Being in the early-stage space means that you’re constantly talking about ideas. The idea might be a new feature for an existing product. Or, it could be a pie-in-the-sky idea for a yet-to-be-formed company. Talking ideas is fun. But sometimes you run into an “Idea Hater.” You know, the person that says one (or all) of following things, repeatedly:
Are these folks wrong to ask such questions? Hell no! It is vital to understanding the competitive landscape, technical feasibility and strategy for establishing a moat. But what defines an Idea Hater is someone that regardless of the answers still believes the product or company cannot be created, let alone successful. Idea Haters do not believe another great company can be built. But all around us, crazy ideas are being turned into great companies. Here are two of my favorites. So the next time you run into a Hater, share these ideas as a reminder that innovation is alive and well. Airbags for bicyclists The pitch: “What about using airbag-like technology to create a more comfortable bike helmet. Think about it. It is inflatable airbag that cyclists wear around their necks, like a scarf. It’s light, stylish and unencumbering. In the event of an accident the airbag inflates and protects the rider's head.” This crazy idea is brought you by Hovding. A Smart Saw The pitch: “You know how the iPhone doesn’t work if the person is wearing gloves. It’s like the iPhone knows the difference between flesh and other materials. Well, what about a saw that detects the difference between wood and flesh. And if it detects flesh, it immediately stops the saw and saves the craftsman finger, hand or arm.” This idea by SawStop actually works. It's the reason my father-in-law still has all ten of his fingers.
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The tension between management and private equity plus the state of the economy in the 1980s is captured in Other People's Money. America celebrates its innovators. When Steve Jobs passed away, millions held vigil and thousands wept. Jack Dorsey and Drew Houston sell out MIT. A picture of President Obama chatting with Mark Zuckerberg goes viral. In short, Americans love people that make things that change the way we live our everyday lives. Financial innovators, on the other hand, do not enjoy the same love and respect. At best, innovators in finance make a lot of money and have tons of fun but don’t become household names. Arthur Rock, for example, should be as well known as Gates, Jobs and Zuckerberg. After all, he created venture capital – the tool that enabled Microsoft, Apple and Facebook. At worst, financial innovators are reviled as fat-cat villains. Look no further than the topic du jour: Mitt Romney and his private equity background. It’s easy to demonise people that “don’t build anything” and “make money on the transaction.” But the bad rap on private equity is misguided. Private equity was an important financial innovation and a key factor in the productivity gains and technology boom that began in the 1990s. Before going any further, this blog is NOT an endorsement for Mitt Romney. It’s simply a look at the overall private equity market, and not a judgment of any specific deals done by Bain or any other firm. This Machine Kills Conglomerates Following World War II, American companies enjoyed nearly three decades of growth. At home, Americans consumed American-made goods. There were no German or Japanese or Chinese imports. These nations were decimated during the war and were rebuilding. And guess which economy provided the equipment, materials and services for the rebuilding? America. In short, America was #winning. This period saw the rise of the conglomerate. According to The New Financial Capitalists by George Baker and George David Smith, three factors led to conglomerations. First, companies became bloated and staid in light of no competition. Second, ERISA (passed in 1974) limited the amount of money pension fund managers could invest into a single company. As a result, pension funds held a small number of shares in a large number of companies. Such a structure fosters passive – not active – shareholders. Lastly, antitrust rules made it difficult for two companies operating in the same industry to merge. To put it all together, managers who face no threats from the outside (competitors) or the inside (shareholders), and who do not want to ruffle the feathers of anti-trust authorities, have only one option with excess cash: buy businesses in completely unrelated industries. It was this formula that led oil industry giant Mobil to acquire Montgomery Ward, a retail chain. Private equity and the leveraged buyout were the change agents that dismantled conglomerates and realigned management with ownership. In its simplest form, a buyout works like this. An acquirer like Bain buys a target company using cash from its fund and debt from either a bank loan or a bond issuance. The target company’s assets serve as collateral for the debt. So a company worth $10 would be purchased using $1 of cash and $9 of debt. Debt is the secret sauce. When a company has an obligation to meet, it must trim the fat and only make sound investments. That means no more corporate jets, lavish headquarters or underperforming divisions bought for the purpose of Empire Building. It means investing in projects with expected rates of return above the companies cost of capital. I equate LBOs to a mortgage. A person who takes on a mortgage will watch his or her money more closely and make financially sound investments -- one hopes, at least. Private equity affected all enterprises in the economy. In order to avoid a takeover, management proactively levered up. (A company that already has debt cannot take on more debt to do a leveraged buyout.) In the end, American companies got leaner and more focused. By the 1990s, the LBO dividend began to pay-off. Companies invested soundly into R&D and process improvements, which in turn improved productivity and helped fuel the information technology revolution. In conclusion, private equity isn’t perfect and it isn’t always pretty. The anger over compensation and taxes is understandable; private equity managers charge a 20% fee on profits earned, which is taxed as long-term capital gains (15%) as opposed to income or a bonus (35%). Partners in private equity firms also use debt to extract dividend payments for themselves; in some cases, these payments are too burdensome and good companies are forced into bankruptcy. Overall, however, private equity is a tool - though sometimes blunt - that moves the economy forward. In 2006, I started a biodiesel operation for The Doe Fund, a non-profit organization in NYC that creates businesses to employ formerly homeless or incarcerated men. There I was: a kid from rural Massachusetts leading 10 men from the toughest neighborhoods in New York. One of my employees, who was about my age, hailed from the South Bronx but had spent the last 10 years in Federal Prison for shooting a rival dealer. Another had started using heroin when he was nine years old.
Today, my team at Spottah is the exact opposite: highly skilled knowledge workers. The degree-to-employee ratio is 1.7. Technology recruiters, not DEA agents, are breaking down our doors. Email is our addiction. These distinct experiences defined my management philosophy. The manager’s job is to understand the goals of his team members, and align those goals with the organization’s goals. The fact that this philosophy works with people three sigmas right or left is testament to its strength. Take Lester from The Doe Fund, for example. Lester’s goal was to land a job with New York City Sanitation. Some of you may be thinking, “‘garbage man’ doesn’t sound like a great goal.” But it is. It’s high-paying, secure, and provides benefits. Once I knew Lester’s goal, I was able to align his goal with the goal of my biodiesel unit. We focused on establishing a safe driving record, following safety protocols, truck maintenance and crew management. Fast forward to Spottah. A few months back, we brought on a new graphic designer named Chris. Chris came to us as a product manager at a major web property. The extent of his design experience were a few side projects and a ton of photography. He knew photoshop and had an eye for design. Being a product manager, Chris had two personal goals. First, improve as a designer, specifically by focusing on logos & icons, textures, fonts and the balance of the screen. Second, he wanted to push the boundaries of the mobile user experience. Initially, I favored an incremental redesign -- you know, change an image size here and a font there and eventually achieve a new look. Incremental change, however, did not align with Chris’s goals. Furthermore, incremental change was not best for Spottah; our success rests on an amazing user experience. So we tasked Chris with razing the old design and completely re-imagining our product. Thanks to Chris’s designs and Yin’s ability to implement anything, the new version of Spottah looks and feels amazing. Here is a taste, but you’ll have to wait a bit longer for the full meal. Sorry. Gaining an honest understanding of your team members’ goals is not easy. A person’s goals may not include the current company; Lester, for example, had a goal of working for DSNY, not The Doe Fund. Also, a person may fear that their goal counters the goal of their manager or another team member; Chris wanted a complete redesign while I initially wanted to move in increments. It is essential to create an environment where people can honestly share their goals. If a company fails to achieve this, than people will project false goals and the manager will not be able to develop a meaningful plan for achieving individual and company goals. Apple TV is an aberration from every other Apple product. Rather than being an all-in-one device, Apple TV is a component that plugs into televisions manufactured by others. Apple, therefore, cannot control the entire experience and thus the overall experience isn’t that good. This is why you don’t see people camped outside for days waiting for the newest Apple TV.
The next and most obvious frontier for Apple is building an actual TV. This is definitely on the company’s mind; CEO Tim Cook was quite cagey when asked about his company’s plans at D10. An Apple TV set is technically feasible. Apple knows how to make beautiful large screens; the 27-inch iMac is a great example. And Apple knows how to take an existing product and totally reinvent it. So if it isn’t technology, creativity or desire, what is holding Apple back from bringing a TV to market? My guess: Retail square footage. By most measures, Apple’s move into retail was brilliant. Retail enabled Apple to control the customer experience, and thus its brand. This is difficult to achieve when selling through independent channels like Best Buy or Staples. But the drawback is limited space for additional - and significantly larger - products like a line of TV sets. According to RetailSails.com, the average Apple store is 7,886 sq ft. While I don’t have the exact figures, my guess is that the median is much smaller because there are handful of flagship stores at 20,000+ square feet and then hundreds of smaller footprints in regional malls. Either way, one thing is certain: the stores are cramped. Finding floor space to display 15 TVs ranging from 27 to 60-inches, plus hundreds of units of inventory, is no easy feat. Big Box retailers will be better equipped to distribute an Apple TV. Since they already have space for TVs, it is simply a matter of taking space from a poor selling brand. Apple doesn’t have this luxury. Sure, Apple will no longer be selling the Apple TV “puck” but that will hardly make a dent in the space required. Retail square footage will continue to be a hurdle. Apple, I predict, will enter the 3D printing market. Currently, there is a huge valley between hobbyist and enterprises. Thirty-six years ago, Apple was founded to fill a similar valley in computing. Today, Apple is the best equipped company to deliver to the masses a beautiful 3D printer and a “Blueprint Store.” To do this, though, Apple Stores will require significantly more square footage. In summary, Apple’s move into retail was a branding homerun. But on the downside, the company now has less flexibility to bring new, physical products to market without simultaneously investing in retail expansion. The best part about being in the start-up community is watching other start-ups. Almost every week, I learn about a new company that stops me in my tracks and makes me say, “Damn, that is so obvious. ABC company is going to forever change the way we do XYZ.” Here are three companies that have given me this reaction.
Kickstarter Venture capital was created 56 years ago. Before Eugene Kleiner’s shot-in-the-dark letter that landed on Arthur Rock’s desk, there was no institution for funding smart people with new ideas. That changed when Rock connected Kleiner and 7 other colleagues with Sherman Fairchild. Fairchild invested $1.5 million into the 8 transistor scientists to create Fairchild Semiconductor. Fairchild Semi was a success, at first, but soon the founders left because they did have enough equity. Two Fairchild employees - Robert Noyce and Gordon Moore - went on to found Intel. (To learn more about the fascinating history of VC and The Valley, check out this interview and the movie Something Ventured.) Venture capital was a tectonic innovation in finance. But in the last half century, not much has change: VCs raise money from Limited Partners and invest in young, un-established companies with mountains of potential. In fact, the major innovation has been the rise of secondary markets like SharesPost and SecondMarket. These exchanges give shareholders of private companies liquidity, which is great. But these markets have not changed the fundamental way in which early stage ideas get funded. The way that VC offered equity financing for early stage companies, Kickstarter offers working capital finance. This is huge. Before Kickstarter, working capital finance was restricted to established companies that had good relationships with banks. Now, a company with a novel product idea can create a Kickstarter campaign and pre-sell units. Since the company receives the money before shipping the product, they have capital on hand to deliver the promised product. In short, Kickstarter gives early stage entities a form of finance that did not previously exist for them. The key question is will Kickstarter launch a billion dollar business? Naysayers say no way; Kickstarter is for crafts and movies. I say, if Kickstarter was around in 1976, Jobs and Wozniak would have created the “Apple 1” campaign. TalkTo Look at the data. Texting is on the rise; voice calling is on the decline. Recognizing this, TalkTo created an app that allows anyone to text any question to any business. Want to know if Whole Foods has your favorite microbrew? Launch TalkTo, select Whole Foods, and shoot off a text. Running late for a dinner reservation? No worries; TalkTo has your back. I was in New York City this weekend and used TalkTo half a dozen times. It worked flawlessly. I was able to get a restaurant reservation, change said reservation, and double check that we would be seated outside. Within one day, TalkTo inserted itself between me and every business that I interact with. In other words, TalkTo -- not the restaurant, bank or hotel -- owns the relationship. This is incredibly powerful: owning the customer relationship is the holy grail in business. In the insurance industry, for example, brokers and underwriters constantly struggle to own the policyholder relationship. Owning the relationship enables companies to better understand customer needs and ensure quality interactions, leading to customers that stay longer and buy more. By building a simple app that delivers as promised, TalkTo is poised to change the way that people find information about and interact with companies. What company recently did that? I’ll give you a hint. It starts with a “G” and ends with an “oogle.” GigWalk I love services that create marketplaces. The two most recent examples are Airbnb and Uber. Airbnb looked at the world and said how can we connect supply (people with spare beds) with demand (people looking for an inexpensive place to stay). Uber did the same thing, connecting underutilized Town Cars with people seeking reliable and convenient car services. GigWalk is connecting businesses that need market research with people looking to make a few dollars. A brand - think Colgate, P&G, etc - needs to understand (or audit) how its products are being placed on the shelf at retailers. The brand could send in a dedicated “secret shopper,” which is costly and logistically challenging. Or, the brand could use GigWalk to push an alert to anyone in the area and ask them to simply take a photo of the Dental Section. I particularly like GigWalk because it is an everyday product. A simple trip the grocery store or Starbucks or a restaurant could net a GigWalker a few dollars. In short, GigWalk looked at the world and said how can we use existing tools to mobilize people to solve a business challenge. Over the past six months, Spottah managed to quiet the "Lizard Brain." It was an amazing streak that would make Seth Godin proud. We delivered a minimal viable product, a beta and two Apple App store releases without thrashing. But like all great streaks, ours came to an end. Between Sunday night and Wednesday morning, we violently thrashed. Think boated Great White.
Without getting into great detail, we planned to push an App Store update on Sunday night. Since releasing our first version in mid-May, we identified a few bugs and “stumble points.” My favorite: Facebook Connect in Norwegian dialect. So we drafted a 20-item requirements list in Pivotal Tracker. One-by-one Spottah’s amazing development team delivered. On Saturday night we received a TestFlight. Every requirement worked. One final call on Sunday to “push the button together.” Sunday. 4PM. The team assembled. We agreed: the new build is tight. We thanked the development team. They, like always, said don’t worry about it. Then it happened. Our partner in charge of the front-end threw out a final request. Our back-end developer said it shouldn’t be too hard, and that he’ll look into it. “Great,” I said. “Look into it. If it isn’t too difficult, go for it.” And so began the thrash. One fix caused four problems. And in the end, the request had the opposite effect: it slowed Spottah down. How did this happen? Why am I so upset that we thrashed? And most importantly, how will the team ensure that this does not happen again? How did this happen? Over-confidence and a lack of discipline caused Spottah’s thrash. During the six months the team has been together, there has not been a single programming challenge that our developers could not solve – quickly. With each precise and timely delivery, confidence grew. Discipline, in turn, waned. After all, why be disciplined in your decision-making when every task is doable? So on Sunday, when the extraneous request was proposed, I had no doubt that the team could deliver. Instead of being a disciplined project manager and asking a line of questions (Do customers want/need this? How will implementing this one item affect other parts of the application?), I resorted to the worst logic in product development: If doable, than do it. Why I’m so upset? I’m upset because thrashing strains the team. The development team bears the brunt of the strain. Developing a beautiful application that is easy-to-use and reliable is difficult, to say the least. Thrashing makes the process more difficult and lowers morale. Who likes investing hours into building something, only to find out after a few seconds of usage that it makes the product worse? And it doesn’t end there. Additional hours are required to undo the now-useless requirement. It’s like building a house, realizing you don’t want to live on that particular street, and then dismantling the house. The business side is strained, too. Since the Apple update process requires deliberate action by the consumer, you don’t want to push the product too hard knowing that an update is in the not-too-distant-future. It makes little sense onboarding people on Tuesday only to ask them on Wednesday to update. Since the business-side is measured by active users (at Spottah, at least) it is stressful to delay marketing efforts. Overall, thrashing harms the team dynamic. While one side of the team burns the mid-night oil, the other is left sitting on their hands. Steps for avoiding future thrashes 1. Invest the time up-front to develop a sensible requirement list….and stick to it! Spottah did the first step. We had a requirement list that addressed bugs, UX improvements and performance. We nailed all 20 items on the list. The one item not on our list led to a thrash. 2. Exceptions to Step 1 can be made but be doubly – no triply – sure you need it. It is naïve to say that you shouldn’t adjust a plan made three weeks earlier. Things change. You could have completely missed something in your customer research. Or, a technology in the stack can change, thus forcing your hand. But before rushing to add an additional requirement: i. ensure that it is absolutely necessary; and ii. understand how it will affect the feel and performance of the product as a whole. 3. Don’t get lazy. We were tired and distracted that fateful Sunday. We had been pushing hard while balancing life; for example, I took the call between my sister’s graduation party and a trip to the movies with my nieces. Under such circumstances, it’s easier to say “Go for it” than it is to ask the hard questions. But in reality, it is easier to be disciplined up-front than it is to unwind a mess caused by small-thinking. DiMaggio’s streak ended in th 57th game. The Patriot’s Perfect Season slipped away in the Super Bowl. And Spottah’s thrash ended a solid run of ships. But we’re a young team and the new season starts today. Holman W. Jenkins, Jr of the Wall Street Journal wrote a spot-on analysis of Facebook. Check out Guess What? Facebook Is Speculative.
My two favorite quotes: "Facebook went public at $105 billion and Friday was selling at $87 billion. At either figure, Facebook's valuation is a projection of a revenue model that doesn't yet exist and hasn't even been articulated by the company. Buying shares at these prices is a bet on capitalist incentive eventually to find a way to turn Facebook into gold. But it's no sure thing. An investor who didn't understand this can find the man who cheated him in the mirror." "[Zuckerberg's] next trick will be to build a bridge between this data and the existing world of ad-supported media that all of us are immersed in every day....It requires of Mr. Zuckerberg a second act of entrepreneurial creation on the order of his first. But a place to start might be finding out who advised Steve Jobs on how to sell the record companies on iTunes. That person probably belongs on the Facebook payroll pronto." Today, is a “turning point” day. Yesterday, Spottah went live on the Apple app store. For more than two years, I have wanted to play the mobile game, so yesterday was an enormous milestone. Tomorrow, I will receive my diploma from New York University’s Stern School of Business. For three years, I attended Stern at night while working during the day. So as I close one chapter and open another, I want to take a moment to share my most memorable lessons from Stern's classrooms. The goal of the MBA is to teach students frameworks in which to tackle real world problems. We covered a ton of frameworks but here are my three favorites. The Value Chain It is easy to grasp that profits rise when you increase revenue and reduce costs. But what does that actually look like in an interconnected supply chain? Enter the The Value-Based Business Strategy by Adam Brandenburger and Harborne W. Stuart, Jr. Every firm sits in the middle of the value chain at some point. The firm buys resources from suppliers (raw materials, labor), turns those resources into a higher-value product, then sells that product to a buyer. Let’s use a clothing company, for example. The company buys fabric from a supplier and hirers workers. Inside the firm, workers turn raw fabric into fabulous garments. The firm then sells those garments at a higher cost to a retail store. In the diagram below, this transaction is marked by the “cost” and the “price.” Pretty straight forward. Here is where the value-based strategy comes into play. The total value of the chain is the buyer’s willingess-to-pay MINUS the supplier’s opportunity cost. The goal of a company is to capture as much of the value chain as possible. This means pushing the cost of inputs downwards to the supplier’s opportunity cost, i.e. the point right before it makes sense for the supplier to walk away and not make the sale. The same thing goes on the buyer side. The goal of the firm is to push upwards the price of its goods to the buyer’s willingness-to-pay. Vibram soles and Intel chips are great examples. Traditionally, these two products were commodities; no one cared about the sole of their shoe or the chip in their computer. As a result, the bootmakers and computer manufacturers captured the lion share of the value in the chain, i.e. there was a big spread between the price charged by Vibram/Intel and willingness-to-pay of Asolo/Dell. So what did Vibram and Intel do? They branded the components. Vibram advertised and put the bright yellow marker on each of its soles. Intel advertised, too, most famously creating the “Intel Inside” campaign. Customers soon demanded the yellow brand on their soles and wanted to know if Intel was inside their PC. This shifted the value away from the end manufacturer and towards the component maker, thus allowing Vibram and Intel to push towards the buyer’s willingness-to-pay point. The Value Formula
Sticking to value, but this time we’re are talking my favorite topic: Finance. Whenever new information arises and I’m trying to value an asset (stock, bond, property, you name it), I rely on a piece of advice from my valuation professor. “When new information comes to light ask yourself: what lever of the ‘value’ formula is being affected?” More specifically, the professor was referring to the perpetuity discounted cash flow (DCF) formula, which is: Value = Cash Flow / (Cost of Capital - Growth Rate of Cash Flows). The levers are the cash flows generated by the asset, the growth rate of those cash flows, and the opportunity cost of capital, i.e. the minimum return acceptable to investors. The purpose of the formula is to discount future cash flows into a net present value. The formula is not perfect, mainly because it assumes constant growth in cash flows, but it is an excellent rule of thumb. To put this in perspective, let’s say you own stock in a Company X. News breaks that the company lost a major contract. What lever is being affected? Cash flow; the company will generate less cash than before. One could also argue that cost of capital is at risk of rising, assuming a reduction in cash flows reduces the company’s chance of survival and thus increases the risk level. But the main lever being pulled is cash flow. Let’s put some numbers to this. Assume before the news, total cash flows were $100, cost of capital was 10% and growth was 3%. Thus, the asset is worth $1,428 (100 / (10%-3%)). Having lost the contract, cash flows are estimated to fall to $75, which causes the value of the company to fall to $1,071 ($75 / (10%-3%)). This is super simple finance but it a great framework to understand quickly how certain events affect asset prices. In short, always ask “what lever is being pulled: cash, cost of capital, growth?” The Growth Diamond So far, the frameworks have been very quant-ey -- my apologies. So let me finish strong with a framework taught by Robert Wright that explains why some countries develop rapidly, like the United States, while others do not develop at all. It comes down to the “Growth Diamond;” Stern professors notoriously love baseball. Home plate is a non-predatory, Lockean government. In other words, growth starts with a government that protects the life, liberty and property of its citizens. Such a government collects taxes transparently, regularly and at a reasonable rate. The government also establishes and enforces reasonable laws. Note that such a government does not need to be a democracy; though they often are. The next phase of development, or first base, is a financial system in which capital moves from savers to borrowers. First base cannot be reached without home plate; after all, the crux of saving and lending are contracts recognized by the courts established by the government. With home plate and first base established, the economy is prepared to take second base: entrepreneurship. Individual actors are comfortable investing into a long-term business knowing that the government will not pilfer it in the night. And even if something goes wrong, the actor has faith that the slip of paper called “insurance” will be made good. And lastly, the actor has access to capital, thanks to first base. Interestingly, not all economies move equally between bases. There are countries with non-predatory governments and financial systems that have less entrepreneurship than others. The final stage, third base, is a management system. Basically, the entrepreneurs that flourished from a stable government and access to capital eventually grow into large, distributed organizations. These organizations have the systems required to undertake large and complex markets like air travel, chip fabrication and automobile manufacturing. I find this framework incredibly helpful as I look at emerging markets. The first question is what type of government does the country in question have? If the answer is non-predatory, than you can begin to look down the base path. The growth diamond is also good for understanding domestic policy. I find myself asking how will a new law or regulation effect any of the bases. In closing, the MBA education was amazing. As I think about more frameworks and lessons, I will do my best to share. Yesterday, Facebook released a roadshow video ahead of its IPO. The video highlights Facebooks’ opportunity to win more advertising dollars, and also points out the company’s role as a social platform. I’ve been thinking a lot about Facebook lately, so wanted to use this opportunity to jot down some notes.
Advertising First, Facebook has the potential to win a bigger chunk of the global advertising market. According to FB, brands spend about $600B on advertising per year. Global advertising spend is a slow-growth business; according to ZenithOptimedia ad spend will grow 4.8% from 2011 to 2012, which is roughly in-line with global GDP growth. Since the overall pie isn’t growing, FB needs to win ad spend from other areas, like television, radio and print. Will they be able do this? Hell yes. People are spending an increasing amount of time on Facebook, at the expense of other media. (Remember, the hours in day are static so time spent on FB equates to less time spent elsewhere.) And what is everyone doing during this time? They are watching videos, reading articles and listening to music. So without even factoring in that FB campaigns are extremely effective, FB will have no problem growing its advertising revenue. Platform The second opportunity is best described with a riddle: What is the only thing on the web that is unique and ubiquitous? Give up? It is your Facebook page. If you’re like me, you have three active email accounts and two phone numbers. But you only have one Facebook page. Thus, developers building social products have no choice but to integrate with Facebook. I found this out the hard way. When we first designed Spottah, which is currently being reviewed by Apple, we decided not to use Facebook Connect. We thought integrating with Facebook would diminish our value proposition of sharing photos among only close friends and family. So we decided to connect by email or phone; after all, close friends would know your email address. We pushed a beta. It was a disaster. No one knew which email address their friend signed up with. For example, I’m registered using my @spottah.com account but everyone was trying to connect with my @gmail.com account. We looked at our sharing process and realized we needed a purely unique identifier. It became immediately obvious that Facebook has a monopoly on unique identifiers and that we would have to integrate Connect. To my knowledge, Facebook has no plans to directly monetize Connect and Open Graph. The goal is to create an ecosystem in which independent developers create great apps that increase the value of both companies. While this makes sense, I could also see a world in which Facebook charges a small amount for Connect and Open Graph. As a developer, I would pay for this. When we started Spottah, I did not think twice about whipping out my credit card to buy computing power from Amazon, analytics from Mixpanel, and smarter email from MailChimp. But all of these are worthless without customers, which Facebook provides. Yet, customers acquired from Facebook are free. The idea of Facebook charging developers is controversial. Many would point to Microsoft as a parallel example. Microsoft never charged its independent developers. A strong supply of programs designed for Windows meant more sales of Windows. This in turn increased the demand for PCs, which Microsoft capitalized on by grabbing the largest chunk of value chain. Microsoft and Facebook are not parallel examples, however. Microsoft had greater control. For Microsoft, the better the ecosystem the greater the sales of PCs. Plain and simple. Facebook, on the other hand, does not have as great of control. Instagram is the perfect example. Facebook enabled Instagram’s rapid growth by improving connections and spreading the word via Newsfeed postings. In the end, Instagram became so compelling that people were visiting Instagram before Facebook, and also spending more time on the app. Realizing this, Facebook bought Instagram, proving that Instagram captured the lion’s share of the value. Instagram will not be the last company to capture a greater portion of the value than Facebook. The key for Facebook will be designing a structure in which they foster independent development but are also able to capture their share of the value created. Congratulations, your start-up received a term-sheet. Now what? If you’re a first time entrepreneur, you’ve been pounding the pavement for months – maybe even years – and a term sheet puts you one small step closer to funding. So, first, enjoy the moment. I know the feeling. Back in 2005, I landed my first sheet for a healthcare retail start-up I was working on. I remember thinking: This is it! Where do I sign? But don’t let the celebration last too long. You’ve got some analysis to do. The first step is building a pay-off diagram. A term sheet lays out the rules for splitting the spoils if and when your company has an exit event, such as a merger, IPO or liquidation. Thus, a pay-off diagram graphically shows what you get and what your investors get given different exit amounts. There are so many variables that go into a pay-off diagram, but I’ve built a model that covers the vast majority of early-stage term sheets. I’ve made it available as a Google Doc Template and you can access it here: There are other models out there, and I suggest you play with those too. Andrew Metrick and Ayako Yasuda have a great tool that allows you to model pay-offs across several rounds. Their model, however, is geared toward the VC investor more than the entrepreneur. Before you dive in, I’ll walk you through the basics. We’ll also look at a few examples. The Variables First, chose the type of security (cell B7):
Third, calculate the common stock on an as-converted basis. You only need to fill in three cells: The current common stock outstanding (D12) PLUS the number of shares issued (D13) and the convert-to-common ratio (D14) of the funding raising event. Fourth, what is the dividend rate (K12)? And is the dividend Cumulative or Accrued (K13)? Accrued means that outstanding dividends are simply paid back; for example, if $5M of preferred are issued and the rate is 8% and an exit occurs 5 years out, than the dividends due to the investor are $2M ($5M x 8% x 5 yrs). Cumulative means that the dividends are compounding. Using the same example, the investor would receive $2.35M in dividends plus principal (5M x 1.08^5). Cell K14 is only relevant to Participating Preferred Capped. Caps are usually a multiple of the investment. So a $5M investment with a 4-times investment cap means that the investor can participate up to $20M. If the investors share of the exit exceeds the capped amount, the investor will convert to common and realize the upside. Lastly, what is the expected time to exit (K9)? This is vital to calculating the dividends due. The Results: Same Variables, 4 Security Types For each security type, we'll assume the company is raising $5M. There are 20M shares outstanding and the company is issuing another 10M on an as-converted-to-common basis. Thus, the founders own 66 2/3 and the investors 33 1/3. Dividends are cumulative and pay a rate of 8%. An exit is expected in 5 years. Remember, the tool is flexible so plug in the terms relevant to your deal. I. Redeemable Preferred Redeemable preferred act just like debt, in that the investor is entitled to principal plus dividend but no upside. For this reason, it is highly unlikely that an early stage investor would accept RP. As you can see from the diagram below, the RP holder receives all the proceeds of the exit up until $7.35M. So in the event of a $50M exit, the investor receives $7.35M and the founders $50-7.35=$42.65M. II. Convertible Preferred Convertible preferred give the investor the option to convert into common stock. Using our example, the investor will convert to common at a $22.50M exit. Why? Because 33 1/3% of $22.5M is $7.50M, which is greater than $7.35M from principal plus dividend. III. Participating Preferred Participating preferred are commonly used by early stage investors. PP give the investor the best of both worlds: they receive dividend plus interest AND also participate in the remaining upside. So, in the event of a $50M exit, the investor will receive $5M in principal plus $2.35M in cumulative dividends. But that is not all. They will also receive an additional $14.21 [$50M-$7.35M)*33 1/3]. The grand total: $21.56M. IV. Participating Preferred (Capped) Participating Preferred with a cap are similar to PP but, well, with a cap. Caps usually refer to some multiple of the original investment. In this example, let's assume the cap is 4x, i.e. 4 x $5M or $20M. This means that the investor can participate up to $20M. Thus, an exit between $47.5M and $60M will yield $20M. (You can see this plateau in the graph below.) An exit above $60M translates to a common stock value above $20M ($60M x 33 1/3). Therefore, the investor will convert to common and realize the upside. (Again, you can see the upwards slope at $60M). Conclusion
Security types and terms matter - a lot. Assuming a $75M exit, the founder that sells redeemable preferred will receive $67.65M. The same exit size but using participating preferred results in $45.10M. Hence, the type of security equates to a $22M difference on a $75M exit. In short, model out your term sheet before signing anything. The attached model should be applicable for a large majority of sheets. If your sheet has more nuances, try building your own. And don't be afraid to contact me; always happy to help. |
JONATHAN STEIMAN
I'm the Founder and CEO of Peak Support. This blog is my take on early-stage companies and innovation. Every so often, there may be a post about culture, networking, family -- you name it. After all, what is a blog if it isn't a tad bit unstructured.
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