing the startups that have been built by unbundling CraigsList shows another risk of the cost leadership strategy; namely that someone else can compete with some aspect of another startup’s business model by pursuing differentiation or focus as a strategic choice. 5It is not clear to me if the unbundling of CraigsList arose from conscious choices made by others observing the markets it served, or if this is a phenomenon that has only become obvious after the fact.

Unbundling CraigsList

Differentiation: A startup that has decided to pursue differentiation as the basis for its broad strategy has chosen to try to develop something that will be perceived as being unique, novel and difficult to copy within its market. The key to success pursuing this strategy is that differentiation must make the startup’s product more valuable to the customers who pay for the startup’s product. Successful differentiation involves a combination of some or all of technological innovation, branding, product features, and design.

A startup might choose a differentiation strategy because it helps insulate it against competition. When implemented successfully, differentiation creates a barrier to entry that is very hard for new entrants to overcome. Successful execution of a differentiation strategy has a strong positive correlation with brand value, leading to customers of the startups products becoming less sensitive to price since by definition a highly differentiated product has no close substitutes.

The cumulative effects over time of a successful differentiation strategy become apparent in a number of ways. The threat posed by buyers reduces over time since they do not have a very good alternative to the differentiated product. Pursuing a differentiation strategy often means that the startup can maintain and enjoy profit margins that are considerably higher than average for that market. Consequently, startups that pursue a differentiation strategy maintain room for maneuvers that would have been unavailable had they pursued a cost leadership strategy instead.

The organizational traits that make pursuing a differentiation strategy possible are; strong marketing and brand-building skills, continuous product innovation, relatively large R&D expense, and an organizational culture that emphasizes customer support.

Examples: Apple.

Risks: The primary risk of differentiation as a strategy is the risk of ceding market share in the terms most people customarily think about it to a competitor pursuing a cost leadership strategy. Perceived differentiation can erode with time as competitors imitate product features and certain innovations are adopted as industry standards. Also, customers might become more sensitive to price and start making trade-offs that put the startup pursuing a differentiation strategy at a disadvantage.

Focus: Most early stage startups should start life pursuing a focused or niche strategy. A startup pursuing this strategy makes a deliberate choice to pin-point its resources on a narrow customer group, a particular product segment, or a limited geographic market. Focusing its effort on that particular target customer, product, or geographic market enables the startup to become very good at serving that niche especially well while gleaning the lessons it needs to learn in order to avoid more costly mistakes if it later on decides to pursue market-wide cost leadership or differentiation. In other words, focus as a strategy for an early stage startup entails pursuing either cost leadership or differentiation in a very narrow market segment in order to create and defend its initial beachhead. Only once that is secured does the startup seek to expand its reach.

Examples: Every early stage technology startup that grows successfully after the search for a repeatable, scalable, profitable business model is complete.

Advantages: I got stuck at this point in the post, unclear how to tackle the rest of it. Fortunately, 5 or so meetings I have had over the past two days with NYC-based startup founders at different stages of progress through the search process helped to point me in the right direction. Each of them is struggling with this fundamental question:

What I am building is so attractive to so many potential customers in so many different industries and markets. What should I do? I do not want to say no to any potential customers.

I get it. I understand the dilemma. Capital is scarce, your burn won’t go away if you wish to keep working on your startup. All these potential customers come along with promises of potential revenues to ease the stress posed by your lack of capital . . . The temptation to “take as much revenue as you can get, from whomever is offering it” is nearly impossible to resist. I get it. I would have the same struggle too if I were in your shoes.

Yet, we have to pause and think about this for a few minutes lest we do something rash.

Paul Graham is often quoted as having said that early stage startups should “do things that do not scale.” I could not agree with him more, in fact there are times when more mature companies could use a modified version of that advice.

What is often not well understood by some investors, and many founders  . . . especially first time founders is why that advice is so important.

Here’s Paul in his own words:

Almost all startups are fragile initially. And that’s one of the biggest things inexperienced founders and investors (and reporters and know-it-alls on forums) get wrong about them. They unconsciously judge larval startups by the standards of established ones. They’re like someone looking at a newborn baby and concluding “there’s no way this tiny creature could ever accomplish anything.”

That initial fragility is why focus is the only strategy that any early stage technology startup ought to pursue. Focus allows the founders and the startup to do a few things in those early days;

  1. Find, recruit, and gain an intimate understanding of the customers whose pain is most acute and for whom your solution is a highest priority item,
  2. Satisfy the needs expressed by these early users, and build product features and a user/customer experience that delights them beyond their wildest expectations,
  3. Use the lessons that you learn during this process of slow growth to figure out how to build the processes and procedures you will need to scale the excellence that should mark your execution at that scale to excellence as your startup exits the search and discovery phase, and lastly
  4. To do all this without stressing the organization to the point of failure.

If you have not done so yet, you should read Paul’s post. He delves into the subject in a way only he can.

Imagine of a team of 3 co-founders with 2 contract developers helping build a product, it could be an enterprise or consumer product . . . and let’s assume they raised $750K in outside capital. Now think of the stress that team would be taking upon itself if it were to try to serve 10 different enterprise customers in 8 different industries. Consider all the ways each of these industries might differ in terms of the business protocols that the startup would have to become subject to, now also consider the ways in which each of the 10 customers might differ from the others. With only a few exceptions, it would make more sense to win 10 customers in 1 or 2 industries . . . Gain experience, gather momentum in those markets, grow the team in step with the growth of the startup’s customer-base and revenues . . . . and only when business development in those initial markets has reached a tipping point, then the startup can begin exploring customer acquisition in other markets. An analogous thought process works for startups building apps for consumers, and reaches a similar conclusion.

Think of it as building a solid foundation before attempting to complete the structure which will rest on the foundation. What ever the size of the structure, it will not last if the foundation that is meant to hold it up is weak.

Most research about why early startups fails lists the top two reasons as some combination of “produced something for which there was no market” and “run out of cash” . . . The research is often not granular enough to enable us to say definitely what exact reason led to those conclusions, but . . . A failure by an early stage startup’s founders to adopt focus as the launch strategy makes those two outcomes inevitable. Why?

First, lack of focus means the startup spreads itself too thin and fails to find and devote its attention and resources to those customers or users with the highest propensity to use, and then pay for the product.

Second, a lack of focus can be exorbitantly expensive if the startup is selling a product that is far from fully-baked to multiple industries. Several rounds of customizations for a small number of customers in a given market without a sales process to increase the revenues from that market quickly results in expenses that can quickly get out of control. It is not difficult to think of how this plays out for startups building apps for consumers.

Closing Thoughts: Every early stage technology startup should start out pursuing a focus as its generic strategy. The time to make a choice between cost leadership and differentiation is once product-market fit has been established, which is the point at which the startups begins to transition from searching for a repeatable, scalable, and profitable business model to building out the organizational structures of a company. Also;

  1. The highly fluid and dynamic nature of the markets in which technology startups operate requires founders to be willing to experiment with combinations of the generic strategies once product-market fit has been established. They crucial requirement is to execute any such hybrid of the generic strategies in a way that strengthens the startups competitive position rather than weakening it.
  2. Strategy is not a “set it and forget it” proposition . . . One of the functions of a good board of directors is a semi-annual review of the startup’s strategy to determine if there’s reason to consider making an adjustment. I do not mean to suggest that the strategy should change every six months, but the board should examine the environment every six months or so in order to ensure that maintaining the current course is the right strategic choice.

 

References   [ + ]

1. ↩ Let me know if you feel I have failed to attribute something appropriately. Tell me how to fix the error, and I will do so. I regret any mistakes in quoting from my sources.
2. ↩ My target audience is made up of  first-time startup founders who do not have any background in business, finance, economics, or strategy.
3. ↩ I am paraphrasing Steve Blank and Bob Dorf, and the definition they provide in their book The Startup Owner’s Manual: The Step-by-Step Guide for Building a Great Company. I have modified their definition with an element from a discussion in which Paul Graham, founder of Y Combinator discusses the startups that Y Combinator supports.
4. ↩ Keith H. Hammond, Michael Porter’s Big Ideas. Accessed on Jun 20, 2015 at http://www.fastcompany.com/42485/michael-porters-big-ideas
5. ↩ It is not clear to me if the unbundling of CraigsList arose from conscious choices made by others observing the markets it served, or if this is a phenomenon that has only become obvious after the fact.

How Studying Bankruptcy And Working On Two Turnaround Assignments Prepared Me To Become An Early Stage Venture Capitalist

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The Chinese Character for Crisis; Danger + Opportunity (From The Ten Strategies For Leading At The Edge)
The Chinese Character for Crisis; Danger + Opportunity (From The Ten Strategies For Leading At The Edge)

 

When I started business school at NYU Stern in the fall of 2005 my plan centered on taking every class in Bankruptcy & Reorganization, and Distressed Investing that I could. I took 3 elective classes in that area; Bankruptcy & Reorganization with Prof. Ed Altman, Case Studies in Bankruptcy & Reorganization with Prof. Max Holmes, and Investment Strategies: Distressed Investing with Prof. Allan Brown.

By my logic, if I learned how to assess and invest in dying companies, and then nurse them back to health, analysing, valuing and investing in healthy companies would seem easy by comparison. I was so sure of this that I also tried to turn my Equity Valuation elective into a pseudo Bankruptcy & Reorganization course too, by opting to value a bankrupt company for my final group-project. I do not recommend trying that.

I was still in business school when the economy began to falter. I moved from UBS to Lehman Brothers in late March 2007. A few days later New Century Financial Corp. filed for Bankruptcy. I was let go from Lehman Brothers a year later, on March 12, 2008. Bear Stearns collapsed and was acquired by JP Morgan Chase on March 16, 2008. I graduated from Stern in May, 2008. On September 7, 2008 Fannie Mae and Freddie Mac were taken over by the federal government. Lehman Brothers collapsed on September 15, 2008. On September 16, 2008 the Fed bailed out AIG.

The rest of 2008 was a bloodbath.

It was in that environment that I joined KEC Holdings, KEC Ventures parent company, in December 2008. I was employee #2. I had been hired into a new role that had not existed before at the company. My responsibilities encompassed any direct and indirect investments the company had made, or might make in the future.

Most notably, the company had already made 2 private equity investments; one in a private jet charter company and another in a fine-dining restaurant group – they were struggling to stay afloat given the economic environment. My first order of duty was to “make sure they don’t die” and “help them come out of this mess stronger than they were going into it.” There would be no financial engineering gimmickry. No tried and true business school textbook “indiscriminate” cost-cutting shortcuts. I had to roll up my sleeves and work with each company as intimately as necessary to achieve the objectives.

This post is about how we navigated that period. It is also about what that period between December 2008 and August 2013 has taught me about the challenges startups face, and my role as a venture capitalist.

Every day is a journey, and the journey itself is home. - Matsuo Basho
Every day is a journey, and the journey itself is home.
– Matsuo Basho

Further Background

Both companies were generating top-line revenues in the range of $20,000,000 – $30,000,000 per year. Both had fallen short of budgetary expectations in 2008, but the aviation company had a more prolonged string of losses than the fine-dining restaurant, partly because the restaurant was a more recent investment at that point. I functioned as an “external management consultant”; I was not a full-time employee of either company, but I worked with employees across the hierarchy of both companies. The restaurant company employed between 400 and 500 people while the aviation company had between 30 and 40 employees after several previous rounds of downsizing.

Both companies had watched as some of their competitors ran into strong headwinds, and subsequently shut down operations because the economic environment was so bleak.

Lesson #1: Understand The Business

Once a company is in financial distress investors have to decide if it is worth saving, and they also have to answer the accompanying question; can it be saved given current known constraints? The only way to do this is to develop a deep understanding of the business, and the context within which it is operating.

Between 2008 and 2012, confidence in the economy was very low. People simply were not splurging on expensive meals or luxury jets. An economist would say that private jet charter and fine-dining both have a high elasticity of demand.

I had no prior experience working at, let alone helping to run a restaurant or a private jet charter company. So I decided to spend the first six months in learning mode. I studied everything I could about both markets while I helped the executives and managers at both companies deal with day-to-day nuts-and-bolts issues.

This was important if I was going to build personal credibility, and if I wanted to win buy-in for my ideas from the executives and managers later on. I had to be able to influence them into doing things they probably did not believe in at the outset, and I had to do this with little real influence.

How this applies to early-stage startups: Today, I look for founders who embrace their expertise, and demonstrate a knowledge of their business that surpasses mine. However, the founder also has to demonstrate an ability to assist me learn enough about their industry to make a decision, and act as a useful sounding board for decisions that have to be made in the future.

Lesson #2: Understand The People

During those six months, I also tried to understand the protagonists in each situation. I relied on a technique I had learned in my Literature in English classes during secondary school in Ghana; character analyses.

A character analyses involves performing an in-depth study of the key characters in a drama, and trying to figure out each character’s story; What motivates that person? Why is that person who they are? What is the person afraid of? What drives that person? How does that person communicate? How does that person respond to pressure and stress. What does that person gain the most satisfaction from? What’s the state of that person’s family life? How does that person perceive me? How do I perceive that person? Does that person buy into the need for a turnaround? Is that person willing to commit to the turnaround? What biases does the person exhibit that I can identify? How does that affect things?

I had to be honest, and to contend with the pleasant and the unpleasant, especially around the perceptions other people had of me at the outset.

I took copious notes, and added to them until I felt I had a decent understanding of each of the people with decision-making authority that I would be dealing with most often; executives, managers, and front-line employees.

Perhaps an important, but often overlooked insight is that an investor should strive to understand the people within the context of the business. For example, is this person a leader or a manager? The distinction matters because it can spell the difference between beating about the bush with no results to show, or getting to the heart of the matter and fixing the problems that need to be solved at a tactical and granular level. Fred Wilson writes about this problem in: Leaders and Executives.

How this applies to early-stage startups: We make seed stage and series A investments. That early in a startup’s life, the people make all the difference. The market is important, so is the product. However, at this stage the future is still so nebulous and difficult to envision that the team that has decided to embark on that journey matters more than anything else. So, I have learned to focus on questions like; How did this team come together? Do the founders take responsibility for outcomes, or do they have a habit of passing blame? Do they have the intestinal fortitude to withstand the difficulties they are bound to face as individuals, and as a team on this difficult path they have chosen or will they wilt under pressure? What evidence do I have to support my answer to this question. What is their approach to learning, as individuals and as a team? Have they faced crises together? How did they fare when the going got tough? I will not ask most of these questions directly, but I will be processing every interaction, every bit of information I get, to determine answers to questions along this line of reasoning.

Lesson #3: Create A Sense of Urgency, But Provide Hope

Unlike a startup, a company in financial distress already has a product that it has sold successfully in the past, it also has a sense of who its customers are and where to find them. It is easy for the people within the company to succumb to status quo bias. This is identifiable by statements such as;

  1. “Everything will be fine, we just need to close this one sale.”
  2. “I feel confident it will happen, we have this sale in the bag.”
  3. “They are not our competitor, they do not do what we do!”

In the face of incontrovertible evidence that “they are up shit’s creek without a paddle” people will still choose to do what feels comfortable.

It was my responsibility to shake them out of that rut. As John P. Kotter says in Leading Change: Why Transformation Efforts Fail; 75% or more of a company’s management has to buy into the need for change, otherwise the chance that the change effort will fail is unacceptably high.

How did I do this? In both cases I did not shy away from asking questions that I expected to generate conflict. Indeed, on several occasions I had to have unpleasant and difficult conversations with the top managers and executives in both companies. I did this even if it appeared that I was “meddling” in areas where I had no business poking around. Of course, the idea that there was a part of either company’s operations that I “had no business” exploring was a fallacy only someone keen on maintaining the status quo would believe.

The message, delivered by the investors and the board, and reiterated by me during my frequent field trips, was simple; “The status quo is unacceptable, and failure for lack of effort is out of the question.” We had one chance to get it right, and we had to make the most of that chance even if it meant discomfort some of the time. We could get there with or without conflict. It was entirely up to us to make that choice.

How this applies to early-stage startups: The time for the whole team to start thinking about the Series A Round of Financing is the night before the Seed Round closes. Some one on the team should always be thinking about what it will take to raise the next round.

The time to start thinking about revenues is yesterday, even if you do not implement those plans immediately. Always have a plan. Always test your plan.

Lesson #4: Investors Have Ideas, But Management Runs The Business

Investors will always have ideas about how a business should be run. Sometimes investors know more about a certain topic than management. It is okay for investors to make suggestions, and to offer ideas to management. However, responsibility for choosing which ideas to accept and which to reject has to rest on the shoulders of management, and management has to accept accountability for the outcomes.

There are a number of ways this aspect of the relationship between investors and management might unfold;

  1. Investors can dictate to management what investors think management should do, or
  2. Investors can teach management how and why things should be done a certain way.

I chose the latter. That approach takes more time, but it is also more likely to lead to permanent change in behavior than the former. Also, once the lessons had taken root that approach allowed me to gradually pull back my involvement without jeopardizing the progress that management was making in improving results. It is an approach that builds self-sufficiency.

As part of the process, we cultivated the practice of communicating:

  1. Why a certain goal or strategic initiative was important for the company’s near term goals and long term vision.
  2. What had to get done in order for that goal or strategic initiative to be successfully executed.
  3. Who specifically was primarily responsible for seeing that it got done, and which executive they could go to as often as necessary in order to navigate what ever obstacles they might encounter.
  4. How it would get done, not in excruciating detail, but in broad terms. For example; Which teams needed to collaborate with one another in order to make it happen?
  5. When the team expected to be able to report back periodically on their progress, and importantly, when the project needed to be complete.

To do this successfully, I had to focus on asking questions and encouraging deeper levels of inquiry than was the custom beforehand. Asking probing questions helped us cut out the “bullshit” of conventional wisdom that is seductively easy to accept.

Each time I heard; “You do not understand, that is not how it is done in our industry.” I would ask; “Why?” That would lead to an examination of the assumptions behind the choices that had been made in the past. Often there was no good reason to refuse to try something different even if it seemed out of step with accepted industry convention.

How this applies to early-stage startups: I am looking for founders at the seed or series A stage whose judgement I can trust enough to feel they do not need me to opine on every decision they ever have to make. That does not mean I am passive. It means I need to trust their decision-making skill and maturity enough to feel confident they will consistently make the right choices for all the startup’s constituents without the need to run everything by investors.

From the investors’ perspective, a policy of “show, don’t tell” goes a long way. To paraphrase the oft quoted saying; “Give a founder a fish and . . . . ” If I feel there’s something a founder ought to learn, I’d rather provide a guide to enable that founder learn the applicable frameworks and how to apply them in day-to-day decision-making situations.

Lesson #5: Create Internal Value By Increasing Organizational Capacity

The way we defined it; Organizational capacity is the harnessing of a company’s human, physical and material, financial, informational, and intellectual property resources in order to enable the company to continually perform above expectations and strengthen its competitive position.

In difficult times especially, it is important that companies do not lose sight of the need to continue to find ways to increase organizational capacity.

One way we did this, in both cases, was to shift both companies off MS Exchange Server and onto Google Docs for Work. This was not easy because of cultural attachments to MS Exchange and fear of having to learn something new. Both companies made the shift, eventually. The immediate benefit they experienced was a dramatic reduction in the costs they incurred for IT assistance. A more important, though less tangible benefit was that both businesses could then afford to give every full-time employee a corporate email address and access to a corporate intranet portal. The benefits were enormous; easier collaboration, easier information transfer and sharing,  and increased security of corporate information and trade secrets. Quicker turnaround on tactical decisions because people could now communicate by chat.

Given the improvements in tools for collaboration, we encouraged the formation of cross-disciplinary teams to tackle some of the problems that each company was dealing with. This allowed people from one area of each business to interact more closely with their colleagues from another area of the business. They developed a better understanding of one another, and of the challenges and constraints that they each faced in trying to execute their day-to-day responsibilities. In turn this fostered a more collaborative relationship across the entire organization. It also enhanced the learning environment for all employees.

How this applies to early-stage startups: It does not take a lot by way of resources to create an environment that is rich in opportunities for cross-functional collaboration and learning. This comes in handy during due diligence because every member of the team will be able to speak knowledgeably about the startup’s immediate and long term plans.

Lesson #6: Direction Must Be Set From The Top, But Engagement Must Begin at The Bottom

We started working on trying to develop a strategic plan for both companies in summer 2009. Before this time, neither company had previously had a coherent strategy.

In consultation with the executives in each company, the board of directors set out the broad areas that the strategic plans ought to cover; Finance, Operations, People, Demand Creation, and Expansion.

Once those had been agreed on, it was my job to meet with front-line employees as well as managers in the field in order to obtain data and insight about how the strategic plan would have to be set up in order to function effectively for them given what each company was trying to accomplish.

That sounds easy. It is not. It took multiple meetings, of several hours each. The restaurant had multiple locations in NYC, one location in NJ and another in CT. I did not visit the location in Chicago, the CFO held discussions with them during his quarterly visits. I had to sift through everything I heard during those meetings, and I had to extract broad themes. Then I had to reconcile that with the strategic framework established by the board. Finally, I had to interpret that information from the perspective of the competitive landscape for each of the two companies. Finally, I had to synthesize it all into digestible chunks for the board, the executives, the managers and rank-and-file employees.

The goal of spending so much time on having these meetings with people across all ranks in each company was to ensure that once the strategy was developed and implemented, there would be complete alignment behind the vision embodied in the strategy, and just as important that every employee would be engaged in and committed to executing the tactical initiatives required to make the strategy succeed.

How this applies to early-stage startups: The founder creates the vision that investors and the startup’s team buys into. The team executes to turn that vision into a living, breathing, growing reality. Investors hopefully act as a positive catalyst to help the process unfold more quickly.

Lesson #7: Do Not Ignore The Soft Issues, Emphasize Both Hard and Soft Issues Simultaneously

My experience might as well be called The Tale of Two Turnarounds. In one company leadership admitted things were awful. They also admitted that they could use whatever help I could offer. They readily admitted their limitations as a team. We had many instances of conflict, but starting from a position of optimism and a willingness to try, the process moved along slowly, but steadily. We created a survey that we administered twice a year to get a sense of how employees were feeling, data that might not be captured in the key performance metrics we monitored weekly, monthly, quarterly, and annually.

We launched the strategic plan in January 2010 after 9 months of work specifically focused on that task. A year later the company made its first ever payments from a new profit-sharing plan that we had created as part of the new strategy. The payments were not huge, but they were evidence that the team’s hard work was paying off. It also created a feedback loop about how actions by employees affect the bottom-line performance of the company.

In the other company the founder, who was also the ceo, was grumpy and relatively uncooperative with investors. To cut a long story short, we launched the strategic plan in April 2010, after about 9 months of work specifically focused on that assignment. Within 6 months 75% of the managers with whom we had worked to develop and launch the strategic plan had left the company or had been fired. It was a classic case in which we would take two steps forward only to take four steps backward.

Morale dipped ever lower. The founders incessant talk about “a vision” and “a mission” became the butt of jokes among rank-and-file employees. It became clear that employees were becoming disillusioned with what the company stood for. While the company fared better than it would have if there had been no attempt at executing a turnaround and developing a strategy, it continued to perform well below its potential.

At a board meeting one day, the founder/ceo went into a vituperous rant about all the areas where the company was falling short. This was in early to mid 2012. I had to burst out in laughter. He might as well have been reciting problems whose solution formed the core of the strategic plan we created in 2010. Implementing that plan would have started the process of solving those problems he was so exercised about that day. We had lost two years for no good reason.

No amount of emphasis on key performance metrics made a difference. Without the founder’s full embrace of the strategic plan, nothing else mattered. I should point out that he had been intimately involved in crafting the strategic plan. This was not a plan that was forced down on him “from on high.” It became clear how badly things had deteriorated when a long time employee quit, this individual was the only employee at the company who had been there as long as the founder.

How this applies to early-stage startups: I am of a firm belief that the team is really important at the seed and series A stage, or at least until uncertainty around product market fit has been largely eliminated. So, I need to develop a sense that a founder is someone I can work with over the long haul . . . Actually, the kind of founder I am happy backing has to be someone I could envision myself working for if circumstances were different. Age, race, gender, religion . . . That is all irrelevant. Early in my process for assessing a startup I focus almost entirely on soft issues.

In one example, I sensed something amiss about the body language between 2 Spanish co-founders pitching a startup to my partner and I in 2013. I decided to tune out what they were saying in order to better observe their body language. There was something about their body language towards one another that did not align with what they wanted us to believe, in my opinion. We passed on their seed round, and decided to watch them till we could get more data about the relationship between the co-founders. That was nearly 3 years ago. I have heard no reports to suggest we made an error in that case.

Let chaos reign, then reign in chaos.

– Andy Grove, Only The Paranoid Survive

Lesson #8: Be Prepared For Chaos; Harness, Focus And Direct It, Empower People

Once employees understood the strategic plan as well as the tactical initiatives that accompanied it, they began developing ideas related to the various functional areas in each company and making suggestions to managers and excutives.

At first this was overwhelming . . . Managers had to do their own work, manage the work of the groups of people that they managed, and now . . . . They also had all these ideas being thrown at them from “left, right, and center.” The initial knee-jerk reaction was to try to “make it stop.”

That would have been a mistake. Among the deluge of ideas were some real gems.

For example, a maintenance department team member at the aviation company noticed that the company could cut down on its electricity usage by changing all the bulbs in its main hangar . . . No one had thought about that over the years, but our discussion about the strategic initiative around improving the product while reducing costs prompted him to take another look at the company’s hangars in search of opportunities to reduce operating costs. Thanks to improvements in technology over the years this was now a measure that could be implemented relatively easily.

In another instance, the team at our restaurant in CT had observed that on certain days of the week large groups of Chinese tourists visited the casino resort in which they are located. They had been thinking of a way to capture some of that business, but had assumed the corporate office would object to the menu changes they thought they had to make in order to execute that plan. As part of our implementation of the strategic initiative around increasing revenues, I suggested they conduct an experiment, analyze the outcome, and then seek assistance from the corporate office if the results looked promising. They did that, and saw a jump in revenues on two days of the week when business would otherwise have been slow. The corporate office gave its blessing, and assisted in making that practice more entrenched by using corporate resources to give it the polish required for company-supported initiatives.

How this applies to early-stage startups: A startup stops being a startup once its search for a repeatable, scalable, and profitable business model is complete. While that search is in process it is important that every member of the team feels empowered to contribute to the discovery of that business model. It can’t be the job of only some members of the team, it has to be part of everyone’s job. The faster a startup gets through the discovery process the better.

Lesson #9: The Turnaround Should Be Its Own Reward; Incentives Should Reinforce Change Not Drive It

It was nice to be able to make payments from the profit-sharing plan that we instituted. The payments were relatively small, yet they were tangible evidence to the employees, managers, and executives that they were collectively well equipped to make it through the ongoing turbulence and correct the mistakes of the past.

The sense of accomplishment employees felt translated into a number of things, among them;

  1. Newfound and increasing pride in being associated with a company that was succeeding where many of its rivals had failed.
  2. High levels of morale and optimism about the future of the company, and their place at the company. Less stress about employment security.
  3. A greater willingness to take the initiative in situations where the possibility of generating business for the company exists.

Basically, every employee was empowered to function as a salesperson on the company’s behalf. We arranged training sessions to equip every employee with the vocabulary they needed to understand in order to do that effectively. We also developed simple tools that they could use. They did not replace the company’s professional salespeople . . . They became an auxiliary sales force.

How this applies to early-stage startups: As startups grow, founders and early team members need to get better at the art and science of “managerial leverage” . . . What is managerial leverage? It is the process by which a manager creates output that far supersedes that manager’s input by using all the resources at the manager’s disposal to influence the work that is done by the group of people whose on-the-job effectiveness and work-output is affected by interactions with the manager.

What is a manager’s output? According to Andy Grove, co-founder and former CEO of Intel “The output of a manager is a result achieved by a group either under his supervision or under his influence.” Great managers create positive output that far exceeds expectations. Below average managers create output that fails to meet expectations given superior resources. Average managers? The team’s output would not be any different if the manager were absent.

The art of managerial leverage is in determining; how to apportion time, where to pay more attention, where to pay less attention, who to pay more attention to, who to pay less attention . . . . etc etc. The science of managerial leverage is in determining; what to measure, when to measure it, how often to monitor what is being measured, where bottlenecks are most likely to occur and why, and how to eliminate them . . . . etc etc.

Managerial leverage drives output. Output drives results. Results are measured and reflected in the KPI’s that founders and investors measure. Getting that order right is critical to a startup’s success.

Lesson #10: Learn To Listen, And Communicate Effectively

It is amazing how many problems can be solved relatively quickly if people would communicate more effectively internally and externally. Communication involves two actions; first listening actively in order to understand what is driving the actions of other people. Second, responding to what other people have said in a way that gets to the root cause of the problem being discussed.

During one of my field visits, I spent 8 hours on my first day listening to the executives talk about all the problems they each perceived, and how they felt the issues ought to be tackled. I spent that day with the CEO/President, the CFO, the Head of HR, and the Head of Sales. I encouraged open disagreement and debate.

On my second day I spent about the same amount of time speaking with the middle managers; again we discussed the problems they each perceived, and how they each felt the issues ought to be tackled.

On the third day I brought both groups together, and moderated an all day discussion about the problems the company was facing. Once again, I encouraged open disagreement and debate. Also, I put the inter-personal issues and conflicts that I had uncovered on the table. Things often got heated. It was my job to function as a pressure-release valve during those episodes. It was not pretty.

For example, I explained to the entire group how the CFO who was disliked by a large number of people within the company had made payroll on too many occasions by dipping into his personal 401(K) savings for example. The irony, the folks who disliked him routinely failed to provide the finance team with the data they needed in order to collect on accounts receivable from the company’s customers.

The outcome of this exercise was that;

  1. Everyone felt they had been given a chance to speak and be heard by the rest of the leadership team, and
  2. We discussed expectations in a fair amount of detail, enough so that more work could be done laying them out in adequate specificity rather than vaguely wondering what people could expect from one another, and finally
  3. Created an environment in which each member of the leadership team contributed in creating a communication framework against which they agreed to be held accountable

Our goals for the communication framework were that;

  1. Every employee should know what is expected of them, as individual team members,
  2. Every employee should know what to expect from every other member of the team,
  3. Employees should know what to expect from executives and managers, and lastly
  4. Accountability should be about improving team and company performance, not punishing individuals.

As Rosabeth Moss Kanter says in Four Tips for Building Accountability; “The tools of accountability — data, details, metrics, measurement, analyses, charts, tests, assessments, performance evaluations — are neutral. What matters is their interpretation, the manner of their use, and the culture that surrounds them. In declining organizations, use of these tools signals that people are watched too closely, not trusted, about to be punished. In successful organizations, they are vital tools that high achievers use to understand and improve performance regularly and rapidly.”

How this applies to early-stage startups: Startups typically have to move quickly, especially if they have taken in capital from institutional venture capitalists. A culture of blame, lack of cohesive teamwork, and a lack of organization-wide accountability is an insidious tumor that will eventually lead to failure. The founders who are most successful in the long run are those who do not shift responsibility when things are difficult, but instead serve as a model that other team members can emulate.

Closing Thoughts

Executing a turnaround and getting a startup through the phase of discovering a business model are really just two sides of the same coin. That experience has led me to the belief that it is when things seem bleak that great early stage investors prove their worth.

Further Reading

Blog Posts, Articles, & White Papers

  1. The Psychology of Change Management
  2. Motivating People: Getting Beyond Money
  3. The Irrational Side of Change Management
  4. The CEO’s Role in Leading Transformation
  5. The Role of Networks in Organizational Change
  6. All I Ever Needed To Know About Change Management I Learned at Engineering School
  7. Changing an Organization’s Culture, Without Resistance or Blame

Books

  1. High Output Management
  2. Only The Paranoid Survive
  3. How Did That Happen?
  4. HBR’s 10 Must Reads on Change Management
  5. HBR on Turnarounds