Is The Daily Deal Backlash Overblown?

According to the business maxim, you can always tell who the leader is in a given market: it’s the one with all the arrows sticking out of its back.

While this axiom is applicable across the business landscape it is particularly relevant in the startup world given that most leaders in an emerging market end up taking as much incoming fire from me-too startups coming up from the rear as they do from incumbents threatened by the continued advance on their territory.

I raise this point because I’ve been surprised in recent weeks at the backlash in the media and across the venture landscape against daily deal sites, most notably Groupon and LivingSocial.

To be sure, the daily deals business has become ferociously competitive. There are now dozens of venture-backed businesses pursuing some configuration of the daily deal/social buying/demand aggregation business model. To this number add the emerging group of established web companies now brand extending into the deals business–Facebook, Yelp, Travelzoo, OpenTable, Amazon, and Google, to name but a few.

The birth of any new industry is rarely elegant, planned or pretty. With little argument, whenever one is dealing with the kind of torrid growth that both Groupon and LivingSocial have experienced one will find plenty of areas to criticize. However, I think some of this criticism is misguided. To call a marketplace with hundreds of competitors vying for consumer dollars emerging might be an oversimplification, but emerging it very much is. Let’s not forget that like the early days of social networking, the winning model in this space has not yet been fully realized. Constant iteration is underway, all being attempted at the breakneck pace one would expect in a marketplace still decidedly in its land grab phase. This means things are going to break — loudly and often. This is not altogether bad.

The daily deals space is the kind of web phenomenon we have seen before: Explosive growth, high user engagement, huge cash flow implications for the companies, lofty valuations, investors elbowing their way into funding rounds, and lots of media attention to fuel the frenzy.

In this environment, Groupon and LivingSocial have broken out as the market’s de-facto leaders and built robust businesses. Revenue growth has been nothing short of spectacular. In turn, the companies have responded by raising sizable funding rounds to further consolidate their positions and extend their reach into new markets. Investors and employees have every reason to be proud of these accomplishments. So far, so good.

This, however, is far from saying that their status as perennial leaders is a fait accompli or that they cannot be felled by either other participants or by their own strategic missteps. Indeed, it is still early days. This is perhaps why I find the latest hand-wringing over Groupon’s recent stumbles in the media somewhat disconcerting.

Massive customer churn is to be expected. Explosive growth, particularly as relates to web companies, raises the notion of the shiny new object theory. This notion should inform us that exponential growth and buzz brings huge consumer curiosity which, in turn, brings an influx of users that will try the product/service once and never return. Is this a reflection of a company that has provided a poor user experience? Or, is this simply the realization that 30-40% y/y revenue growth is likely unsustainable and that large swings in customer churn will be in evidence for a long time to come? I am in this latter school of thought.

The “churn” issue so often cited by critics is not simply a matter of consumers being fickle but one of SMBs and merchants as well. They are still trying to figure out how to work with deal sites and whether such marketing campaigns are right for their specific businesses. This will take time.

The Spaghetti Test. Additionally, daily deal sites are incented to build vast Rolodexes and cover wide areas of terrain to extend their brands. This means lots of offers are being written across broad categories of SMBs where the suitability of the daily deal model is still not thoroughly understood and where there is little historical frame of reference. While most managers are loath to admit it, the Spaghetti Test of  ‘throw it against the wall and see if it sticks’ inevitably drives a lot of iteration around determining which offers resonate and which do not. This results in a lot of mediocre offers that don’t perform well which can leave merchants and consumers with a poor experience.

Work to be done. Critics are right to point out that there is still a lot of work to be done in elevating the daily deals business to deliver on the full promise of its massive potential–both for consumers and for businesses. Merchants need better post-deal monitoring and CRM-like tools to help with yield management and provide better tracking and analysis. Merchants also want more control and flexibility over how offers are created, sold and redeemed so they can maximize profits while minimizing the impact on their organization when the “crush” of redemptions comes. [Fortunately, startups are already innovating around these themes to fill precisely these voids.]

Consumers, for their part, are demanding better offer targeting, more consistency in pricing and redemptions, and less intrusive appeals in order to fight against emerging deal fatigue now evident across the space. Personalization software needs to catch up so that users can better tag offers of interest and opt-out of those that are annoying or redundant (Cupcakes? Again?)  Also, Hyperlocal and Location-Based-Targeting need to demonstrate that they are more than just elegant theories.  Too many service-oriented SMBs (i.e. hair salons, etc) have gotten burned in money-losing offers for premium services to out-of-town customers with whom there is no opportunity to develop a long-term customer relationship. That kind of mismatch is being corrected but hyperlocal offer targeting has a ways to go.

Ultimately, the scale that Groupon and LivingSocial have achieved has likely put them beyond the reach of most competitors. The battles ahead, therefore, will be over how best to go vertical. The winners will be those most savvy at customer segmentation and in finding unique offerings positioned against specific themes and product categories. Predictably, there are numerous companies doing precisely that — tweaking group-buying mechanics and applying them to niche, premium markets and making a successful play in those areas. In another market in another time, this “go vertical” approach may have doomed a company to a market insufficiently large to support its efforts. However, as companies such as Gilt Groupe and One Kings Lane have demonstrated, the daily deals market is large enough that even pursuing a niche approach and a narrow customer segment can prove to be enormously lucrative.

Why VCs Rarely Back “Family” Founders

I recently met with a promising startup led by a husband-and-wife founding team. This was not a standard investor pitch meeting. I had known the husband of the duo for several years and agreed to meet informally to be brought up to speed on progress at the company.

Admittedly, it is not often that I meet with a founding team composed of individuals connected via bonds any deeper than college, a previous work experience, or a long-standing friendship. Truth is, start-ups founded by husband-and-wife teams or by those connected through familial bonds amount to a tiny fraction of the companies that successfully raise venture funding each year.  On the one hand, this fact might appear odd given how signficant “mom and pop” businesses factor into the nation’s economy and, indeed, its economic history. The cliché that small business is the backbone of the US economy is only accurate because “mom and pop” or family dominated businesses comprise the greatest number of vertebrae in that very same backbone. The dearth of family-founded venture-backed start-ups, therefore, makes for an intriguing discussion.

To be sure, there have been family-founded or husband-wife startups that have raised venture money and gone on to be quite successful. WebMethods is one such company. However, the bias in traditional venture circles against investing in husband-wife and family-run startups is long-standing and rooted in some uncomfortable realities.

1. Idiosyncratic risks in a husband-wife or family-dominated team. It’s axiomatic that investing in young, unproven companies involves a great deal of risk. To be successful, a venture investor must adroitly balance that risk. That involves making choices and tradeoffs over which risks are tolerable and acceptable as part of the venture process, and which risks are not. What differentiates family-run or husband-wife startups to a venture investor is that they introduce risks that are unique by their very nature.  Hence, these risks are idiosyncratic and not in evidence at startups backed by the more common assemblage of former colleagues, college roommates, and friends.

One such risk is that of divorce in a husband-wife team or a severe disruption in a familial relationship in the case of a startup team dominated by family members. Both can cripple management effectiveness.  Any venture investor who has been involved in the removal of a founding member from a portfolio company can attest to how complicated and disruptive that process can be. Add to that the aspect that the co-founder being removed could be bound by marriage to another co-founder–with the common circumstance that one co-founder is engineering the removal of the other–and one can quickly see what a morass this situation can become. Sons firing fathers or brothers firing brothers play out no less dramatically and painfully for the companies and the investors involved. The emotional fallout in such disruptions can all but disable a company.

2. Recruiting difficulties. For any emerging growth company to scale effectively, it must attract a world-class team. However, top management talent interested in advancement and increasing responsibilities will typically avoid a husband-wife or family-dominated startup where decisions on hiring, promotions or compensation could be colored by family relations or other marginalia. Accurate or not, the perception will persist that a talented manager will be unable to ever take the top leadership post at a company where the competition for that post is likely a family member. Additionally, few people who ever sat through a tense Thanksgiving dinner of their own relish the idea of ever getting in the middle of a familial or matrimonial spat, much less on a daily basis.

3. Lack of defined roles. Finally, there is the touchier discussion about the importance of clearly defined roles in both the business context and in the familial/marital one. Couples and family members that go into business together too often learn that this is a decision that can damage their underlying romantic or familial bonds in ways they never imagined. The bluntness and constructive criticisms that must occur in order for there to be efficient business communications can often fray emotional connections and strain relationships, sometimes permanently. Roles get convoluted. Spouses and siblings lose their identities in service to the needs of the business and find they have trouble talking about anything outside of work but work itself.

As any management textbook will attest, the effective management of teams requires clear leadership, objectivity in decision-making, some reasonable approximation of “professional boundaries” and a clear demarcation of roles and responsibilities. The blurring of lines that comes from founders and/or managers having one role at the office with their “colleagues” and another role at home too often flies in the face of that reality for venture investors to ever become sufficiently comfortable in order to proceed with an investment.

When Investing Too Early Isn’t “Wrong”

I recently had a twitter exchange with early stage venture investor Mark Suster over the issue of being “too early” as a venture capitalist and what that means in the current climate. While I genuinely like and admire Mark and am not one to publicize my disagreements (or would that be disa-tweetments?) with other investors over what are primarily philosophical matters, I thought the content in the exchange was valuable and supported some re-examination.

Mark made what I would consider a somewhat sweeping statement–namely, that investing too early was the same as being wrong. I responded that this entirely depended on the perspective being considered. Let me explain.

There scarcely exists a technology sector that became vibrant and consequential that did not experience a great deal of stops, starts and stalls early in its evolution. Most of the early “failures” in a space — i.e., companies that had a piece of the solution figured out but perhaps not the entire solution — were venture-backed companies. Many of the same venture investors in those early failures learned from the experience and went on to back later entrants that became juggernauts in that given sector. Were those investors wrong? Would those investors have developed the insights, market knowledge and ecosystems critical to their becoming investors in the eventual market leaders without those early experiences? Would the sector have developed as it did without the flame-outs?

My answer to those rhetorical questions is emphatically “no.” As has been evident  across technology markets for decades, technology advancement occurs in waves of innovation that beget other waves of innovation, and so on. The early failures provide formative experiences for the investors that were involved and for future entrepreneurs behind new entrants in that sector that can plainly see what worked and what didn’t for the previous class of market entrants.

Take, for example, the notion of Pattern Recognition among venture investors. Much has been written about the concept, including an earlier piece in this forum. Tangential to pattern recognition is the idea that a venture investor’s early forays into a sector provide a great education — wanted or unwanted — about what will ultimately be successful in the space and what simply doesn’t work. It also provides the investor a great deal of market knowledge and an ecosystem of supporting companies and entrepreneurs that will serve that investor well for years to come in his or her chosen area of investment, and even in other areas. This is called active cross-pollination and it is critical for long-term success as a venture investor.

To pull on that thread a bit further, venture investing is not a discrete, narrow vertical exercise. Good investors are constantly influenced by outside factors, parallel markets, advancements in technologies that appear unrelated until an epiphany occurs and interesting combinations can result. From the embers of a previous failed investment can come a dormant technology or a seasoned manager that can be re-potted into a new venture and can enable that venture to become enormously successful. The point I make in raising this is that the future success would not have likely occurred without the early mis-step. I have several examples of this in my own career.

There is an oft-told piece of black humor among attorneys about a veteran attorney counseling a young protegé. The senior attorney remarks, “When I was a young attorney like you I lost a lot of cases that I should have won. Now, with my years of experience, I win a lot of cases that I should probably lose.” No one is suggesting that venture investors new to a sector should message to entrepreneurs that they are “learning” on their deals. That said, to maintain that experiences on early investments do not positively inform decisions made on later ones is simply folly.

So, can one be “wrong” by investing too early in a sector, as Mark suggests? Most definitely. This occurs when an investor develops an investment thesis, makes an investment in a company against that thesis, leaves the sector after that company fails to never invest again in the space and never leverage the lessons learned from that experience into other investments. Hopefully, this does not occur very often among professional venture investors. The mere statement that anyone invested “too early” in a sector implies that the given sector did ultimately develop into something substantial. With any luck, the earlier investors that helped shape the sector with early bets were able to prosper by participating in the eventual winners. Historical venture returns seem to bear that out.

Ten Lies Entrepreneurs Tell Investors

Bill Reichert, a partner at early stage venture fund Garage Technology Ventures, gave a talk recently at Dublin SmartCamp 2010 in which he offered some thoughts on how entrepreneurs often get themselves into trouble with investors with ten lies that they often tell in pitch meetings. Personally, I would say “lies” is a strong term. More accurately, these are statements that are either unknowable or that lack foundation or sufficient evidence to support them.

While the statements are largely self-explanatory, I thought it helpful to provide some additional commentary in the interest of helping entrepreneurs understand why investors have a difficult hard time finding these arguments credible and why, in most cases, it’s best to simply avoid making them altogether.

1. Our projections are conservative

This kind of argument typically lacks foundation. What is a conservative estimate in a new industry where much is unknown about the growth path of companies in this space? Are there reasonable comps to reference? A better approach is to build sensible, data-driven financial assumptions and make sure they are supportable.

To be clear, making aggressive growth forecasts in a financial model is not a deal-killer. Indeed, venture investors want to see the potential for explosive growth in the business and will likely not invest if they are not convinced that the business can become a juggernaut. That said, whatever growth assumptions are made should be grounded in some logic and consistent with how the industry functions.

 2. Our target market is $56 billion

Are there $56 billion markets? Of course there are. That’s not the issue. Having a large market is one of those necessary but not sufficient components to securing funding. An entrepreneur must also make a compelling case for what portion(s) of that large market are truly addressable, how the company intends to attack those addressable segments of the market, and, once a beach head has been secured and early validation has been achieved, how the company intends to roll out its solution more broadly.

3. We have a world-class team.

Sounds terrific. Based upon what, exactly? How are we defining world-class?  This is just sloppy semantics. Like the word “genius”, “world-class” is one of those phrases that is bandied about cavalierly in the start-up community.

Let the investor be the one to judge how impressive the team is. Insisting that the team is world-class at the outset won’t impress investors to suddenly embrace it as gospel.

4. Our average sales cycle is 90 days.

There are few sales cycles this short, so insisting a company can enjoy that privilege will strain credibility. Entrepreneurs should shy away from making this kind of statement. As in #1 above, making this argument is not necessarily a deal-killer nor entirely wrong if it is indeed the case for this company and this market. However, if this argument is made then the entrepreneurs need to be prepared for a lot of collective eye-rolling and some pointed questions demanding data to support it.

5. We have no direct competitor.

This is perhaps the one comment that is most likely to persuade me to end a pitch meeting early and abruptly. There is always competition. Before pitching any investor, an entrepreneur should have thoroughly investigated the entire competitive landscape and identified not only current competitors (direct or tangential), but also developed an understanding of all the potential competitors that could enter the space at any moment. Like any good chess player, an entrepreneur must be thinking several moves ahead. She should ask, ‘Who could easily get into this space? Are there incumbents in tangential markets that could extend their reach into the market? How would our company compete with those better-financed, more established incumbents and their competitive solutions? What is defensible in our solution and our approach?’

If the start-up is fortunate enough to obtain funding and if the company executes well, one thing is sure to happen: if there wasn’t much competition previously, there will certainly be fierce competition now. A market entry plan should incorporate not only the thinking around how to enter the market but also how to stay competitive once new entrants emerge—both other start-ups and incumbents extending their reach.

6. No one else can do what we do.

This statement strains credibility because it assumes that the management team has hit upon something no one else has actively considered nor has the capabilities to successfully execute. In reality, this is very very rare.

7. All we need is 2% of the market.

Investors are not interested in a company that can be content with 2% of the market. As I like to say, “You are either in the lead, in the hunt, or in the way.”  Venture investors aren’t just interested in backing potential market leaders; they must be backing potential market leaders. There is little room for ventures that can, at best, be a nice little business. There is nothing wrong with “nice little businesses,” mind you. Most small business in this country would fall into that category, but that does not make them appropriate venture investments.  

8. We’ll be cash positive in 12 months.

This argument is problematic on a number of levels. First, it strains credibility. Few businesses can achieve cash flow positive one year after launch. Second, if the company hits this milestone this quickly it raises a lot of uncomfortable questions about whether this business is really that attractive, whether this market is that substantial, and whether the management team is being penny wise and pound foolish by focusing on achieving this at the expense of investing in growing the business. 

While it may appear counter-intuitive, most investors are not primarily focused on getting a company to achieve cash flow positive in a narrow time frame. Their primary interest is in building a substantial company. This usually means embarking upon a torrid growth path which, in turn, often means that a great deal of capital will be necessary to fuel and sustain that growth which will, in turn, often push out the timeline of becoming cash flow positive.

9. I’ll be happy to hand over the reins to a new CEO

This is one of those ‘live by the sword, die by the sword’ dilemmas for entrepreneurs. Typically, one of things that influenced the investors to consider investing in the entrepreneur’s business was the entrepreneur’s sheer determination and tenacity. Investors love vigor and drive in a start-up CEO. However, that zeal also often comes in a personality not easily persuaded to step aside in the face of challenges and outside pressures. A CEO who is so invested in the business and considers it her baby is not likely to readily hand over the reins once investors feel a change is necessary at the top. That said, a good chief executive must grasp the effectiveness of everyone on the team and when that team member may no longer be the right fit for the company’s needs at that time. This is best communicated through actions over time, not through empty pronouncements.

10. Our contract with [Big Company] will be signed in two weeks.

Investors who have been involved in partnership agreements will agree that when it comes to large companies nothing takes two weeks.

The real danger in raising this argument, and many of the previous ones, is that it signals to the investor that the entrepreneur is naïve. This is, perhaps, the greatest risk to the entrepreneur. Investors are quite forgiving. They understand that there are many unknowables; that market conditions can change at any moment;  that exogenous factors can creep in and fundamentally alter a business’ prospects. This is par for the course. However, what is critical for the investors is for them to feel supremely confident that the management team is capable enough to be nimble and to navigate through the speed bumps as they occur. What truly alarms investors is the sense that an entrepreneur is not savvy nor experienced enough to know how to react to these headwinds nor how to think about sales cycles, nor what typical growth expectations should be for a company in this market, etc. Gaffes such as these can effectively kill a financing because they can have the effect of undermining the investor’s faith in how the entrepreneur will manage the business post-financing.

Hosting a Good Media Event

Some time ago I wrote a post on tips and best practices that I felt start-ups ought to consider in getting the most out of media relationships. The impetus for the piece had a lot to do with recent reports I had been getting from portfolio companies about media interviews that had not gone as well as company management had hoped. Story angles had been mishandled, sensitive information had been unwittingly divulged, and statements were seemingly taken out of context. In this piece I’d like to cover a sunnier subject–namely, how to effectively run a media event.

Last night, portfolio company Runka.com, a destination site for eco-friendly products at discount prices, conducted its first formal media mixer in San Francisco. I prefer to use the term “mixer” as opposed to “launch party” given that the site went live some weeks ago and, quite frankly, “launch party” still carries with it some dot-com era connotations for many in the start-up/VC community. To this day I have a hard time seeing the phrase “launch party” on an invite without it conjuring up images of hosted martini bars and overflowing trays of sushi in a wildly overpriced nightclub.

In any event, the Runka.com gathering was by all accounts a success. Vendors were contentedly exhibiting their wares. Oscar-winning actress, author, and environmental spokesperson Mariel Hemingway was the headline speaker. Organic wines and delectables were served (on biodegradable plates, naturally). Finally, there was a good but manageable number of representatives from the media in attendance.

Pulling off a successful media event is by no means a herculean task, but it does take some planning. For those start-ups planning a function to broaden their brands and get the word out about new products, services or strategic relationships, below are a few tips that can make a big difference in how best to meet the objective.

Setting and Managing Expectations: This should fall directly into the ‘painfully obvious’ category, but I am endessly amazed how seldom start-up teams methodically think through what their media events are intended to accomplish. Sometimes the excitement and buzz of throwing a party or press conference swamps all the sober thinking that needs to take place about what the objectives are of the events being considered. What, specifically, needs to be achieved in order to consider the event a success? Is success being defined quantitatively?  (i.e., how many reporters attend; how many stories get written and appear on the event in print and other media, etc) or…is it more qualitative? (how our customers, partners and employees perceive the event and how our brand or our new product is thought of?) Get clear on this early so as to best avoid awkward post-mortems on poorly executed events.

Consider Logistics Carefully: A good decision on a venue depends less on how fancy the room is or how trendy the nightclub is and more on practical considerations. Does the room photograph well? Is there sufficient lighting for good shots and clear audio for videographers? Is there sufficient protection for weather changes? Is the staff well-trained working with media people and their demands? Is there excessive noise, traffic, other distractions? Is it close to downtown and/or is it easy to get to from where most of your VIPs live and work? (This is very important if you are considering a happy hour mixer and expect media people and other VIPs to pop over after work.) Finally, think through the date. Do you want the event to stand alone and not compete with anything else that day or week or would it be better attended piggy-backed on another event going on simultaneously whereby people might already be in town and could stop over? (This works particularly well if there is a big convention going on at the same time. People are not likely to fly in for your mixer, but they can be enticed to attend if they are already in town for the convention down the street.)

Develop A Clear Newsworthy Angle: Ask, ‘where is the story here?’ Media people won’t be responsive to a plea to offer coverage for a clearly promotional event no matter how good the free booze, snacks and gift bags. Make sure there is an angle or hook on which a story can be developed? Is your angle local or national? Is it timely? Will there be information disseminated at the event not available in a press release? Is the event piggy-backing on something recently in the news? [For the Runka.com event, the team scheduled it on the eve of the 40th anniversary of Earth Day. This offered up obvious story lines to reporters about how far the green movement has come since the first Earth Day in 1970, the evolution of eco-friendly products into the mainstream, how Runka.com product offerings intersect with that evolution, etc.] Finally, will there be a newsmaker there? Credible spokespersons and even celebrities can add a certain punch to an event if there is a reasonable chance that that person might make news at your event.

Woo Everyone; Not Just Media Folks. A common mistake of start-up teams is that they focus too intently on wooing representatives from the media and they lose sight of the most important goal which is to have a great event. Media people are followers, not leaders. They are not interested in being the story and, what’s more, you wouldn’t want a room full of nothing but media people anyway.  People don’t attend events because they think there will be a lot of media there; media attend events because they think there will be a lot of people there and, hence, potential for a scoop on a new product/service or other story angle.

Following Up: After the media event is over, the cheese trays have been picked clean, and the blue recycling bins are filled with empty wine bottles, the real work begins. The long-term value that comes out of a media event is in how well the follow-ups are handled, how media relationships are forged and managed, and how the event is talked about in the past tense. You might find that only half the number of reporters that RSVP’d actually showed up. Don’t be discouraged. Reporters routinely overbook and skip events they planned to attend. Follow up anyway with the media–those who attended and those who didn’t–with appropriate press clippings, blog postings, video clips of important speeches, and any other info on the event. With the plethora of social media tools and video apps like live streaming now available, there are innumerable ways to relive or recreate a media event for someone who couldn’t otherwise attend. Even if the reporter skipped the event, he or she may still write a piece later on the company or the event itself; if not, there is a good chance he or she will make the next event if it appeared that the skipped event was successful.

Don’t Be a Media Snob: Echoing an earlier point, just as it is a mistake to focus solely on media folks at the expense of getting a good group of attendees, it is similarly a mistake to get too caught up in wooing mainstream, big-name media outlets at the expense of smaller publications, bloggers and influencers. The media landscape is rapidly evolving. More often than not, establishment media outlets are late to the game on catching a new tech trend or hot company. Bloggers, local trade publications, and online magazines are often the ones breaking stories on emerging companies and trends. Use this to your advantage. As the budgets at mainstream outlets continue to get squeezed, they lean more and more on what is being tweeted and written about in cyberspace to develop story ideas. If your event is only attended by a smattering of small-time bloggers and niche publications, fear not. These outlets can open enormous doors for you and your company. More than 20 years ago, as a college student, I launched my first startup. As the company grew rapidly, none of the establishment media showed any interest in what the company was doing; that is, not until I was quoted in an American Airlines in-flight magazine. At the time, I thought little of appearing in an in-flight magazine. However, that small blurb was read by a reporter at The New York Times. That led to a profile on me and my company appearing in the Sunday NYT a few weeks later. Before long, The Wall Street Journal called. You guessed it, they read the NYT piece. And on it went — all because I took that call from that American Airlines freelance writer that needed a quick quote on a story about to go to press. Print stories begat other print stories. Media was viral, even back in 1988. It is only exponentially more so now. In much the same way that a successful start-up must take care of its earliest customers, a company intent on a healthy relationship with the media must take care of even the most obscure news outlets that first show interest in what it is doing.

The Case for Why Thin is In

A pair of thought-provoking posts in recent days has taken opposite sides of the issue of whether start-ups should run “lean” — as a strategy, not simply a function of a tough fundraising environment — or continue to invest heavily in the business before key milestones and points of validation are achieved.

It helps that both posts (here and here) are well-researched and come from respected voices in the venture community, notably Union Square Ventures’ Fred Wilson and former entrepreneur and recent addition to the VC community, Ben Horowitz of Andreesen Horowitz. Not surprisingly, I found much to agree with in both pieces, but I’m more persuaded by Fred Wilson’s arguments that ‘Thin is in’ – both as a path to market leadership and as a strategy to retain sufficient equity in the company to fuel growth later on in the company’s evolution when capital is cheaper and more productive.

Ben Horowitz’ “Case For The Fat Startup” points out convincingly that some entrepreneurs may be overplaying their hand in VC meetings about how lean they can run, as if running lean is the panacea for all that ails the startup community. Many who have been around the start-up community long enough remember the “Get Big Fast” mantra of a decade ago and how rampant spending by companies whose business models were far from well-sorted led to a lot of carnage that took years to unwind. The scar tissue is still very much there. To this day, many limited partners remain leery of returning to the venture capital asset class because of the concern that few truly learned the lessons of the tech bust years. 

For this and for a variety of other reasons, it behooves a start-up team to demonstrate to investors its ability and its willingness to be very capital efficient — particularly during the early days when key market validation points have yet to be achieved. Venture investors, particularly in the current environment, have little appetite for investing capital just so a new team can throw things at the wall and see what sticks.  Angel investors may be a little more willing to accept that kind of super early stage risk, but even angels are now demonstrating less willingness to back companies at the concept stage.

That said, running “lean” needs to be seen more as a tactic, not as a long-term strategy. As the corporate world learned with the Reengineering fad of the early 1990s (yet another recessionary period), a company cannot cut its way to growth. At some point, companies need to fuel growth to solidify market position, acquire smaller companies with specific assets, add talent, and to do a host of other things critical to achieve market leadership and to remain a market leader. This typically takes capital. Lots of it.

My perspective comes from the software and services world, so much of what I say next would not reasonably apply to very capital-intensive businesses in the clean tech or hardware manufacturing realm where large capital infusions early on would be a requirement. With that caveat, I maintain that most early stage companies founded upon software/services-based business models should eschew raising and spending large amounts of capital until most early stage risk factors have been controlled for, or at least well-understood. For many first-time entrepreneurs, this is hardly a choice as few would reasonably be able to raise large amounts of capital without those factors being addressed, but it is still important to point this out. Messrs Horowitz and Andreesen were able to raise large amounts of capital due in no small part to their successful pedigree. This is clearly the exception and not the rule. That said, there are still examples of companies today viewed by venture investors as extremely attractive and those same investors will try aggressively to fund — even over-fund — those companies just in order to participate in the deal.

The pressure for certain “hot” companies to take more money and deploy that capital is very intense. While this might be seen by some entrepreneurs chastened by the current fundraising environment, quite cynically, as a “nice problem to have” it is still a problem, in my view. There are very few success stories involving companies that burned through tremendous sums of cash while they were still working out their business models, service offerings, and the like. Instead, the reverse is much more common — Pets.com, Webvan, Kozmo.com, to name but a few. Once a company is supporting hundreds of staff and millions in monthly burn, it becomes extremely difficult to remain nimble and to quickly adapt to fast-evolving markets. Even if a company, once it realizes it needs to downsize and adapt, is successful in reducing staff and the attendant burn of those resources, often the shock to the system that such a right-sizing has on the organization is too much to overcome. Morale can plummet and the “blood in the water” image of the company in the talent pool can jeopardize its ability to secure key partnerships or to hire again once better times return.

A final reason as to why most young companies should hold off on executing large financings and ramping up spend in the early days is due to valuation and equity dilution issues. Staying lean typically means less dilution because a company that has yet to sort through key early stage risk factors will simply not command the valuation it will likely command some months later when those issues are clearer for investors. As such, raising large sums when there still exists significant early stage risk will bring with it signficant dilution. From my experience, it is much better to secure large amounts of capital at a later “inflection” point when that capital is seen as fueling specific growth initiatives and not to extend runway while the company still deliberates on whether its business is viable.

In summary, there are clear reasons and opportunities for start-ups to fuel their growth with cash, but those exceptions are, to my mind, swamped by the more compelling reasons for young companies to sort out product/market fit and other points of validation before raising and deploying large amounts of capital. One of the ironies of the tech bust was that the overspending during the frothy years — particularly around communications – radically lowered the cost of launching a business, building a product, and getting that product into the marketplace. Companies that have pitched me in recent years often have a product, customers, revenue, and are sometimes at cash flow breakeven — all before raising a dime of institutional capital. A decade ago it might have cost $10mm to get a company to that point; today, often a company has done that with $300,000 from a few friends and family angels.

The Market Penetration Trap

There is no shortage of pitfalls in a typical VC pitch where an entrepreneur’s new business opportunity can unravel in the eyes of a venture investor.  However, if I were to pick one area where management teams often tend to get caught in their own underwear it is when the subject of market penetration is first raised.

As any primer on raising venture capital will attest, targeting a sufficiently large market is a necessary but not sufficient requirement for most venture funds. Big markets provide the requisite upside a venture investor needs to feel comfortable that the new enterprise can carve out a sustainable business and defend that market position. Experienced investors know that many successful companies course-correct a number of times before they find the right market position, product and strategy for long-term success. As such, big markets are somewhat more forgiving; companies can muddle their way through, make mistakes in the early days, and still have a hope of building a significant business. Small markets rarely allow for that.

What big markets also offer investors is the potential for (relatively) bigger exits. As has become obvious across the venture landscape in recent years, the average fund sizes at many venture firms has increased, and larger fund sizes typically bring requirements for larger exits to effectively “move the needle” for that fund. Roughly speaking, billion dollar funds are going to need billion dollar exits. While this is not a hard and fast rule (and many of my friends at billion dollar funds would argue that they still want to see early stage deals with lower capital requirements and possibly smaller exit windows) the hurdle for a small deal at a big firm is pretty high. My suggestion is that if you are pitching a firm whose most recent fund is $500mm or larger and your company’s financial projections are for a business with a revenue profile in Year 5 of $50mm or less, you’re probably wasting everyone’s time. The partner you present to may love the business and its product or service but it will likely get nowhere at the Monday partner meeting when that partner presents your deal to his or her other partners. It would be best to focus on smaller funds or, even better, focus on a larger market opportunity.

Assuming you get over the ‘big enough market’ threshold as discussed above, here is one key piece of advice to entrepreneurs pitching professional venture investors: steer clear of statements such as “We just need (low single digit) percent of the market to build a really big business here folks!” These statements are fraught with peril and VCs will often visibly recoil when they hear a presenting company trot out such a naive comment. The reason for this resistance is that there is rarely support given by the entrepreneurs about how they arrived at that number or how the product or service can reasonably scale to that level.

The other trap that comments such as these set for a presenting management team is that it often makes the entrepreneurs appear to be focused on attaining low market penetration. That’s not an appealing goal for most VCs. The entrepreneurs make the mistake of thinking that by trotting out a number such as 6% the venture investors will consider the goal modest and, thus, achievable. Unfortunately, what the VC hears is that the founding team intends to work tirelessly (with the VC’s capital) to build the business and if everything goes according to plan (it never does), they will have 6% of the market in five years. No self-respecting venture investor is likely to be interested in a business that will have 6% penetration after five years of effort. If the team executes well and if after five years the company has only 6% market penetration, then something has gone terribly wrong.

What I advise start-ups to do when confronting the market size/market penetration question is to first define the market well and define what part of that market is truly addressable. This is commonly referred to as the TAM (total addressable market) number.  If this is well-reasoned then it demonstrates to the investors that you have thought long and hard about your customer set, how to reach them, and why they are right for your product/service. Next, I would recommend that you emphasize that your goal is market leadership and that market leadership may not have a fixed percentage so early in the game. Markets can be fundamentally different – consolidated markets versus fragmented markets, new markets versus mature ones, and so on. What is considered success in those markets can vary widely depending on market structure and the behavior of market participants. Where the low market penetration percentage figures become important is to demonstrate that the business can achieve profitability fairly quickly. A business that requires, say,  20-30% market penetration to attain profitability is a tough sell. That hurdle demonstrates that you are probably in too small of a market segment, are not terribly capital efficient, or likely both. The best combination would be a big market, a large TAM number, a product or service that can scale quickly and cheaply, and a fast path to profitability with minimal market penetration and low capital requirements. Oh well, we can dream, can’t we?

“Angel Finders” Are Often Neither

As any lay student of economics will be aware, in times of market dislocation, “cottage industries” will pop up to fill the market need. In college, the dearth of available and affordable student housing created a seedy underworld of apartment brokers that would charge fees to students to secure them housing. Often times, these were hardly outside “finders” at all — they were often the apartment managers themselves. Rather than simply offer the apartment to the best applicant, as their job description would suggest, these managers carved out a nice little side business for themselves by effectively auctioning off the available apartment to the student — or typically, the student’s parents — most willing to pay the highest finders fee.

Fortunately, while securing funding remains challenging in the current environment, I have yet to hear of angel groups charging finders fees to invest in companies. Let’s hope it doesn’t come to that. Instead, there seems to be a bit of a boomlet of groups and individuals offering start-ups introductions to investors and charging for the service. This is nothing new. Some angel groups have long charged start-up companies to present at their conferences and many of these angel organizations continue to defend the practice as necessary to offset organizational and event costs. I would suspect that there is merit in a few of these cases, but I do not understand why these angel organizations cannot devise another compensation model so that struggling start-ups are not footing the bill.

Jason Calacanis recently opened a new salvo in this debate by taking issue with a few angel organizations that charge start-ups to appear at their conferences. Additionally, there are individual “finders” now openly offering introductory services to start-ups for upwards of $7,500. This fee is not a success fee, mind you, it is simply for the introduction to a venture fund or angel investor. Whether that introduction leads to an investment in the start-up or not is irrespective of the fee burden to that company.

Like most in the venture community who have opined on this, I take issue with any group or individual that charges companies simply for an introduction to a potential investor. However, where I part company with the other critics is that my opposition to the practice is not based upon some discomfort I have in fee-based services for start-ups as a whole. There are lots of good advisors and consultants out there that work with start-ups.  In the course of a year, I see many pitches for potentially promising companies that are a mess and could really benefit from an experienced set of eyes to refine them. This can be quite valuable. Refining a set of documents or helping on a young company’s strategy is enormously time-consuming and these advisors should be properly compensated. Equity is best, but one cannot pay the mortgage on equity alone given the high failure rate of young companies. Painting these professionals with the same brush as “angel finders” is quite unfair as many do good work helping young companies grow their businesses and attract funding. Rather, where I find the whole “fee-based introductions” that angel finders practice objectionable is that it seems to completely undermine itself with bona fide investors. Let me explain. 

“Finders” come in all shapes and sizes and even the most reputable professional services providers often either directly or implicitly dangle the carrot of investor introductions to secure their start-up clients. Some of this is legitimate; much of it dubious at best. The most common complaint I hear comes from start-ups themselves who engage high-priced Silicon Valley law firms for their legal work based upon the assumption that the law firms will tap their VC networks to help the young companies secure required funding. While this does happen in some instances, I would submit that this is more the exception than the rule. Many on the investment side receive daily email blasts from these kinds of firms hocking their latest clients and often times these cold pitches are a quick one-way trip to the deleted items folder.

Bottom Line: While many high-priced, pedigreed law firms do good work and are a value to the community, if you are a young, cash-strapped start-up and you’re hiring a $500/hr law firm to do your most basic corporate formation work mostly because you think that that law firm can get you in front of ivy league venture firms, you’ve already proved to me that you’ve flunked Entrepreneurship 101.

As to the looser confederation of intro-only finders out there, common sense should prevail here. Never pay for just an intro. If an angel finder or other intermediary loves your company so much that they feel it is fundable among their “network of angels and VCs” then they should either (1) prove that conviction by putting their own money in the deal; or, (2) get involved as a board director or in another capacity where they have equity and, hence, a stake in the company being funded.

Think about it this way: when a venture or angel fund is sent a deal referral from an intermediary, the first thing that is considered is the value of that relationship. If this is someone the fund has known for some time and that generally refers interesting deals, the fund will give that deal more consideration that if the opportunity came from an unknown person or “over the transom.” The second factor the investor looks at is what the interest of this person is in showing that investor this particular deal. The VC partner or angel fund deal manager would ask: Is he/she an investor? Why are we getting it? Why our firm versus the hundreds of other firms out there? However, If the VC or angel gets a deal from someone who is being paid just to make the intro, it’s pretty much a dead issue. For a referral relationship to be valuable, it has to be based upon reputation and reputation is only built over time by being associated with quality companies and quality entrepreneurs. A Rolodex of top venture firms can be wrecked almost overnight by sending out low-quality opportunities. If the angel or VC intermediary is being paid for an intro, that intermediary is not discriminating because it implies that any company that pays the fee will secure the intermediary’s services, which means the value of the referral to reputable investors is just about zero. Indeed, the intro from this kind of intermediary could be more damaging than no intro at all because the venture and angel community is very small and no investor wants to feel they are looking at an opportunity that is being shopped simultaneously to everyone else in the community from someone being paid to do so.

A Good Man In A Storm

Combing through yesterday’s WSJ I came across a piece on the phenomenon of the ‘Bullwhip Effect’ and how it was beginning to be observed in the broader US economy. While this phenomenon is usually discussed in terms of manufacturing and distribution channels, an analog to the Bullwhip Effect is also apparent in markets where young, high growth companies are typically concentrated. Demand kicks up and market sentiment improves which sends companies scurrying to bring back laid-off workers or to engage anew in hiring if such plans were put on hold.

While I have long been an advocate for being methodical in building out young start-up teams — especially small, fragile teams where each additional hire can dramatically affect a company’s culture and DNA — I find too many emerging growth companies make critical mistakes in hiring that can have long-ranging consequences. Here are just a few:

1. Jesus Christ is not currently available. Being picky is one thing, but there is sometimes an arrogance that seeps into a hiring process that is both counter-productive and bad for broader public relations. All companies would love to be able to identify the best candidates that represent an ideal match for the company and that have the potential to become future leaders of the enterprise in the years ahead. The truth is that no hiring process is ever really capable of that level of granularity and foresight. As such, the general rule (for most start-ups) should really be to find the best person available for a given role with respect to the current needs at the company and hope that that individual can grow into a long-term future at the company as he or she demonstrates value to the enterprise. Assessing fit on the basis of a handful of artificial and scripted meetings is hardly optimal. No matter how rigorous the process, no one can really assess the fitness of a candidate for a given role until that candidate is performing that job, at that company, and working with that set of peers, superiors and subordinates at day-to-day challenges in the fast-moving environments in which most start-up companies operate.

For years I have heard stories from long-suffering colleagues about withering multi-month processes over positions that were hardly the most influential at the companies in question. Making a hiring process a Bataan Death March for candidates may feed egos at the company and reinforce some internal sense of superiority among managers there about how exclusive and discriminating the company could be, but chances are that taking that long to fill a critical role is exacting a significant cost on the company in terms of lost opportunities. The next time you find yourself interviewing for your company, say, a Sr VP of Alliances candidate on his or her 11th interview in month five, consider for a moment your most direct competitor and the hypothetical impact of that competitor having found a Sr. VP of Alliances three months earlier and that person being on the job during that time pursuing all the market and alliance opportunities that your company would be pursuing had it brought someone aboard months ago.

2. Hire cooks, not chefs. Celebrity chefs are great but it’s the line cooks that really keep restaurants humming. Food writer Anthony Bourdain had a great line about the difference between cooks and chefs. His point, if I recall, was that people who considered themselves cooks, and were not ashamed to use the term to describe themselves, were better hires. Cooking is a craft, not an art form. Those who consider it an art form often require constant stroking and handholding and don’t think it’s important to show up for work on time. The analogy for start-ups teams is to do your best to avoid prima donnas by finding versatile, hungry managers who would not think it  “beneath them” to incorporate tasks into their workload that might be lower than their job titles might suggest. A natural salesperson loves to sell. A great Corp Dev, BD or Alliances person lives to do deals. If a senior sales person accustomed to managing large enterprise sales accounts is not open to helping a junior colleague with closing a small sales opportunity, that should tell you something. Great hires strive at every opportunity to add value, especially in the early days of a new role. Even in more established, successful start-ups there remains a culture and mentality of everyone grabbing an oar and helping however they can. Getting stuck on formalities or on what it says on the business card should be a red flag.

3. Hire fast, but fire faster. Many VCs and HR execs may take issue with me here, but I am a big believer that when it comes to fast growing start-up companies in an economy pulling out of a deep recession, the right move is often to (1) set a tight spec and a fair but rigorous hiring process and stick to it; (2) hire quickly and deploy that candidate as quickly as practicable; and, (3) if the candidate turns out to clearly be a bad hire — every company has them — remove the problem quickly through transfer or termination, bring on a better candidate, and move on.

4. Fewer constituents, fewer hands, a tighter process. Nothing both complicates hiring and aggravates job candidates more than a hiring process that lurches forward without direction, that has too many constituents that demand that they touch and sign off on all candidates, and that has a spec that undergoes constant evolution. Clearly decide what the spec is early on and decide who will be vetting candidates. Decide, also, how long each step in the funnel will be and who shall have ultimate authority to waive candidates through to subsequent steps. Finally, be disciplined about setting an end date to when new candidates are added to the top of the funnel. It’s bad form to bring in new candidates when others are already nearing the end of a multi-month process. Not closing off the process to new candidates brings about the tendency of companies wanting to see everyone and of putting off hiring decisions on the off-chance that the perfect candidate is just around the corner but has yet to emerge. Too often, companies that fall victim to this trap ultimately never find the candidate everyone can agree upon, no one is ever hired, a long-suffering junior staffer ends up having to pick up the slack, headhunters get frustrated and stop referring candidates, and the company misses out on accelerating its business because the need is never filled.

Caution: Bad Partnership Ahead?

Some time ago our friends at PEHub ran a post from contributing blogger Georges van Hoegaerden on the subject of how best to spot inferior venture capitalists. As one would expect, the intended audience was entrepreneurs seeking venture funding. Broadly speaking, there were some good points.

To be sure, the venture community is guilty of many failings when it comes to interacting with entrepreneurs and there are plenty of opportunities for improvement — particularly in the areas of communication around timelines, assessing the level of interest in the entrepreneur’s company, and the funding process itself. I wanted to focus this post, however, on areas where entrepreneurs unwittingly damage their prospects for a capital raise. I consider these tendencies ‘warning signs’ in that once they are exhibited they usually foretell problems to come in other areas of the VC/entrepreneur relationship and many venture investors simply nip such interactions in the bud than continue to invest the time to properly vett the opportunity.

I suspect that every venture capitalist that has been at this game a while has compiled his or her own list of warning signs to look for when first engaging with an entrepreneur. While it may appear somewhat unfair for an entrepreneur to be dismissed unceremoniously early in a funding process for being guilty of one or a couple of these infractions, venture investors are human, pressured for time and bandwidth, and will lean upon their own pattern recognition to avoid problematic relationships.

1. Demanding that investors sign non-disclosure agreements without merit. I covered this subject at length in a piece, A (final?) word on NDAs, a couple years ago so there’s no sense rehashing it here. The usual VC pushback on NDAs is that (1) they expose them to liability should their firm later decide to fund a competitor (or a company that might reasonably be considered a competitor) and that (2) there is often an adverse selection problem inherent in the request itself. In short, if your idea is that easy to steal/replicate/jeopardize simply by your telling me about it, I am probably not interested anyway. Finally, and perhaps most tellingly from my perspective, in the hundreds of times I been asked to sign an NDA before seeing an Executive Summary I can recall only a handful of those occasions when an NDA might have been warranted. It’s a red flag when an entrepreneur does not understand the opportunity well enough to determine whether there is something truly proprietary that could warrant having an NDA. It tells me that the team does not really know what is important and that it might have an inflated view of the value of what they have built or are trying to do.

2. When the level of paranoia becomes an obstacle to communication and information sharing. In a continuation of point #1 above, unfounded paranoia on the part of the founding team is another red flag that comes up early and often. Intel’s Andy Grove famously titled his book ‘Only The Paranoid Survive’ . Many venture investors consider it important that their portfolio companies constantly be in a healthy state of paranoia. However, the key word here is healthy. Start-up teams need to be constantly focused on incumbents and their competitors and need to think many steps ahead lest they miss out on opportunities that might allow a competitor to steal a key customer, outflank them on a partnership deal, or make another move that could doom the company. Where things get problematic is when a founding team turns that paranoia inward and begins to hoard information, distrust its partners, block employees from speaking with investors or other stakeholders, and take other irrational actions.

If early in the fundraising process a entrepeneur appears vague or less than forthcoming about sharing key information, we will usually lose interest in the opportunity. While I don’t suggest that entrepreneurs blizzard VCs with every document in their files, it is usually better to overshare and let the VCs determine what information is most important in their diligence process than to make the VCs feel they need to pull teeth to get basic questions answered and documents provided.

3. Not understanding the fundamentals of the venture business or the firms being approached. First-time entrepreneurs would do well to spend a little time understanding the venture business before formulating a fundraising plan. I am struck by how many teams that approach us have little to no basic understanding of how the VC business works and how deals get funded. Additionally, it’s critical to do some research on the firms being approached.

4. Getting stuck on valuation at the expense of everything else. Valuation is important, no question, but I think it still takes up far too much time and attention during the funding process and subsequent negotiations. When investments are successful, no one ever remembers (or usually cares) about what the valuation of the first round was. For a company to succeed all team members and stakeholders must be aligned. That alignment comes from a reasonable valuation that is set properly and balances out the inherent risks in the opportunity to the investors, founders and employees. Entrepreneurs that turn down a term sheet hoping they will find another investor that will provide that same capital at a higher valuation are rarely rewarded for taking that risk. Similarly, a good and responsible venture firm that hopes to be around for a while would be foolish to structure a financing so Draconian that it has the effect of demoralizing the team and earlier stakeholders and hampering future fundraising prospects.

Smart, experienced entrepreneurs focus on finding the best partners, not necessarily the cheapest money. If an entrepreneur starts laying out lofty valuation demands early in the process when we are still far from a term sheet, it usually has the effect of throwing cold water on the relationship. Wait until the hook is set; then lay out a cogent argument for why you think the company is worth what you insist it is worth. You might not get that valuation, but you will have a better chance at finding the right partner and the proper amount of capital needed to accelerate the business.