Profit is Not an Ugly Word

Leo Bloom: “Heh, heh, heh, amazing. It’s absolutely amazing. But under the right circumstances, a producer could make more money with a flop than he could with a hit.” – quote from the movie The Producers by Mel Brooks.

Some of you may recall this memorable line which was the premise of this classical movie. The plan was to raise a significant amount of money, find a play that would “flop” on opening night and keep the unused funds. An ingenious ploy; save for the fact that the play was a hit, more than 100% of the equity had been sold and the main characters ended up in prison.

So, let me begin by apologizing for the somewhat dour tone of this blog. I think of this line as I see pitches that seek to raise more and more capital with an apparent disregard for the spend or “burn rate,” with entrepreneurs chalking up their expenses to the investment needed to grow. Every entrepreneur I ever met believed they could grow faster with more dry powder. But the successful ones realized that just like one’s personal finances, at some point, you must “pay the piper” (face the music, come to Jesus, yada, yada, yada).

I would have thought we learned our collective lesson from the dot com boom / bust. Back then, despite substantial losses, valuations were sky high and investors began to focus on other “metrics” which soon took the place of the old reliable P & L. Just like the Cabbage Patch Kids, one day someone decided that these companies were in fact ugly, and shortly thereafter, most were trashed and entrepreneurs were sent home to live with their parents.

I want to be clear here; if you are running any type of business, you need a clear path to profitability. I saw a recent article with an entrepreneur calling out investors for just asking when the company would turn a profit, which the author interpreted as just stifling growth. How dare they? Well I ask, how dare you build a business model without such a pathway and put your stakeholders (especially employees) at risk with the hope that someone will be smitten with your traction or stickiness and rescue you with an acquisition deal? That’s not building a viable business; that’s the equivalent of legalized gambling.

Please do not get me wrong. I am not implying that one must be profitable to attract investors. If I believed that, I would not be so respectful of angels and VCs that make the early-stage ecosystem work. Thank goodness for them. But if you think investors do not believe that a sustainable business is nirvana, you just have not asked the right questions. That path to profitability must not only be clear but in sight.

The great entrepreneurs I know are better than that. They realize that this not a Max Bialystock shell game. They need to seek profitability and realize the clearer the path to this goal, the more likely it is their journey will be successful.

Stages of a Business Life Cycle – Why It Matters Where You Are

“Where you stand depends on where you sit.” – quote attributed to Rufus Miles of Princeton University

I have been privileged to serve businesses in all stages of their life cycle. For example, I am now helping an owner sell the business I helped him to acquire over 30 years ago. Over the years, I have helped companies deal with a wide variety of issues and realize the commonality is often the current stage of the life of that business. More importantly, focusing on “where you stand” in the cycle can help an owner address the typical issues they will probably face not only in this stage but the next. It’s the old “I am more afraid of what I don’t know” syndrome I see so often. So while a complete listing of what to consider at each stage is way beyond the scope of any blog or article, some brief highlights will get you thinking.

It may have been the Boston Consulting Group or another organization which introduced this concept (or a derivation thereof) years ago, but to me there are typically four stages of the business life cycle:

  1. Startup
  2. Emerging
  3. Growth
  4. Mature

Startups are characterized by developing proof of concept, they are pre-revenue, may have a minimum viable product (MVP) and the owners are usually trying to define themselves. Challenges are funding, funding, funding (angels, friends and family), sharing equity and recruiting team members (usually centered around those that believe in the founder(s) vision.)

Emerging companies do have an MVP, some traction, and are looking to develop an effective approach to the market. They have raised funds from friends and family and are looking for that next round. Challenges are more sophisticated funding (VC’s, etc.), honing the customer experience, the product and approach, expanding the team, more disciplined equity grants and trying to keep control over everything – – being a bit more “directed” but monitoring culture.

Growth is when you start to hit stride. Product is developed and is appealing to the sweet spot of the market. Financing is less of an issue and you probably have cash flow to fund basic growth: your balance sheet is your friend. Team members are now recruited with more specific objectives in mind. Equity is more guarded (like a fine wine) and delegation and timely reporting of Key Performance Indicators replaces informal chats as to “how things are going.” Discipline works its way into almost all aspects of the business and controls (versus control) is the key word of the day. Organic versus acquisition growth is a constant subject of discussion.

Mature companies have usually achieved stability in market presence, financial rewards and in management team composition. Thoughts turn to succession planning, risk management (protecting what you have built) and perhaps an exit plan. Processes are helping keep the business intact and acquisitions and dispositions are a more frequent part of the conversation.

So there are issues to address at each stage in the life cycle, and at times, owners get a bit ahead of themselves like adolescents tend to do. Hopefully, by identifying where you are in the process and understanding that where you stand depends on where you sit, you will be able to successfully see your way through it.

Stock Books Are Not Checkbooks

Leo Bloom: “She also owns 50 percent of the profits.”
Max Bialystock: “Mrs. Alma Wentworth.”
Leo Bloom: “She owns 100 percent of the profits.”
Max Bialystock: “Leo, how much percentage of a play can there be altogether?”
Leo Bloom: “You can only sell 100 percent of anything.”
Dialogue from Mel Brook’s 1968 classic The Producers

When I first started consulting with owners on equity sharing (a long time ago in a galaxy far, far away) I never thought that four decades later I would still be giving advice on the same subject. But to quote Ronald Reagan, “There you go again.”

I was just brought in to consult with an early stage company that has concluded (and I agree) that the time is right to join forces with a larger organization in order to “ramp up” and maximize the potential of the product they have developed. We are helping with the efforts to prepare the company for sale. Quite honestly, in most cases the task at hand relates to analyzing and summarizing financial data. I am always amazed that so many (almost every) early stage companies I go into have an array of valuable financial data that could really help the owners more effectively run their business, but most do not want to spend the money to get it. So it is usually up to the accountants to either verify the data by completing an audit or analyzing the data as part of the due diligence process. But I digress.

One of the first questions I raised was if the company had any contracts with key employees or vendors. The first answer was no. Well, I soon learned that while in the owners’ minds there were no contracts, they did have letters outlining deferred pay and stock ownership for at least 12 current and former employees and vendors; everyone from an old landlord to the ex-CIO. As we started to put together a rough “cap table,” the dialogue above came to mind. We finally herded all the stray cats and assembled a very ugly picture. In addition to the dilution, it was fraught with business, tax and (dare I say it) accounting issues. A great deal of time and fees later, I sat down with the owners to understand how this had happened.

Their response harkened back to what I heard 40 years ago; they did not have the cash so they offered ownership instead. So here are my three reasons why this is a bad idea:

  1. Lack of faith – in most cases, these “deals” are exchanges on a 1 to 1 basis; like exchanging $5,000 of rent or pay for an equivalent number of shares in the company usually at or near founder prices. If you really believe in your company, how does this demonstrate your faith in its future value?
  2. Tax issues – without getting into the gory details, unless you do the right things at right time, there can be unforeseen tax consequences. Nothing says I appreciate you more than a tax bill with no cash to pay it.
  3. Control – unless you follow the right discipline, you can end up with stock ownership in the hands of someone who has underlying interests which may not be consistent with yours. This is never a good thing.

So if you are an owner, please treat your equity like a precious child and only use your stock book as a checkbook as a very last resort.

Show Me The Money – The Question Early Stage Fund Seekers Are Afraid to Ask

“Fundraising is the gentle art of teaching the joy of giving.” Quote from Henry A. Rosso – fund raising master

Over a long Holiday weekend, I had the chance to read through and comment on a handful of pitch decks. It may have been my good mood, but I really think the quality of these decks is getting better especially as it relates to early stage fundraisers including most of the basic components of a solid deck. There are plenty of guides out there to show what the contents of a deck should be – – in fact we have a good one at our Withum website if you just go to withum.com and search for “pitch deck.” So as Mona Lisa Vito from My Cousin Vinny would say, “So, what’s the problem?”

Despite the better quality, I was amazed to see that except for one deck, there was reluctance for these companies to address the “proverbial elephant in the room” – – namely stating how much money they are looking for and how they are going to use it. It appears to be like the fear of asking someone out on that first date.

So for our fundraising friends out there, here are five simple Dos and Don’ts when it comes to covering the “ask” in pitches:

  1. Do tell investors how much money you are looking for. Be clear about how much and how you are willing to layer rounds in, say as you achieve certain milestones.
  2. Do support this amount with summary (and detail if requested) calculations including a reasonable reconciliation to your basic cash flow. Provide a summary phrase that is descriptive of each major goal. A phrase like “develop a mobile app” is more helpful than “ramp up operations.”
  3. Do indicate to investors your flexibility as to form of investment. If you are comfortable with convertible notes, or SAFE documents or prefer a straight common stock investment, help guide a potential investor.
  4. Don’t show funds will be used to settle old debts or for significant owner salaries. Paying off old problems like existing debt or back pay does not move a business forward. Setting aside an amount for some minimum salary / payment to owners for their survival is not fatal but it probably helps if this can be avoided.
  5. Don’t imply this amount of funds is all you will need unless your projections clearly indicate this to be the case. Nobody likes the gift that keeps on giving. It is a frustration for investors and it is better to state upfront where you expect to be once the money is spent and how you will be positioned for the next stage of your growth.

The punchline here is not to forget the punchline. Just think about telling a long story and leaving that all important ending out. Listeners will look at you quizzically – – they expect – – in fact they demand you bring the story to a close. It is the same with your pitch deck. Potential investors want to know the punchline – – what do you need and how are you going to use it? Teach them the joy of giving.

Equity Plans Part II – Are We There Yet?

Most of you will recognize this oft repeated question which parents have heard for years. Popularized in the movie and television show by the same name as well as the movie Shrek, it is the question that sends a chill down any parent’s spine; especially when asked by a 5-year old on a long road trip. So why do I use it here especially considering Part I of this blog cited “the time has come” from Dr. Seuss? Well as they say, timing is everything and so it is with Equity Plans as well. So let me explain.

Very few people would ask someone to marry them after just one or two dates, even if they believe that person may be the “love of their life.” Yet I deal with loads of startups where the second conversation an owner has with a key potential hire turns to sharing ownership. Worse yet, without thinking through what they are offering, many offer too much equity only to find they lack enough for others (fast forward to “The Producers” by Mel Brooks – “what percent of Springtime for Hitler do they own?”) or worse yet; that key hire does not work out.

So I spend a great deal of time fixing these issues and there is nothing enjoyable about it. Legal agreements are usually incomplete; the process turns into a he said he said deal and then there are tax consequences to muscle through. It always comes down to having a well-documented equity plan and in all cases, the company “wasn’t there yet.”

So what do I advise? Very simply, have a plan. (You can look at my blog of December 19, 2013 Equity Sharing 101 for Startups for more guidance.) Of course a good attorney is the key here and while many of the documents are somewhat “boilerplate,” you must have a handle on the key provisions. So two quick cases.

In the first, a CTO was brought into a startup, and within a month, the CEO thought enough of him to offer him 10% of the Company in “Founders’ Shares” (no vesting). The CTO was focused more on coding than job satisfaction and within a year, realized he did not want to be there anymore. Fortunately, the CTO was so focused on getting out he never considered the potential value of what he had, and he basically gave back the shares and moved on. No agreements were in place; that CEO just lucked out.

In the second case, it was a similar fact pattern except the key person granted equity had been there a bit longer and felt he had substantially contributed to the Company in the five years he was there. This was another case of an early grant of equity and no provisions for separation. There was a falling out and a “settlement” is still in process. The CEO is spending a great deal of emotional time addressing this not to mention legal and consulting bills. It is not a pretty sight.

So please consider a bit of a delay to provide time for thought to make sure “you are there” before you enter an equity plan. But once you decide, move quickly and purposefully in concluding your plan and getting it all signed and delivered.

Your Business Plan; Are You Making a Living or a Killing?

“Go ahead. Make my day.” Harry Callahan (Dirty Harry) – from the movie Sudden Impact

I get the opportunity to see a good number of business plans / pitch decks each week and I focus on the section of the plan I believe is most critical. While some may believe it is the management team or barriers to entry; to me it is the financial projections. So at this point, you have to be saying, “Of course; he is a CPA. What is so surprising about that?” The truth is, there is no other place in a pitch where one can get a better picture of the “directional indicators” of a plan. Please allow me to explain.

Years ago, a colleague of mind was tired of working the long hours at our firm and wanted to become his own boss. He bought a Basking Robbins franchise. He accomplished his objective; he still worked long hours but now he was working for himself. However, at the end of the day, all he did was replace salary with small business income; from a financial perspective he was still just making a living.

If you are doing a pitch before investors, remember they are focused on high rates of return; getting their money back in multiples of what they invest. They are looking at what we euphemistically call “making a killing” and they are looking for you to “make their day” by showing them how. So where does the projection fit in to all of this?

First, what is the size of the opportunity in your eyes? If your projections show that in five years, your revenues will be $5 – 10 million, you cannot make enough money to attract most investors. Please do not get me wrong; growing a business to this size is a real accomplishment and can be financially rewarding. It is just not a killing.

Next, does the financial model follow the plan? If the plan is a SaaS model with monthly subscription payments, revenue is simple; multiply the expected users by the planned fee and that should be revenue. So now I can see how many users you expect to have (market share) as well as the monthly payment (market price). I can also look at how you plan to get to that level of users.

Finally, are the projections logical? If your margin or operating costs are substantially different from competitors, do you explain why or are you just plugging numbers to provide a financial result some online advice indicated was what investors want to see? It is a simple logic test that many fail on a daily basis.

Shakespeare said, “The eyes are the window to your soul,” and I think your financial projections serve the same purpose as it relates to your plan. So after you get done “crunching the numbers” please step back to see what they really say. There is nothing wrong with creating a nice profitable business model that might allow you to make a very good living for a long period of time. I have had hundreds of successful clients who have followed that path. Just keep in mind how this approach has to “step up” if you are looking for that investor who wants you to make their day.

Are You Solving a Real Problem?

“I gotta’ fever and the only prescription is more cowbell” – “The Bruce Dickinson” –  from the SNL skit with Christopher Walken

Many of the startups I meet have gotten the message that in order to have a sustainable business model, one has to solve a problem.  That solution can come in a few forms – perhaps it is providing a capability that did not exist previously or making it quicker and more efficient to satisfy a recurring need.  For the former, I would suggest LinkedIn which opened up the world to our personal business profiles and for recruiters, gave them access to people who were currently employed – not just those in transition.  The latter would be characterized by Uber – transportation on demand.  So, the message seems clear, but achieving this goal has remained somewhat elusive.

I see a good number of pitches every week.  I think one recurring theme is the absence of an understanding of the importance of this message; you need to ease the pain or bring comfort for your product or service to be sustainable.  So, many pitches start with the standard “how many times have you tried to…  only to be frustrated by…” Unfortunately, at times, the “problem” they present is one that many of us rarely encounter like booking a trip around the world.  When the problem they present is not real, you can feel the silence in the room.  It makes me harken back to the old Family Feud scenario – you know, the one where the host asks a question like, “Name something that rhymes with ”time” and the overthinking parent responds “sublime.”  This is usually followed by an attempt at supportive applause from family members who know in their heart that answer is not going to appear when the host announces “our survey said.”

So, how does this happen?  I am still somewhat surprised at the lack of market research and even “web surfing” that is done when someone comes up with the centerpiece of their investment thesis.  It is like they are Bruce Dickinson, and all they are focused on is more cowbell.  As the great scholar in this space Jeff Timmons once said, “an entrepreneur knows the difference between an idea and an opportunity.”  Look, I am clearly not at the center of the startup universe, but when I see an idea which looks just like other pitches I have seen and a presenter is not even aware of that competing product or sights a difference such as “ours is a mobile app,” it makes you understand how tough this part of the equation really is.

So, please make sure that before you invest a lot of time and energy, you get some objective people (like advisors or others you know in your network) to provide some really critical feedback on how much “pain” is caused by the problem you are addressing.  It may take longer to get on the road to success, but with the right approach, you have a much better chance of completing your journey.