Who’s Got Your Back?

Hey, small business person! Yeah, you… the Startup CEO with less than 100 employees. You and I both know you’re paying the worst possible health insurance rates around. If you’re lucky enough to be able to afford to provide health insurance to your employees you’re lumped into a group insurance plan with absolutely no control over your rising premiums.

You want to do the right thing for your employees. You want to have at least a fighting chance to hire and retain your good employees, so they don’t run to the safety of a bigger larger company in these difficult times. So who’s lobbying for you?

“In a new report released [last month], the government watchdog group Common Cause found that major health care interests have spent upwards of $1.4 million a day to lobby Capitol Hill so far this year…”

According to Kaiser Health News, the National Journal reports that this political spending amount represents a 73 percent increase since 2000. The report also finds that campaign contributions to members of Congress jumped $40 million since 2000, to $94 million in the 2008 election cycle.

Health reform is “a historic confluence of issues that, as a consequence, has the Capitol swarming with lobbyists and awash with money,” NPR reports, “These days, just about every interest has a lobbyist. Drug manufacturers, hospitals, doctors, pharmacists, marriage counselors, chiropractors, unions.”

What? You don’t have a lobbyist in Washington? Uh oh…

What Startups Can Learn From Punk Rock

This weekend I went to the first show of Green Day’s “21st Century Breakdown” Tour. I’ll admit that although I enjoy Green Day’s music, as a former owner of an independent (punk) record label I am in the camp of those who feel like Green Day lost some credibility when they jumped to a major label back in the earlie 90s. But as I watched the show Friday night, I couldn’t help but have a renewed sense of respect for Billy Joe, and the rest of the band as business people. They “released” and incredible product that night — and I couldn’t help but take notes on the lessons that every startup should take away from their efforts.

Know Your Customer

When Green Day got a lot of flak for leaving the indie world, Billy Joe was incredible cognizent of the fate that awaited him. He knew that as much as he loved punk rock, his decision as a “business man” would ultimately austrecise him from many of his early fans. In an interview with Spin magazine he was quoted as saying:

“I couldn’t go back to the punk scene, whether we were the biggest success in the world or the biggest failure … The only thing I could do was get on my bike and go forward.”

So if he’d lost is “punk scene” base, who was his new customer? The answer is really quite simple — and it’s clear that Green Day understand this and has developed and refined their product to specifically cater to their customers. They are a pop band - targeting the large part of the population that feels a little out of step, a little beat down, slightly disgruntled, but not violently so — but ultimately they aren’t targetting the fringe - they are targetting the mainstream.

If they were too dark - they would turn some of their potential customers away. If they were too “happy” and “bubble gum” - they would surely lose this audience. But they’ve walked that balance intentionally. As my wife said, they come off as “nice guys” but they have just enough “F’ing” edge (with a sprinkling of four letter words to make the point) to allow the angst ridden teens in the room to suspend their “too cool for school” attitude that might lump them into the crowd of the teeny-bopper-dance scene.

The Lesson: Know your customer, build the product that they want. Serve your customers needs better than the next guy. Refine your product with them in mind. Find a way to be true to yourself - while still filling the needs of your customers.

Give Your Customer A Stake In Your Success

No, I’m not suggesting that startups should try the whole Vonage - let your customers participate in your IPO strategy. I’m simply talking about the fact that customers will want you to succeed, and will overlook your faults, and praise your successes more, when they feel like they’re part of your team. This is a really obvious idea, but one that businesses often overlook, or simply miss the opportunities to leverage. But not Green Day, no… they got this one down.

For a rock band it’s pretty easy right? Get the crowd chanting and singing along. They already love you, let them show you that love. You’ve all seen it, the classic Rock Star move, hold the might out toward the audience as if they’re singing into the mic.

They had the audience chanting “Hey Ho”, clapping their hands, doing the wave. But that’s Crowd Involvement 101. Green Day understands this strategy so inately that they take it to a whole new level.  At the concert, Billy Joe pulled no less than four audience members up on stage. The first, was a young child who couldn’t have been more than 10 years old.

“Whao- Who’s that little shit!? - You! Come up here! Wow!”

Now, I’m not sure what his parents were thinking… but I’m sure they knew what to expect… but the point is, Green Day knows that this kid will be a customer for life. Was this his first concert? Maybe. Was Green Day his favorite band before the concert? Maybe. Is Green Day his favorite band now? Hellz yeah! Imagine the viral marketing punch they got from that simple event. And it works because they know their audience.

As if that wasn’t enough, the ended up pulling two more audience members one after the other on stage to sing along to “Longview”. After the first girl came on stage, she mostly wanted to hug and kiss Billy Joe, and didn’t exactly have the best (if any at all singing voice) - but being the gracious “nice guys” (or should we say cunning businessmen) that they are - the band played along, smiled and said…

“She was pretty good - do you think you can do better?” — Now THAT is Classic customer service!

As one happy customer leaves the stage, and all the girls in the audience who got the vicarious thrill of hugging and kissing their favorite rock star dreamed of what it would have been like if they’d been pulled up on stage — the band simply stepped on the pedal and went back to the well one more time.

If one fan can get you that kind of engagement, two would be twice the fun right? The second fan to be pulled up was a goof ball of a guy - who actually did know the lyrics and had plenty enough personality to share the stage with Billy Joe. He too hugged and kissed Billy Joe and when handed the mic professed his love for the artist and band. “Who wants to f*ck him? (pointing to Billy Joe) — Sorry, is that weird?” No Billy Joe, shakes his head — that’s not weird. That’s exactly what he was looking for.

The Lesson: Get your customer involved in your success. Let them root for you. Make them part of your team.

Don’t Be Afraid To Take Risks

The most compelling example of this audience engagement came for the song “Jesus of Suburbia”… where one audience member yelled out to Billy Joe that “he could play guitar” and couple seconds of dialog between the fan and Billy Joe including “can you really play? really? can you play Jesus of Suburbia” — next thing we know this fan is on stage.

Lest you think this is a review of a rock show and not an article about business and startups, consider this for a moment. This is a business, producing a product, and about to present one of their most popular items for an audience of several thousands to enjoy… and sight unseen (and more importantly quality on verified)… they are about to allow a random customer to enter the mix and play a major role in the “launch” of this product. This could turn out to be a huge mistake…

Instead — it was by far one of the most brilliant, daring, and entertaining things I’ve seen an artist do in a long time. Huge risk — even bigger reward.

Now, really, I think there was not that much practical risk here. After all, I just explained how a big part of the “Green Day Product” is based on audience participation. There are plenty of bands that have the attitude that the live show is about having fun and sharing an experience so if the kid is a little rough, it won’t be a total disaster. Worst case scenario, they can just turn down his guitar and the audience would be none the wiser. But that said, you never know what can happen when you introduce this kind of an element to your product.

The Lesson: Don’t be afraid to take risks! Especially when the reward out ways the risk, and the risk is related to your core value proposition, and feeds your existing relationships with your customers.

Wow! That was Special!

I spent most of today at the Small and Special event hosted by Jackson Fish Market, and I have to say it far exceeded my high expectations. The venue was amazing. The presenters were each amazing and inspiring in their own right! Even more amazing was the synergy between the presenters. Hillel and crew orchestrated a perfect program with an amazing flow of very diverse yet all equally compelling entrepreneurs who were all building amazing businesses out of things they loved.

But maybe most amazing part of the event was the energy from the crowd!

The audience did a great job of creating a live tweet stream, and from the tweets and retweets you could tell that some of the best lines from the speakers struck a common chord with the audience.

Some of my favorite presentors included…

Eric LeVine of CellarTracker.com talked about how he originally started CellarTracker as a project to simply keep himself busy after leaving Microsoft after 13 years… to have a reason to get out of his PJs in the morning. His passion for wine, and a vision of building a “spreadsheet in the clouds” has turned into the worlds largest wine database with over 80,000 collectors tracking over 13.3 million bottles of wine with soon to be more the 1 million reviews.

With over 15,000 customers voluntarily paying on average $40 per year, he’ll gross over $500,000 this year. Not bad for a guy in his pajamas!

Steve Bristol from LessAccounting.com has an interesting perspective on why smaller companies have an advantage over larger companies.

“Two people are smarter than one, but four people are definitely not, and then you have companies with thousands and then they are idiots!”

Jon Rimmerman of Garagiste had a lot of inspiring things to say about following your passion and focusing on your customers. He doesn’t have an online store, and he spends $0 on marketing, but he does have 100,000 people on an email list, who read his “wine poetry” and if they want to buy some wine from him, then great… but that’s not his focus. Well, something is working because he vaguely described his business as generating “less than $30million a year in revenue, but only a little less than that”. But my favorite line from him was his answer for why people buy wine from him.

“Because I have smelled the wine maker’s breath!”

Rachel Venning, co-founder of Babeland, recounted who she and her co-founder were motivated by their interests in activism, feminism, gay and lesbian issues, and the realization that they simply wouldn’t fit in at IBM, to start an adult toy shop that focused on celebrating sexuality without the sleazy unfriendly atmosphere at traditional establishments.

Their business has grown from and $18,000 initial investment to over $12 million in revenue, from four locations and an online store.

There were several other great presentations, and as I said, Hillel, Jenny, and Walter did a great job in organizing an amazing event. You can’t help but walk away from an event like that being inspired by these amazing entrepreneurs and inspired to go out and redouble your own efforts to build a great business.

If the VC Model Is Broken, Then What? How About: Be Special!

I can’t help but shake my head a little when I read that 52.9% of VCs think that their own approach is broken. Why are VC’s so concerned, you ask? Well, we’ve been talking about this issue a lot lately, but it all boils down to finding the next buyer who’s willing to pay more for the business than they did… and those hopes are vanishing:

Fifty three percent of VC’s say that they are “very worried” about when the IPO and M&A markets will return.

So what can you do about this as an entrepreneur? How about focus on your business? How about making money the old fashioned way? Earn it!

Personally, I’m really looking forward to tomorrow’s Small and Special conference, where some of the brightest minds in the Seattle entrepreneurial scene will be getting together to exchange ideas, best practices, and inspiring stories about how they’re building businesses by focusing on what’s important: great products that matter to real customers.

I hope to see you there!

Is “Out of Sight, Out of Mind” a Good Strategy for VC Backed Companies?

A group of researchers from Harvard Business Scholl recently published a study that showed that startups whose headquarters are further away from their VCs are more likely to be successful than companies that are closer to their investors. Xconomy and PEHub both ran articles about the study and reach similar interesting conclusions about why this effect may occur.

Researchers hypothesis that the fact that the portfolio company is further away, implies that the cost of hands on monitoring are greater, and therefore VCs do more due diligence before making these investments. Presumably this greater diligence results in better odds of picking winners.

“A takeaway might be that firms should think very carefully about their decision-making process in terms of geographic criterion,” says HBS professor Josh Lerner, who co-authored the study with Henry Chen, Paul Gompers and Anna Kovner. “I think there’s a mental trap in saying that because a company is so nearby, it’s not as costly to do the transaction.”

Hmmmm, that could be. Maybe it is about better investment selection. But maybe we should also consider the other potential side effects of having your investors right next door. Is it possible that these near by investors who are more engaged in their local portfolio companies are actually causing the poorer performance?

It’s clear that the objective of the VC fund is to grow the enterprise value as fast as possible. So, that, as we’ve discussed in many other posts, they can eventually find a buyer who is interested in paying a greater price for the company than they paid for it. They’re looking for an exit, and are less focused on building a sustainable defensible business.

Notice I was clear in saying that the goal is to grow the “enterprise value” of the company. I didn’t say “business” or “revenue” or “profits”. Sure, those “minor” details contribute to the enterprise value, but for early stage growth companies they aren’t nearly as important if you’re going for a “mega exit”. Scale is the only thing that matters!

Imagine for a moment that YouTube had not been acquired by Google. Where would they be today? They’ve got a ton of traffic, and they’ve got a ton of expense; but they still have yet to figure out a monetization strategy for all that traffic. You can be certain that if YouTube was still independent, that the investors would be doubling down on growth and still ignoring monetization.

So is it that VCs are willing to invest in distant companies because they believe they have the right mix of assets to be successful without significant oversight and intervention? Or are smart entrepreneurs willing to take money from distance VCs because they know it will reduce the distractions that often comes attached to that investment?

Cash Cow

As I’ve mentioned in my last couple posts, there’s been a lot of talk about bootstrapping, VC investments, and lifestyle businesses in the Seattle entrepreneur scene lately. I was recently sent a link to an interview with James Hong of HOTorNOT.com. He has an interesting, I’ll say fresh, perspective how they chose to build and manage their business.

What I found particularly interesting about this interview is that James is pretty direct about the fact that he and his co-founder will milking this business for the cash. They made business choices that would never have been accepted by their investors had they taking outside funding.

Sure, there was a lot of luck involved in their success, and they were very much there at the right time and the right place. And today, HOTorNOT has faded, and is far from the cash generating juggernaut it once was. But their business was generating as much as $5 million a year in PROFIT, split between two owners. Not a bad way to create “FU Money” as James calls it.

The interview is a little long, but it actually covers a lot of different topics, and is certainly worth a view. Thanks to Ram for sending this to me.

More Cracks in the VC Business Model?

One of my favorite Seattle area entrepreneurial focused blogs is written by William Carlet, an attorney at McNaul Ebel Nawrot & Helgrn PLLC. William has written several posts recently about how macro shifts in our economy may have big implications on how the traditional VC business model works.

The headline of course is that VCs operate on a “hits” model where their gains are always predicated on finding a buyer who is interested in purchasing the asset at a higher valuation then the last round. Some critics of this approach will go as far as calling this the “next bigger fool” approach to investing. But with all those hits come a lot of misses, and if the market for those “exits” is changing (or possibly disappearing) then the VC business model may be at risk.

As part of the response to the recent economic crisis, the current administration has proposed sweeping reforms of the financial regulatory framework. There’s been quite a lot or resistance and speculation about the uselessness of these changes and the negative impacts that these changes could have on startup companies.

William had a great post today about why he believes that these changes are inevitable and he suggests that the VC industry should stop resisting this change and instead focus their energy on trying to influence the details of the regulations to be the least painful for them.

[His] opinion is that VCs and the startup community should focus, not on opposing regulatory reform altogther, but on making the case that a VC’s registration and reporting should not encompass detailed information about its funds’ portfolio companies.

Although I agree with William in general, that resistance is futile. I’ll take it a step further. I believe that the bigger problem for the VC industry is that their business model looks exactly like the kinds of investment vehicles that the public is clamoring for greater regulation around. As much as VCs would like to disassociate themselves with the “Wall Street” crowd (no matter how credible their argument for differentiation might be), in the eyes of the normal public they look the same.

VSs will be hard pressed to avoid the “Hang’em High” atmosphere so pervasive in America toward those “Wall Street” types.

Consider for example, the parallel between Sir. Allen Stanford’s alledged fraud. CNBC reported that in late 2008 Stanford purchased property in Antigua and only a couple months later reported that same property’s value had grown more than 50x on statements to investors. Now I’m defintely not suggesting that reputable VCs would participate in the type of fraud that Standford has been accused of.

But the problem with private company valuations are that there is no standard methods for reaching a valuation. It’s all black magic which ulitmately boils down to the price that the highest bidder is willing to pay.

The reason, I believe that regulators will prevail in their efforts to regulate VC firms, is that for all intents and purposes VC firms are practically identical to “hedge funds”, which have become the “Boogeyman” of investment firms. The only real difference is the strategies employed by the funds to generate returns. But ultimately they are managed pools of capital, and any definition that covers hedge funds will likely cover VC firms.

As I said in a comment on Williams blog…

Unfortunately the two trends leading to this call for regulation may make the issue of disclosure a fait accompli.

The first trend is the concern of systemic risk. Although I agree with the assertion by the industry that their scale is so small that it is very unlikely for them to contribute to systemic risk, we must note that it was in fact leverage that created (or at least exacerbated) the systemic risk in the CDS market. And the concern over systemic risk will contribute to what I believe will ultimately be a call for the VC industry to also be subject to detailed disclosure oversight. Even at small scale, if the particular investment activities of a firm utilize leverage to create returns, then the war wounds from the recent melt down will drive a paranoid knee jerk demand for full disclosure of the strategies of the fund.

VCs aren’t inherently a leverage oriented investment vehicle, but they’ll be forced to disclose their actual strategies in order to “keep them honest”.

The second trend is the concern over fraud, ala Madoff and Stanford. Whether or not real fraud like these cases is common or not will hardly be the point, because these stories are simply so compelling that Politicians will make hay over the need for greater regulation and oversight. The idea that any kind of a fund would need to protect the details of their portfolio for confidentiality or proprietary protection flies in the face of the outright scams that took place under the current regulatory framework.

My bet is that regulation is absolutely going to happen, and that that regulation will require a pretty transparent disclosure framework around “portfolio” cost basis and current valuations, as well detailed disclosure of past performance of the funds. I agree that this will have a chilling effect on the VC model. But I suspect this is also just one more nail in the coffin of the existing VC model.

In the meantime, as entrepreneurs, we would be well advised to focus on building actual businesses that generate revenue and profits. What a novel concept?

Never Make it Personal

Being successful at business requires a thick skin, a “killer” instinct, and often times personality traits that in other settings  would be described as anti-social, and maybe even sociopathic. We all remember the great quote from Andy Grove (Intel’s CEO from 1987-1998):

“Only the paranoid survive!”

This week I was reminded on a valuable lesson I learned years ago about walking that line between having a healthy competitive instinct and taking those behaviors a step too far and creating an unhealthy corporate culture. I read with great interst Matt Hulett’s recent blog post “Focus On Your Competitor’s Tail Lights“. The basic gist of his post is that it is important in business, particularly growth businesses to have an obvious adversary.

First of all, let me say, I totally agree with Matt. Having an adversary can provide a much more tanglible rallying point for a team than dry (boring) metrics. And, since I worked with Matt for years in the early days of RealNetworks, I know that Matt is the kind of leader that can take this sort of a team motivator and make it exciting and fun for the team.

But, I’ve also seen this approach go wildly wrong in the hands of leaders that forget the human side of the equation. Here’s the thing: people love an enemy. It seems there’s something hardwired in human beings to rally around fighting against a common foe. But as a leader you need to make sure you don’t take this “they are our enemy” attitude too far.

Why not? Well, we must remember that it’s a very small world. Particularly in business, and even more so in the software industry. Many of the “enemies” Matt and I rallied against in the early days of RealNetworks have become our co-workers, partners, customers, and potential aquireres today.

If those battles become too personal the business implications can be quite devistating.

Here’s a classic example: In the early days of RealNetworks, one of our chief competitors was a company called Xing. When RealNetworks was focused on delivering streaming audio over the internet (then most access was only 14.4kbps modems), Xing was building MPEG Video on demand solutions. Of course Real was always planning to get into video, and we thought we had a better strategy to get to mass market, but they were “ahead” in video. They were the tail lights we focused on.

Xing was so much of a focus for us, that the name of the internal competitive marketing email group was “Xing”. If you had any intel or competitive feedback from the market for any customer or competitor, you sent it to the “Xing” internal mailing list. It was a giant bullseye for us. We were all focused on it. And frankly, we often got pretty blood thirsty on that list.

Fast forward 4 years later, and RealNetworks had IPO’d had a market cap of over $10 Billion (yes, those were the days)… and Xing had been crushed. But they were still alive, and they had some key patents and intellectual property around MPEG recording and playback. The natural thing to do was to aquire this former competitor. You can imagine the tension that existed between the “old timers” from these companies. And things got even dicier when one of the top engineers discovered this old email list from back in the day.

In our effort to rally around a common enemy, we let it get personal… and it eventually came back to bite us. Competition is great, but don’t let it get personal!

I’ve seen similar behavior that had even worse outcomes. Teams who did great work, built great technologies, and generally dominated their industry, but who got there leveraging a war-like mantra focused on destroying their number one competitor. It worked great until their number one competitor (who really had been beaten) ran for the safety of a much larger company in the industry. Unfortunately that larger company was the number one customer of this killer team. You can imagine how those war wounds impacted the long term business prospects. It wasn’t a pretty sight.

To walk that line without crossing it, I like to visualize two Marshal Arts Masters. They bow to each other before and after each battle. They respect each other as warriors. While in the ring they are 100% focused on defeating their adversary. But they keep the level of respect, and never make it personal.

Will Health Care Reform Help Entrepreneurs?

I am always fascinated by watching the reaction of businesses to various issues related to government reform. The media loves to portray most businesses and business people as ruthless, greedy, and generaly anti-government. However, in my experience, things are always more complicated than they seem.

At the risk of starting a debate about big vs. small governement, capitalism vs. socialism, let me say that in my experience, businesses and entrepreneurs in general are largely motivated by a strong sense of “self preservation” and “selfish” motivation. I’m not suggesting this in a judgemental way, I’m just calling it like I see it. Most people are motivated by choices that benefit them, and entreprenuers tend to have a stronger sense of that compass that the average person.

So here’s the question, will Health Care Reform benefit entreprenuers? More specifically, since my company is a small business/high tech startup, will it benefit small businesses and high tech startups like mine?  (Hey, I’m an entrepreneur, I’m mostly motivated by selfishness!)

We have to first start by acknowledging that there is in fact no plan yet. Although the current administration has outline a set of principles that they would like to see guide the plan, they’ve been clear to put Congress in the lead of crafting the actual plan. Based on the fact that there is no concrete plan to discuss, I’ll avoid quibbling over the potential details of the potential reform, and instead zoom out and look at the bigger question of Health Care costs.

I won’t beat around the bush, based on my calculus, Health Care Reform would dramatically benefit my business. I also believe that it would be a net positive for the vast majority of High Tech Startups, especially in the Seattle area. Here’s my reasoning, with a little bit of data to back it up…

  • Health Insurance is a significant portion of the overall expenses of most small businesses. In fact more than 40% of small businesses report that health care costs eat up 10% of their payroll expenses (reference).
  • Many small businesses opt to not provide health care coverage because they simply can not afford it.  Thirteen million Americans, nearly one-third of the uninsured, are employees of firms with less than 100 workers. (reference) The portion of non-elderly Americans who are not covered by employer base health insurance is growing (reference), and much of this growth in uninsured comes from small business. The percentage of small businesses offering coverage dropped from 68% to 59%, while large firms held stable at 99%. (reference)
Not to put too fine a point on this, but this all comes down to the high costs of health care. And things aren’t getting better as costs continue to rise. And as costs rise, small businesses are forced to stop coverage or choose worse coverage in an effort to contain these costs.
  • In a recent national survey of small businesses, 75% reported that they did not offer benefits to their employees, citing high premiums as the reason. (reference)
  • And as is often the case with providing services on a smaller scale, since administrative costs associated with health insurance programs are fixed, smaller businesses pay a larger proportion of their premiums toward non-health related costs (like enrollment, marketing, and collections). (reference)
  • 54 percent of businesses with health coverage now or in the past two years reported choosing coverage with higher out-of-pocket costs in response to premium increases. Meanwhile, 35 percent reported switching to insurance that covers fewer services, and 12 percent dropped coverage entirely. (reference)
But it’s not just the direct costs that impact small businesses. I can’t count the number of times I’ve spoken with entrepreneurs who say they lost a great candidate because some larger company offered better benefits.
  • Forty percent of small businesses said that health costs have had a negative impact on other parts of their business (for example, contributing to high employee turnover or preventing business growth).
    (reference)
As an American and an entreprenuer, I believe passionately that America will do best when it fosters innovation. And as someone who has worked in startup technology companies my entire carreer, I am absolutley convinced that small enterprises offer the best opportunity for innovation and economic growth. Anything that helps small businesses focus on their business and innovation will, in my judgement be a boon for America. For that reason I am very excited about the prospects of massive health care reform in our country.

Bootstrapped vs. Lifestyle Businesses

In Seattle we have a very active start up entrepreneurial community with many great resources for news , debate , education , and discussion . Recently there has been a rash of rather public debates about the virtues and implications of Bootstrapping your business. This debate has, unfortunately devolved on occasion into a bit of mudslinging.

At a recent Seattle Tech Startups presentation, Jeff Lawson of Twillio wrapped up his talk on cloud computing with a rather funny send up of quick one-liner answers to every question ever asked on the Seattle Tech Startups mailing list.

Of course what Jeff intended as a joke about common threads that never seem to end, turned into a giant thread that never seemed to end .

Although I ususally try to stay out of the mix on these often zealot-like arguments, there was one message from a local VC, who I know and have worked with in the past that seemed to get lost in the shuffle. And I was simply compelled to respond and explore his point more deeply.

My reply: More on the Bootstrapper Debate

I had decided to sit back and watch this debate from a distance because, as Jeff pointed out in his slide deck that started this most recent thread, this is just one of those classic "arguments" that erupts every couple months on the list and never really changes or evolves anyone’s opinions. So why add to the noise?

But there were a couple really interesting things that Bill mentioned last week that stuck with me. And after chewing on them for a couple of days, I thought I’d try to turn the spotlight on a couple of commonly held believes that I believe may warrant a closer look.

Date: Fri, 12 Jun 2009 18:33:39 -0700
From: "William K ‘Bill’ Bryant"

…when investors (VC or angel) describe a business as "lifestyle", it means "the business isn’t designed or intended to scale to a level that would justify outside investment, given the inherent risk of making an investment in a young company and the need for that capital to generate a high rate of return on a risk adjusted basis".

I appreciate that Bill as an investor is trying to be incredibly candid and direct here. One of the things I really admire about Bill is that unlike 99% of the investors (particularly VCs) you will meet, Bill will give you the straight poop! He won’t sugar coat it. And, I think he’s also willing to listen when people are direct (back) to him as well. So with that in mind, I’ll take a stab at dissecting his comments a little to get to an even more basic analysis.

Let’s be honest: "…the business isn’t designed or intended to…" should read "… the investor, based on their analysis (exhaustive or cursory) has reached an opinion that the business doesn’t meet that investors criteria to…"

Most investors do very very little analysis to understand what that business is actually intended or designed to do. Most investors make their initial decision based on a very simplistic pattern match. That pattern matching algorithm certainly looks for basic "scaling" traits in a business (in fact Bill does a great job of outlining them below)… but they rarely actually spend enough time doing diligence to actually determine the "intent and design" of a business.

There isn’t anything explicitly pejorative about the word; its simply a factual statement that the business is…

I’ll take exception with the use of "factual statement"… but if we tune it to "opinion of the investor" then… yep, agreed 100%. And of course, these investors don’t mean it as a pejorative… because VCs and Angles never ever want to insult you as an entrepreneur, because they don’t want you to cross them off your list if you DO come up with a business they want to invest in. They use ambiguous code-words like "lifestyle" because they’re hoping you won’t be insulted by the term.

But the business isn’t one where an "asset" or "enterprise value" is being created that would allow for an outside third party investor to invest and get an acceptable return.

Ahh! Now, here’s a really important gem. We should all take a second to look over and understand. Are you creating something, some (non-cash) "asset" that will provide greater "enterprise value"? This speaks very directly to Jeremy’s point that if you take outside third party money, they are only going to be interested in investing in your company if you can grow your enterprise value (Enterprise Value: it’s the "sellable" value of your company less your cash and or other tangible assets. For public companies it’s easy to determine, Market Cap less Cash). Have you ever wondered why a public company can have Market Cap that is less than their current cash position? Because investors are betting that their enterprise value is less than worthless. You could be raking in the cash, but still have a business with zero EV.

ALL outside investors want return. All growth oriented investors (e.g. Angels, VCs, others) want capital gains based returns. That’s why they don’t want you to have an S-Corp (profits must be paid through to common share holders). Some outside investors would be willing to take solid dividend returns (which certainly could be done with a business with minimal EV), but those types of investors are not Angels & VCs and they are not going to invest in your risky as of yet not profitable and established business.

For example, you and your friend decide to start a web design shop. It generates $185,000 per year, enough to keep the two of you more than busy and making a decent wage. Neither of you have a desire to expand the business beyond what the two of you can support. That is a "lifestyle" business.

Great description of a lifestyle business. But let’s be blunt, no VC ever takes a meeting with these guys. Not even if they’re their best friends. The most important part of this description is "Neither of you have a desire to expand the business beyond what the two of you can support.".

Here’s a clue entrepreneur: if you’ve ever thought to yourself I only want to grow my business to $X in revenue per year and stop after that… because that’s all I want to earn and I don’t want the headache that might come along with being any bigger than that… Then you have a lifestyle business. Nothing wrong with that. As Bill mentions, that $X might be quite impressive. I know plenty of Dentists who make WAY more than most CTOs I know. But that’s a lifestyle business.

In Year 3, you invent software that allows you to build world class websites at 1/10th the cost of your competitors. Instead of licensing the software to other web dev shops, you decide to open up offices in key metropolitan areas based on this "secret sauce". You estimate that each city will cost $250K to open or a total of $5M, and each city will generate $2M by year 3.

As the entrepreneur, you now have the choice of convincing individuals in each city to forego salaries in return for a cut of the business in their locale, trying to convince a bank to loan you money based on your rich uncle co signing the loan, investing your own money by breaking open your piggy bank, or raising money from investors, angel or VC. But this is a "non lifestyle" business in that it is creating an asset that investors can see their way clear to a return from their investment.

Again, Bill does a great job of explaining why some "asset" or "enterprise value" needs to be created to get a growth oriented investor to pay attention.

For those geeks out there who love a good geeky success story, look no further than 37 signals. They almost fit this story line perfectly. At first glance they look very much like a web consulting shop. But in the process of looking pathetically unfundable, they built a platform that does scale and create a high margin recurring and growing revenue stream… with minimal increase in expenses.

But here’s the cold hard truth for you entrepreneurs out there: even if you have this "asset" as part of your design and strategy and plan from day one…. most investors won’t see it, won’t believe it, or won’t want to invest. And they will use some excuse to tell you why they don’t think the investment is right for them.

If you believe the 37 Signals guys, they will claim they always envisioned building this scalable platform from day one. Maybe they did, maybe they didn’t, I won’t dare question another entrepreneur’s creation myth, but what I do know for sure, there is no way early stage investor would have seen the forest for the trees in their initial offering and made a bet on them. NO WAY!

There are plenty of great "bootstrapped" companies that investors would love to be a part of (Dell and Microsoft being among the more prominent examples of "boot strapped" companies that eschewed early investors).

And now we get to the most important part.

Bootstrapped !== Lifestyle.

Did you notice the switch here? At first Bill was talking about Lifestyle businesses, and he did a great job of clarifying the difference between lifestyle and non-lifestyle. But you CAN bootstrap a non-lifestyle business.

Microsoft WAS bootstrapped. — I guarantee you that at no time did Bill Gates ever think he only wanted to grow the business to $X so he could sit back and live on it. He had a mega non-lifestyle vision from day one. He chose to bootstrap.

Dell WAS bootstrapped. — Have you ever listened to Michael Dell? Do you think he started a company with his name on it believing he’d just build a little lifestyle business? Uh… think again.

Choosing (or being forced) to boostrap does not mean your business is a lifestyle business. If Microsoft and Dell don’t prove that point, I’ll offer one last example:

UrbanSpoon vs. Yelp.

These two businesses are essentially the same market, very similar product offerings, and are both creating non-lifestyle businesses as determined by using Bill’s definition. Namely they created intellectual property in the form of Software that they owned outright (not a work-for-hire for their clients), and that software had the characteristic that it drives a high margin revenue stream largely uncoupled from the company expense structure.

One company chose to bootstrap, the other chose to take VC funding. One has had an exit in which the founders saw as much as a 100x return on their investment. One has not yet had an exit. Neither was a lifestyle business…. although I know (for a fact) that some investors have described either or both as such.

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