3 Numbers All Entrepreneurs Should Know
In the early days of a startup, it can be tough to find good data to help with decision-making. Put a priority on these three numbers, and you'll be fine.
By Don Rainey
In the early days of a startup, it can be tough to find good data to help with decision-making. Put a priority on these three numbers, and you'll be fine.
By Don Rainey
TechCrunch ran an excellent post from a VC that is optimistic about the future. William Quigley makes excellent points and I agree we have reached a tipping point...
Editor’s note: this is a guest post from venture capitalist William Quigley, managing director at Clearstone Venture Partners. Earlier this week I issued a report about the positive changes that have recently taken place in the venture capital industry. These changes are profound and will have a lasting effect on both the venture capital asset class as well as today’s start-ups. Much has been written about the so-called “golden age” of venture capital in the late 1990s dot-com era, when the likes of Netscape, Yahoo, Amazon and eBay were created. Yes, those certainly were great times for founders and early stage investors, but I will let you in on a little secret: for all of the brilliance, ambition and hard work that went into building these iconic companies, the vast majority of the capital appreciation in these businesses took place only after they went public. To put it another way, the rewards for building a truly great business – say, the world’s biggest etailer or the largest online auction site – accrued mainly to the public shareholders. That’s right. The ones who went through all the hard work of logging into their E*Trade accounts and clicking the “Buy” button. They participated in over 99% (literally) of the value created from these brilliant entrepreneurs and their wonderful companies. Now understand, I don’t begrudge the public investors, but as either a founder, early stage company employee or investor (angel or VC), why bother taking all of the early stage risk when you could have earned far more just buying shares of your company once it went public? Let’s also keep in mind that public companies are generally a lot less risky than private ones. Less work and lower risk. That is how it used to be for public shareholders, but that era has ended for good. Let me give you some perspective on how much things have changed since the last tech cycle. Amazon.com, the world’s largest Internet retailer, went public at a $440 million valuation. Hard to believe, isn’t it? A company worth $90 billion today was worth just over $400 million when it went public in 1997. That skimpy valuation represented less than one times its forward 12 months of revenues, a multiple more closely associated with a corrugated cardboard manufacturer than the most important innovator in retailing in the past 100 years. eBay went public at a $650 million valuation, representing less than three times its forward revenues. Amazingly, this valuation was considered adequate even though at the time of its IPO, eBay had already established itself as the pre-eminent auction site on the web. Go back to the earlier part of the 1990s, and it gets even more extreme. Cisco, the most important company in computer networking infrastructure, went public at $225 million, a valuation representing just over one time its annual revenues. Remember, this was supposed to be a time when venture capital and entrepreneurship was highly rewarded. It turns out, until very recently, public investors, those who waited until the hard work was done and the upside was evident, were the ones who earned the greatest returns. Nice work if you can find it. We have now entered a new era, a marvelous era, in fact, for those brave enough to start a company and bold enough to build a global business. This new era, what I call the “real golden age” for company builders and private investors, allows for enormous value creation before a company even goes public. Google was the catalyst for this change. When it went public in 2004 at a $40 billion market cap, many thought the Internet bubble had returned. Something had changed, but it wasn’t a new bubble mindset. It was the understanding that some companies were now able to create value far faster than was possible before. Those investors who thought Google was overvalued at $40 billion soon learned that, in fact, it was dramatically undervalued. In 2010, Google earned nearly $19 billion in gross profit and almost $12 billion in operating profit! Of course, if investors had known that when Google went public, they would gladly have bought the shares at the $40 billion valuation. Then again, some investors gladly did. So what happened in the span of six or seven years that caused public investors to go from valuing Amazon or eBay at a few hundred million dollars to valuing Google at $40 billion? I believe three permanent changes occurred during that time period that allowed heretofore unprecedented valuations to take hold. First, the proliferation of Internet access. When my partners and I launched our consumer Internet fund – idealab Capital Partners – in 1997, we already thought of the Internet as a mainstream phenomenon. How wrong we were. Consider that, even by the year 2000, only one-third of the U.S. population had Internet access. Today, nearly every US household has Internet access, many with a high-speed broadband connection. The growth rate in China makes the U.S. figure look downright sluggish. China has gone from about 20 million Internet users in 2000 to close to 500 million today. These extraordinary growth rates in Internet adoption were not fully reflected in company valuations in the last tech cycle. Now they are, and investors are giving businesses like Facebook,Zynga and others the benefit of the doubt that they will capitalize on the value created by far higher global Internet penetration rates. Second, the rise of the hedge funds. Since 2000, the number of hedge funds have doubled and the assets they manage have nearly tripled to $2 trillion. Why is this important? Because hedge funds often specialize in particular asset classes, like technology stocks, and with that specialization comes superior knowledge and a greater insight into the potential terminal value a company can achieve. This was not the case in the 1980s and 1990s, when many of the iconic technology start-ups were born. Microsoft went public in 1986. Keep in mind this was 11 years after its founding, by the way, for those who think the present eight-year standard for going public is too long It was offered to the public at a $640 million valuation, or about three times its annual revenues. Yet, at the time of its IPO, Microsoft’s Windows was already the world’s dominant operating system. However, there were few technology-focused mutual funds, which were then the primary buyers of tech IPOs. And so, very few investors appreciated the speed and scale at which Microsoft could grow. Accordingly, the company was valued modestly by its investment bankers and nearly all of the gargantuan value of the Microsoft franchise was made available to the public shareholders. Think that Facebook ‘s public shareholders will have the same luxury? The investors who bought Microsoft shares at its IPO and held onto it for the same amount of time it was a private company – 11 years – were treated to several hundred billion dollars of capital appreciation, not the $650 million that Bill Gates, Paul Allen and the other early employees earned for their 11 years of grueling start-up work. Compare the Microsoft, Cisco, Amazon or eBay examples to what we see in the post-Google era. VMWare went public in 2006 at a $12 billion valuation. It quickly rose to a $30 billion market capitalization. Thus, the existing investors (parent company EMC in this case) captured over one third of the company’s likely terminal value. Google’s founders, pre-IPO employees and early investors also did quite well, capturing a respectable 25% of the companies likely terminal value. And what of those earlier tech giants – Microsoft, Cisco, Amazon and eBay? The founders and early investors of these extraordinary businesses captured less than 1% of the terminal values of their businesses while they were still private. The valuations of today’s private tech leaders – Facebook, Zynga, Groupon and possibly Twitter – are such that I believe upwards of 50-75% of the terminal values of these companies will be captured by the folks who did the real work and took the real risks, those who quit their jobs and begged, borrowed and cajoled friends, families and angel investors to take a chance on their far-fetched idea. Here is the important, and game-changing, point: in order to participate in the great wealth creation taking place in this and future technology cycles, you will have to be a founder, an early employee or a private investor. The so-called easy money will be earned before a company goes public. This is a radical shift from earlier technology cycles. The third factor contributing to the far high valuations accruing to private companies today is the speed at which companies can now exploit the global marketplace. When I was at idealab in the 1990s, none of our start-ups attempted to address international markets in the first few years of their existence. In fact, for many of those companies, international markets didn’t become a serious focus until after they went public. How times have changed. Today it is possible to pursue an international growth strategy almost as quickly as a domestic one. The cost of running a global business has dramatically shrunk, and while costs of going overseas have plummeted, the revenue opportunities have increased manifold. Just consider where three of the largest economies were 10 years ago, and where they are today. India was a $500 billion economy in 2000. Today it is a $1.4 trillion one. Brazil was a $600 billion economy ten years ago, compared to $2 trillion in 2010. The growth of China’s economy in the last decade is breathtaking, from $1.2 trillion to $5.7 trillion in just 10 years. Combined, these three economies have added $6.8 trillion to world GDP since 2000. Public investors are aware of these economic figures, and they are rewarding companies addressing the global marketplace sooner in their lifecycle. Groupon has taken note. It is just four years old and already operates in 35 countries. Given its international ambitions, it is likely that within two years Groupon will have upwards of 20,000 employees outside of the U.S. A potential $25 billion IPO valuation awaits it for going global faster than its peers. What makes the change I have just described so fascinating is that so many of the traditional limited partners to venture capital funds have withdrawn from the asset class in the last few years, understandable perhaps after 10 years of poor returns. But just as the game has shifted to rewarding private investors over public shareholders like never before, limited partners have decided to look elsewhere for exceptional returns. I believe that is a mistake. Going forward, those who participate in building new companies and providing the start-up capital to fuel the growth of those businesses, will be handsomely rewarded like never before.
Fascinating article from the New York Times about the mind of an entrepreneur. "A thin line separates the temperament of a promising entrepreneur from a person who could use, as they say in psychiatry, a little help." Absolutely true!
Just Manic Enough: Seeking Perfect Entrepreneurs
Seth Priebatsch’s passionate pitch won over investors for his latest start-up.
IMAGINE you are a venture capitalist. One day a man comes to you and says, “I want to build the game layer on top of the world.”
You don’t know what “the game layer” is, let alone whether it should be built atop the world. But he has a passionate speech about a business plan, conceived when he was a college freshman, that he says will change the planet — making it more entertaining, more engaging, and giving humans a new way to interact with businesses and one another.
If you give him $750,000, he says, you can have a stake in what he believes will be a $1-billion-a-year company.
Interested? Before you answer, consider that the man displays many of the symptoms of a person having what psychologists call a hypomanic episode. According to the Diagnostic and Statistical Manual — the occupation’s bible of mental disorders — these symptoms include grandiosity, an elevated and expansive mood, racing thoughts and little need for sleep.
“Elevated” hardly describes this guy. To keep the pace of his thoughts and conversation at manageable levels, he runs on a track every morning until he literally collapses. He can work 96 hours in a row. He plans to live in his office, crashing in a sleeping bag. He describes anything that distracts him and his future colleagues, even for minutes, as “evil.”
He is 21 years old.
So, what do you give this guy — a big check or the phone number of a really good shrink? If he is Seth Priebatsch and you are Highland Capital Partners, a venture capital firm in Lexington, Mass., the answer is a big check.
But this thought exercise hints at a truth: a thin line separates the temperament of a promising entrepreneur from a person who could use, as they say in psychiatry, a little help. Academics and hiring consultants say that many successful entrepreneurs have qualities and quirks that, if poured into their psyches in greater ratios, would qualify as full-on mental illness.
Which is not to suggest that entrepreneurs like Seth Priebatsch (pronounced PREE-batch) are crazy. It would be more accurate to describe them as just crazy enough.
“It’s about degrees,” says John D. Gartner, a psychologist and author of “The Hypomanic Edge.” “If you’re manic, you think you’re Jesus. If you’re hypomanic, you think you are God’s gift to technology investing.”
The attributes that make great entrepreneurs, the experts say, are common in certain manias, though in milder forms and harnessed in ways that are hugely productive. Instead of recklessness, the entrepreneur loves risk. Instead of delusions, the entrepreneur imagines a product that sounds so compelling that it inspires people to bet their careers, or a lot of money, on something that doesn’t exist and may never sell.
So venture capitalists spend a lot of time plumbing the psyches of the people in whom they might invest. It’s not so much about separating the loonies from the slightly manic. It’s more about determining which hypomanics are too arrogant and obnoxious — traits common to the type — and which have some humanity and interpersonal skills, always helpful for recruiting talent and raising money.
Some V.C.’s have personality tests to help them weed out the former. Others emphasize their toleration of mild forms of mania, if only because starting a business is, on its face, a little nuts.
“You need to suspend disbelief to start a company, because so many people will tell you that what you’re doing can’t be done, and if it could be done, someone would have done it already,” says Paul Maeder, a general partner at Highland Capital. “There are six billion human beings on this planet, we’ve been around for hundreds of thousands of years, we’re a couple hundred years into the industrial revolution — and nobody has done what you want to do? It’s kind of crazy.”
Timely advice from HBR contributor Anthony Tjan. It's pretty easy to get lost in an idea and forget to focus on the basics of business. I was told once that "cash is king"... true then, true now.
Dear Entrepreneur: Think Cash, Not Ideas
Last week NBA legend-turned-entrepreneur Magic Johnson sold his Starbucks franchises back to the corporation for a reported $75 million. Rumor has it, he's freeing up some cash to invest in a professional sports team (he also sold his stake in the Los Angeles Lakers basketball team).
About 12 years ago, Magic Johnson formed a joint venture franchise program with Starbucks (Urban Coffee Opportunities) to open coffee shops in developing urban areas such as Harlem. The goal was to reinvigorate under served neighborhoods with jobs. It was a a successful partnership. Under the Urban Coffee Opportunities, more than 100 Starbucks operate in under served urban neighborhoods across the country, including Atlanta, Chicago, Detroit ,Los Angeles, New York and Washington, D.C.
Starbucks' purchase of Magic's 50 percent share of the joint venture is an important endorsement of the power behind small businesses with real cash flow models. It's also a counter-intuitive lesson to leaders about how good businesses and good partnerships can work in under served areas. Doing things where others don't — or won't — inspires me and my colleagues in our daily work.
Our venture firm, Cue Ball, considers franchise opportunities. We're selective, but we like the simplicity of their business models. The attractiveness of most retailing and restaurant franchise opportunities comes down to the unit economics: how much money is required to open a unit, and how long will it take to get the payback? If the concept is good, there should be a healthy on-going cash flow stream. Let's say you build a Starbucks for X dollars. The profits pay back that money in Y years, and you calculate the on-going cash flow minus requirements for ongoing maintenance and improvement. This can quickly give you a "back of the envelope" sense of how much money you can make, and you can quickly assess a concept's economic potential.
In the "sophisticated" business circles of MBAs, tech entrepreneurs, and private investors franchise restaurants, retail and other consumer service startups produce a negative, knee jerk reaction. The cocktail conversation dismissal of these investments usually starts with the assertion that the vast majority of restaurants fail, and that such concepts require a lot of capital and time. Plus, they're not Big Ideas. They're not cool.
It's true that most restaurants fail. Then again, most technology start-ups fail, too. And yes, you need capital and time to get them going. Of course, biotech companies spend a decade and billions of dollars just to bring a single idea to market. Still, tech investors will argue, in the "capital efficient" VC world we live in today, you can start and test the viability of digital media and social networking enterprises with very little capital before committing larger follow-on investments. But do they know that most restaurant and retail concepts have long used a similar stage-gating pattern for investing? To see if a restaurant chain concept can work, you start with one, and if you have unit economic success in that first unit, you replicate or improve on that success with subsequent units. At that point, risks have been significantly mitigated and there is an argument to be made that the subsequent capital required has relatively low risk relative to the return potential. Indeed, once the first few Starbucks in under served neighborhoods demonstrated success, the opportunity to repeat a cash-generating concept was quite high. Compare that to, say, a social media startup where risks persist and are constant as tech is a much more volatile and changing business than coffee service.
So why are tech and pharma and other sexy ideas VC darlings while coffee shops aren't?
It is easy to get lost in the excitement of starting or investing in innovative start-ups and focus on big ideas and big markets, all the while forgetting that the most important business criterion besides the team is a cash flow model that works. The real focus in any investment should be on risk-adjusted returns and not on what investors consider cool. From an investing perspective, people and business models should always trump the idea and market. The "little guys" who have the simple idea but real cash flow models may have as much of a chance to create value as the "big thinking guys" who have the big idea without the cash flow model.
Magic Johnson knew this. In 10 seasons with the Lakers, estimates put his earnings (not including endorsements) at about $18M. Let's round that up to $20M, or even $25M.
Over roughly the same number of years after his NBA career, Johnson's Starbucks venture earned him more than three times that amount. Not bad for the kind of investment many VCs would dismiss before even finishing their cocktail.
Anthony Tjan is CEO, Managing Partner and Founder of the venture capital firm Cue Ball. An entrepreneur, investor, and senior advisor, Tjan has become a recognized business builder.
