Category: Startups

Building a Startup - Head in the clouds, feet on the ground

1/21/2014

In my novel, The Silicon Lathe, there's a section where after having been burned by an unethical CFO, the CEO tries to trap prospective replacement candidates by seeing if they'll stretch the rules of accounting to make books look good to investors and shareholders. After one candidate storms out of the interview, outraged at the CEO's suggestions, they hire her on the spot. This really did happen and it was the beginning of a longstanding business relationship that led to multiple successful startup companies.

The job of a CEO is to lead the charge. The CEO has the vision and an ability to communicate that vision to the team, to customers, and to investors. By its nature, the job is one of communicating optimism. Many of us are probably too optimistic, but without that optimism, it's difficult to spark the enthusiasm and energy that are critical to a company's success.

At the same time, that optimism can lead to disaster. Sometimes you'll underestimate risks of a new customer contract or costs of a new product development or marketing campaign. You may see a huge opportunity that could lead to the overnight success of the company. But, that temptation to swing for the fences on every pitch usually leads to a strikeout. If you have your head in the clouds, it's hard to keep your feet on the ground. So, how do you do both?

Find someone who understands and respects the forward charging requirements of a CEO, but who can pull your feet to the ground from time to time. Recognize the value of conservatism as a balancing factor in the success of the business. Look for someone who can be your watchdog in terms of legal and ethical issues.

These people are rare, so if you find one, keep her/him close and don't underestimate their value to the business. This doesn't mean you won't take risks or that you'll always follow this person's advice. Your role as CEO is to gather all the information, assess the risks realistically, and then make your decision. With a bit of luck and common sense advice, there will be plenty of opportunities to take a big swing without risking it all.

Angel Funding

Always Hire 10s

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Angel Funding

1/14/2014

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You've looked at bootstrapping and are unable to fund the business yourself, talk your employees into going without salaries, or find customers who will help fund the development of your product. You're looking for outside investment and know that at this stage raising Venture Capital probably isn't possible. So, where do you go? Angels!

Angels are private individuals or groups who are interested in helping entrepreneurs get started. They could be family and friends, former entrepreneurs who made good, or groups of private investors who can pool their monies. Family and friends typically will offer small amounts of money. Former entrepreneurs will often provide $25K-$50K to get you started. More successful ones who believe in your company might go as high as $100K. Angel Funds may go as high as $250K to $500K.

Although it's tempting, I'd advise you to avoid family and friends if possible. You don't need Uncle Jim, who made money selling used cars, telling you how to run your business. And, you don't need the guilt you'll feel if you lose the money that Aunt Mary invested.

So assuming you're going to take money from a 'Qualified Investor' (someone who is considered knowledgeable and able to afford the risk), in general, you should be prepared to give up about 25% of your company for your first angel/seed round of investment where you raise $250K-$500K total.

Experienced Angels can be very helpful. They've been where you are and most are looking to 'pay back' a bit of their good fortune. They can provide business advice, introductions to customers and other investors, and they usually have a lot of credibility in the market and the investment community.

Your choices for structuring the deal generally fall into convertible debt where the investment is considered a loan, but a loan that can be converted to equity at a later date, and equity where the investors will own shares of your company, usually preferred shares.

Convertible debt means that you take loans from the investors but that they will have the right to convert to equity at some time or event in the future (e.g. you decide to raise a Series A round from VCs). Pricing that conversion can be tricky. A bit more on that below.

Offering equity is a bit more complicated than taking a loan. You need to create a preferred class of stock and structure the preferences, including voting rights, board seats, liquidation terms, terms for converting to common stock, and more.

While I'm thinking about it, let me advise you to be careful with liquidation preferences. In general, VCs and Angels will ask that their investment be repaid in the event the company is liquidated. The problem lies in the definition of 'liquidation'. As an entrepreneur, you're probably thinking that if the company goes under, it's only fair to let the investors get as much of their money out as they can. However, in most cases, 'liquidation' also includes sale of the company. In an upside sale (as opposed to closing down the company and selling off assets), this means that you pay back the investors, then they convert their preferred stock to common and share in the remaining proceeds of the sale. I call this the 'double dip'. Avoid it if at all possible.

Coming back to equity versus debt, in general taking a loan as convertible debt works better for you than giving up equity. However, if your angels are helping your company in a big way, it seems only fair that they should share in the equity up front and not have their upside limited in the debt conversion.

The most challenging part of either convertible debt or equity is valuation. While most of us would like to value our companies high, thus giving up less equity now (with equity funding) or later (with convertible debt), valuing too high can be a dangerous trap. It may cause you to give up much more of your company with future investments if you haven't proven and increased your valuation, and for the convertible debt, the conversion may cost you hugely.

If you gave your Angels equity, they share in your downside by being diluted. If you gave them convertible debt, their conversion would be at the new rate and they would have more of the company.

So, be careful with valuation. For a great article on Angel Funding, which is still relevant, if a bit old, see Mark Suster's Angel Funding Advice.

Why You Should Avoid Venture Capital

Building a Startup - Head in the Clouds, Feet on the Ground

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Why you should avoid Venture Capital

1/7/2014

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Okay. You know I'm biased. I'm a big proponent of bootstrapping a startup and don't have significant problems with going for Angel Funding if you really need it. We'll talk about that in my next post. But what about Venture Capital? Why am I so against it?

Well, philosophically, I like the idea of building a sustainable business. I think you win the game more often by going for base-hits or short yardage most of the time and only taking that big swing or long bomb when you can afford to do so - not at every at-bat or down. Sorry for the sports analogies, but if you're looking at Venture Capital, you have to be ready to 'swing for the fences' or to 'throw the long bomb'.  A Venture Capitalist (VC) is not looking at a sustained effort to win the game. They're looking for you to take big chances so that if you do win, you (and they) win big.

I know this sounds cynical, and I do see need for Venture Funding at some stages of a company; e.g. funding a major expansion or preparing to go public. But I'm skeptical of early stage investments unless you are willing to risk it all.

I have some experience with VCs. For several years, I consulted to multiple VC firms doing technology evaluations. I also took one Series A round of investment in one of my first companies. There are some excellent VCs out there.

I don't think they're shy about their objectives or methods.  As one VC told me early in my career, if he invests in ten companies, he expects one to hit that home run. Three to four will fail outright, and the others will amble along, potentially growing, but not fast enough to be of continued interest to the VC.   Most of these good companies will be sold off with no significant upside to the founders, or closed down by being denied additional funding after over-extending themselves with VC money.

We all like to think we're going to be the one in ten. Realistically, if we're good business people, we'll likely end up in the five or six who are reasonably successful, but not setting the world on fire in the VC's three to five year timeframe. If we swing for the fences, there's a very good chance we'll be among the three or four companies that fail outright.

Even if you're confident you have the next great idea and can beat others to the market to succeed and hit that home run, I encourage you to hold off on VC investment until at least a Series A round. Get your business started, prove the model, show the customers and then take your big swing.

Since this series of posts is about starting up a company, except in unusual circumstances, I would discourage you from taking seed money from a VC.

While I'm sure there are some well-intentioned VCs offering seed money and actually helping entrepreneurs get started, I can't help but think that a VC who sets aside a small part of his fund for seed funding is taking unfair advantage.

Rather than actually committing to fund a company via a Series A round, seed funding allows a VC to gain control of a number of ideas and people with very little commitment. There's no commitment to additional monies, no commitment not to take the ideas generated and fund another company with them, no commitment not to hire people away from you.

Worse, if you develop a dependency on the VC's money, when it comes time to raise more, you're at a disadvantage. If your VC decides to pass, your chances of raising money elsewhere diminish dramatically. After all, if the VC who provided the seed funding isn't investing again, what does that say? Why would anyone else invest?

Even if they do decide to participate in a Series A round, you're going to be battling valuation. If your seed money was convertible debt, you could be in a very difficult place when negotiating.

I could tell you horror stories and I invite those who've gone the VC route to share theirs. I also invite VCs to tell us their feelings about seed funding.   Perhaps they can change my mind.

In the meantime, consider bootstrapping or Angel Funding. We'll discuss that in my next post before moving on to more operational issues in startups.

How to Build a Startup - Funding/Fundraising

Angel Funding

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How to Build a Startup - Business Structure

12/11/2013

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Before diving much deeper into funding, I thought it might be worth doing a post on structure of the company from a tax/income point of view. We'll get into internal personnel organization in later posts.

One of the first things you'll be faced with in starting your business is whether you should be a sole proprietor, partnership, LLC, S-Corp or C-Corp.

As a sole proprietor, your company is an extension of you, yourself. From an income point of view, all income goes directly to you and all losses come out of your pocket. In addition, you have direct responsibility for anything that you, your company, or your employees do that may make you liable to legal or debt actions. You can protect yourself from this liability by securing insurance for your business.

Generally a sole proprietorship is suited for a small self-funded business that will face limited exposure in terms of potential legal liability. There is no basic structure to allow investment into the company so you'd need to make private arrangements (typically loans) for any funding you can't provide.

Partnerships are similar to sole proprietorships except that the ownership, profits and expenses are divided among the partners according to their percentage of ownership. While partnerships work in some cases, I've seen many situations where a partner isn't carrying his or her load, where a partner wants to leave the company, where a spouse decided to intervene, and many more problems that in my mind make this a challenging structure for your business. If I were looking for a partner-like structure, I'd probably pick an LLC instead.

An LLC or Limited Liability Company has the structure of a partnership where the income and expense pass through to the owners like a sole proprietorship or partnership. Its primary advantage is that it adds a layer of liability protection. Its simpler to form than a corporation and doesn't require the formality of a corporation (e.g. board and shareholder meetings).

In our country for good or bad (e.g. campaign contributions), a corporation is considered to be an individual and thus, many liabilities go to the corporation itself and don't pass through to the owner(s).   This is called the 'Corporate Veil'. Many expenses like healthcare, retirement monies, equipment and software purchases, inventory, etc. can be assigned to the corporation even if they benefit the owners.

For an entrepreneur looking for investment and for potential exit, a corporation may be the best choice. Note that forming a corporation has costs and in states like California, there is often a minimum tax payment after the first year, even if the company has no income.

The simplest corporation is an S Corporation. An S Corp is like a sole proprietorship except that you have some protection of the 'corporate veil'. You are limited in the number and types of shareholders you can have but you can provide stock in exchange for investment. All income passes to the shareholders.  This may be the best choice if your goal is to take as much money out of the company as possible but to have the protection of a corporation.

One big advantage of an S Corp is in Social Security Taxes. I expect that at some point, this loophole will be closed, but under current law, shareholder distributions (profits) are not subject to Social Security Taxes. That is, the corporation could pay you a salary of say $70,000 per year, and if you had profits of $30,000 in a given year, you'd pay no Social Security tax on that $30,000. You do need to draw a 'reasonable' salary. That is you can't take a $1 salary and pay yourself $99,999 in profits. Note that all profits in an S Corp are assumed to be distributions to you and are taxed accordingly.

S Corps are limited somewhat in the number of shareholders and if you're thinking of going public, you'll need a C corporation. In addition, because of the flow-through of income and expense, there is less protection for the shareholders than in a C corporation. And, in a C corporation, you have more flexibility in terms of how you recognize revenue and expense. C corps are much better if you think you're going to do reinvestment in your company as opposed to taking all the profits every year. Profits in a C Corp may be doubly taxed if you try to touch them. You'd need to declare a dividend after paying corporate tax on the profit, then those receiving the dividends would also be taxed on the dividends.

Bottom line, if you're looking for outside investment, are thinking you might want to go public someday, want as much protection as possible and want to invest in the growth of the company, minimizing those taxes, go for a C corporation.

In all cases, you'll need a business license, even if you decide to operate the business out of your home. For a sole proprietorship or partnership, you'll also need to file a fictitious name statement. You don't need to do
that for a corporation because a corporation is a legal entity itself and has a name granted by the state.

How to Build a Startup - Part 3

How to Build a Startup - Funding/Fundraising

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How to Build a Startup - Part 3 - Funding

12/2/2013

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Okay. You have your idea. You've sized your market and you're ready to start.

Now you should choose the structure of your business and the type of funding you'll need. Going back to why you're starting a business, what is your overriding motivation? I posed a few questions in Part 1, but of these, what is your priority?

Do you just want a decent income that can support you, your employees and your family, giving you independence?
Do you want to get rich?

That's not to say that you won't get rich with (1), but if getting rich is your primary motivation, then your approach will be quite different.

Let's start with (1). You want control, independence, and a decent income that can support you and your employees. If an IPO is in your future, it's at least 4 or 5 years off.

If control is a priority, then most likely you won't want outside interference in your business. You probably don't want to go the route of seeking seed funding followed by larger venture capital investments. Your choices then include the following (in order of the degree of control you maintain):

Bootstrap the business.
Borrow funds to get started.
Crowd Funding.
Angel/Private Investment.

I'll discuss Bootstrapping in the rest of this post and the others in future posts. Note that borrowing funds can be risky. You can borrow from friends and/or family, but you might be surprised how much they want to help. Getting loans obligates you to payments which you need to be sure you can meet.

Crowd Funding sounds good, but new SEC rules make this less attractive.  See I Would Still Pass on Crowd Funding.

Angel/Private Investments offer an attractive possibility though you will give up some control. We'll go into that in a future post.

I must admit that my favorite way to start a company (I did it three times this way) is bootstrapping. In reality, even if you decide to go big with full-on Venture funding, you'll probably need to bootstrap at least enough to get a prototype built or to demonstrate the concept of your product/service.

With the tools available today, you may be able to kick off your startup while you're still working at your present job. Of course you need to be careful to ensure that your employment agreements, in particular patent and confidentiality agreements, don't prohibit you from doing this.   Be very careful here. You also need to be careful in contacting clients of your existing employer. In California, again depending on agreements with your employer, this is usually allowed if your contact is informational and doesn't solicit - "I just wanted to let you know that I've left XXX and am now working for NewCo. My contact information is..."

Note that even if you've left the company, you may be subject to restrictions on information you use or even skills you've learned. Check your employment agreements!

Ultimately, in an ideal scenario, you start your business while continuing your previous job. This means you don't have to pay yourself a salary or benefits.

Often, a good way to start is to begin by offering services - consulting or software development. This makes you profitable from day one. It can also be a good way to do additional market research - consult for your target market and you'll get real insight into what your customers really want/need.

In my first startup, I began by consulting to enterprises who needed unique networking and security products. This involved assessing their requirements in detail, researching what was available in the marketplace and making recommendations for specific products and services, noting the current market deficiencies.

People talk about luck and I guess I was lucky. But I believe you make your own luck by positioning yourself to be ready when opportunities arise. In my case, after a few contracts, I found customers willing to pay for development of products that weren't found on the market in exchange for unlimited licenses (in that case it was software) or for a much reduced guaranteed price (a hardware/software product).

I bootstrapped my second startup through a combination of consulting and contract software development. I hired employees and contractors to do development and banked the profits until I could afford to leave my then-current employer and fund our own product development.

Bottom line: if you have a product or service you can offer use that to raise your initial funding and you'll be in a much stronger position if/when you decide to raise additional capital.

How to Build a Startup - Part 2

How to Build a Startup - Business Structure

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How to Build a Startup - Part 2

11/26/2013

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Obviously, the first thing you need in starting a business is the idea for the business: what product or service are you going to provide?

Most of us choose something we're already familiar with, probably something we've done in the past or are doing now. This should help minimize the risk of failure in your new business.

However, there are a few who decide to go for a complete change. A good friend of mine was a successful lawyer who dropped all the stress, pressure and incessant compromises of law to purchase a UPS Store franchise. He did quite well with his first, and now owns several.

Keep in mind that having expertise in an area is no guarantee of success. Another friend purchased a break-even retail business. She is an expert in the field and very well respected. She has superb marketing and communication skills and a solid track record. Unfortunately, although her products and her services were well-received, there just weren't enough buyers in Santa Cruz to sustain sales of her higher-end products and she's been forced to close. She made the mistake of not fully assessing her market.

So what do these non-tech businesses have to do with your high-tech startup?

The bottom line is that for any business to succeed, high tech, low tech, product, or service, you need to have a market which is sufficient to sustain and hopefully grow your business.

That may seem obvious, but too many people fail to make a realistic assessment of their markets and of how they're going to get penetration into those markets.  You need to completely understand the size of the demand for your product or service in your target market.

For my first startup, I got lucky. I had worked for IBM, then a startup, then a consulting firm. For both the startup and the consulting firm, we used client-funded software development to build our products. Having lined up most of these clients and brought in enough revenue of this type to grow these previous two businesses, I was confident that I could do the same thing with my fledgling service business.

Without producing a formal market analysis, I started the business and was profitable from day one - a contact introduced me to a large Japanese company who paid me to consult and ultimately funded software development. Starting out, I was 100% certain that my service offerings would immediately generate revenue. From that point, I put together a business plan.

Again, it may seem obvious, but you need a business plan. My first was wildly optimistic on the sales side and surprisingly, I was lucky enough to achieve my goals. I'll get into this more in upcoming posts on bootstrapping and raising funding, but for now, let me just say that 'wildly optimistic' forecasts are normally the first steps on the road to failure.

For each idea you have for your business' service or product offering, you must assess the market. This can be difficult for a new type of product or service, but if you understand your market and its associated demographics, and can come up with an approach for how you're going to enter this market, you should be able to generate some useful numbers.  At the very least, this is a sanity check. Once you think you've got something viable, have someone else, who isn't going to be associated with your business, play devil's advocate and try to tear it apart.

If your idea survives that, it's time to move onto your business plan. A business plan is critical because:

It helps you organize your thoughts about what you're offering.
It serves as a roadmap for moving forward.
It should be a checkpoint to keep you from ruining yourself financially when things don't go well - if you're missing your projections, you need to reassess them and your entire plan.
You won't raise investment funding without one.

Of these, (3) is probably the most critical. Most successful entrepreneurs fail twice before succeeding. I've seen too many people pour more and more money into their businesses thinking they'll turn the corner if they can keep going a bit longer. They lost their savings, their homes, and in some very sad cases, their families.

To ultimately be successful, you must know when to throw in the towel. To continue with the fighting analogy, throw in the towel and be healthy enough to fight another day. If you don't, you may kill yourself financially and never be able to recover.

To get a business plan started, you can spend money for consultants and/or pay for books or online resources. However, I've found that the Small Business Administration has a fantastic set of guidelines, and tools for startups - all kinds of startups including high tech. This resource didn't exist when I started out and wasn't very good even 5 years ago, but I think they're now the best source on the web, paid or not. Check them out here.

My next posts will get more into the subtleties of actually getting started. We'll start looking at Funding options. Boostrapping will be first.

How to Build a Startup - Part 1

How to Build a Startup - Part 3

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How to Build a Startup Company

11/14/2013

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Tony Deblauwe's interview at WorkBabble.com got me thinking. He asked about my motivations to write, about my thoughts on the Silicon Valley and about starting and running new companies.

In particular, I realized that the following questions would be good jumping off points for my thoughts on how to form a startup.

Given your passion for technology and recreation, how have these two passions influenced your view of how to run a business?
What are the new challenges for getting start-ups off the ground today versus when you started your first business?
What guidance would you give new Founders regarding scaling their business?
Describe the ideal team culture.

Over the coming weeks, I'm going to describe my experiences with not only my three startups, but with the startups my friends created. As you might expect, while several of my friends took their companies public. More failed. Most started again and saw some degree of success. However, several ended up bankrupt. I'm hoping that by going through these experiences, those of you considering a startup or who are already part of one can avoid the mistakes my friends and I made. Note that even without mistakes, pitfalls await. You will encounter unscrupulous people, greedy investors, employees who will put you and your company at risk, and competitors who will resort to whatever is necessary to ensure you fail.

Balancing all of that is a challenge. We'll get started in my next post.

How to Build a Startup Company - Part 1

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Forward>>

Building a Startup - Head in the clouds, feet on the ground

Angel Funding

Why you should avoid Venture Capital

How to Build a Startup - Business Structure

How to Build a Startup - Part 3 - Funding

How to Build a Startup - Part 2

How to Build a Startup Company

Steve Jackowski

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