Startup 132: Why an Exit Strategy is a bad idea
My apologies that it has been so long since I’ve written but I’ve been a little busy the past year and a half. I started a new company called ZangZing which is building a new service to help groups share photos. You can sign up for the beta here. I am also on the board of 3 other companies – Lookout, Smartling, and ccLoop – and an adviser to a fourth – MobileIron.
Exit Strategies
I have been meaning to write about the question of “Exit Strategies” for many months.
Not only has there been lots of press about exit strategies with Groupon turning down a multi-billion dollar offer from Google, but in about 1 out of every 2 recruiting interviews, I am asked the same basic question, “What’s the company’s exit strategy?”.
Let me get right to the point. If you work for a company or meet with a startup CEO that says they have an exit strategy, then you should find the nearest exit. Think of a company with an exit strategy as your floor lighting that will illuminate and guide you to the nearest exit – which may be behind you. (OK, after flying almost 1.5 million miles, airplane humor is too easy).
Now some of you might be asking, “But Joseph, you sold a couple of companies. Why and how can you credibly you say that?”
Well, it’s simple. I don’t believe there really is such a thing as an exit strategy. And I have never had one for any of my companies. An exit strategy implies very short term thinking about how Google, or Facebook or some other deep pocketed, cash rich company is going to come along and scoop the company up. And that type of thinking is simply a bad idea. Check out the definition of exit strategy from Wikipedia:
An exit strategy is a means of escaping one’s current situation, typically an unfavorable situation. An organization or individual without an exit strategy may be in a quagmire. At worst, an exit strategy will save face; at best, an exit strategy will peg a withdrawal to the achievement of an objective worth more than the cost of continued involvement.
When you think of a startup, it’s probably not a good idea if the team is thinking about escape or saving face or withdrawal.
Instead of thinking about the exit, startup teams (and potential employees) need to be laser focused on a success strategy. This means thinking (and asking) about the 3-5 most important things that will make the company successful, e.g. Who do we need to hire? What products do we need to build? How do we grow our user base? How do we make money and become profitable?
A success strategy is about building value. And when you are successful and build value, then you will have lots of options including continuing to grow the company, selling the company, taking a company public, merging with another company and more.
So stay focused on your company’s long term success and along the way you will have lots of hard choices about if and when to “exit”. In writing this, it seems so obvious, yet I am continually amazed that so many people think and ask about exit strategies. Hopefully no one will ask about exit strategies in any future interviews and if they do, then I know they are not good at doing their homework. 
Leave a comment and let me know what you think.
And here is another post about strategy planing that you might appreciate. If you don’t know where you’re going, well, you’re lost.
Lastly, you can also follow me on twitter or subscribe to email updates.
Exit sign courtesy of heathbrandon
Airplane exit sign courtesy of joeshlabotnik
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Startup Term Sheet – Liquidation Preference
This is the second post in a series attempting to demystify startup term sheets. If you have not read the first post about Valuation, you can find it here.
Startup Term Sheet – Talking Stock
As mentioned in the previous post, a venture capital term sheet is a letter of intent that outlines a potential investment in a startup. The first and usually most debated item is the valuation as it has the largest effect on the dilution or amount of ownership you give up in order to receive funding. Once you agree on valuation (while keeping in mind the option pool twist), it’s important to understand what you have actually sold.
As in the public stock markets, you are basically selling shares of ownership. In the case of a traditional venture capital investment, each “round” or time you raise venture funding is typically referred to as a “series” and labeled alphabetically. A first round is typically referred to as a Series A, and subsequent rounds as B, C, D and so on.
Additionally, the shares sold to investors are “preferred stock” as compared to what is called “common stock”. Common stock is what founders and employees receive. Preferred stock is given to investors as a result of providing large sums of capital and they therefore receive various preferences over the common stock holders. These preferences include liquidation, dividends, unique voting rights, veto rights, and various other protections that will be discussed in future posts.
In exchange for the additional preferences, the price per share of preferred stock is typically greater than that of common stock. This lower price is why founders and employees can typically purchase shares in an early stage company for pennies per share. The price differential is changing somewhat with new accounting rules but more on that in a future post.
This post will review Liquidation Preferences, which are potentially the most dilutive preference to the common shareholders after the valuation and option pool size.
Liquidation Preferences – What’s the big idea?
Startup term sheet Liquidation Preferences sound like a preference for who has the right to drink from the water cooler first. And metaphorically, that is correct. Liquidation preferences provide that upon a sale of the company, the preferred shareholders are paid before the common shareholders are paid anything. In other words, they drink first from the proceeds from a sale of the company.
The simplest and most desirable liquidation preference for founders and startup CEOs is an amount equal to the amount invested, also know as a “1X Liquidation Preference”. This preference basically says that the investors get their money back before anyone else. That is of course assuming there are no creditors.
Let’s go back to the example from the first post on Valuation. In that example, Series A preferred shareholders paid $4 million to invest in the company. In the case of a 1X liquidation preference, the preferred shareholders would receive their $4 million before any of the common shareholders receive any payment for their ownership.
If for example, the company is sold for $5 million, the preferred shareholders would receive $4 million first and the remaining $1 million would be split across the common shareholders – even though the common shareholders may own a greater percentage of the company.
Let’s look at an example of what would happen if the same company is sold for $50 million. An additional right of preferred shareholders is that they can convert their stock to common stock at any time. In this example, it is more beneficial to convert their preferred shares to common. Instead of simply being paid back their $4 million, they would convert their shares to common stock and instead receive their 40% ownership portion of $50 million for a total of $20 million (assuming all the option pool shares have been issued).
What’s the twist?
This seems and is actually a pretty reasonable right. The investors put up the money, which was presumably used to pay out salaries to the team, and therefore the investors should at least get their money back first. And generally, a straight 1X Liquidation preference is what I advise founders or startup CEOs to accept.
However, there are two Liquidation Preference twists for which to watch. The first is a multiple greater than 1X and the second is called “participating preferred”.
First Twist
Sometimes investors will ask for a multiple greater than 1, for example a 3X Liquidation preference. In our example, this means, that investors would get $12 million of any company sale before any of the common shareholders. Therefore, this is dilutive to the common shareholders for any sale of the company for less than $30 million as that is when it is beneficial for the preferred shareholders to convert their stock to common and participate based on their ownership. The basic math being 40% of $30 million equaling $12 million, which is 3 times, the amount invested in the series A.
Often times this will be used in the case that investors want to ensure that the founders and startup CEOs are incented to focus on long term value creation versus “flipping the company” for a smaller amount earlier. It is also commonly used in later rounds of financing where the valuation has increased significantly and the investors in those rounds want to ensure some level of return.
In general, it is beneficial to have all the preferred shareholders use the same 1X liquidation preference especially since investors typically have preferred voting and veto rights for a potential company sale that will be discussed in a later post.
Second Twist
The second twist for liquidity preferences is called “participating preferred”. This right allows that investors not only get paid their liquidation preference multiple but then can also participate in the payout of what’s left as if they had converted to common stock. That’s right, they get their liquidation preference multiple such as a 1 or 2X liquidation preference and then also participate on an “as converted basis”.
This is referred to as double dipping since they participate as preferred shares and also as if they converted to common stock. This is very dilutive since it means that effectively the preferred investors get a share much greater than their actual ownership. If investors insist on this, it is common that there is a price for the sale of the company at which this right goes away, for example a sale of the company for $100 million or more. Yet I strongly encourage that participating preferred should be negotiated out and avoided whenever possible.
Keeping It Simple
One of the reasons many term sheets today are 1X liquidation preferences with no participating preferred is because investors in early rounds of funding, are often not the primary investors in future rounds. And as a result, if a Series A investor gets aggressive liquidation preferences, then future investors will ask for the same if not even more aggressive terms which may ultimately hurt the early stage investors in addition to the common shareholders.
Therefore it’s best to keep it simple and have all preferred shareholders with a 1X liquidation preference and to be treated equally regardless of when they invested. The concept that all preferred shareholders have the same right is a legal term referred to as pari passu. If you can negotiate a 1X Liquidation Preference, with NO participating preferred and treat every Series on a pari passu basis, you are getting very reasonable terms. And as mentioned in the last post, the way to ensure reasonable terms is to have multiple potential options for investment. The more bidders you have, the more clean your term sheet will be. Stay tuned for the next post on Anti Dilution Provisions and Dividends.
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UPDATE: Continue reading the next post Startup 126 – Term Sheet Anti-Dilution
Other links and references
Startup 124: The Term Sheet – Valuation and Dilution
Download sample Term Sheet from National Venture Capital Association
Drop In Dime Photo by Chaval Brasil
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Term Sheet – Valuation and Dilution
Lots of folks have asked a very common question about startups: “What is a Term Sheet and what do all the terms mean?” In general, a term sheet is a non-binding letter of intent that outlines a potential investment in a startup. Since there are lots of terms as part of a term sheet, I will break the discussion of the terms into multiple posts to get the content out more quickly and in smaller digestible chunks.
Term Sheet – What’s the Big Idea?
Before jumping into post-money valuations, liquidity preferences and other legal mumbo jumbo, you must first decide whether you want to go down the path of taking venture capital.
The main reason to raise venture capital is because you need money to get your company off the ground or your growth is significantly constrained by not having more cash to invest. Put more simply, cash is the biggest inhibitor to your company growth.
It turns out that in some cases, you are better off growing your business organically especially in the current world of web and software as a service in which the needs for cash are dramatically lower than ever.
The Flip Side
Of course, just because you need money to grow, it does not mean that venture capitalists will want to invest in your company. Not only do you need to decide if you need funding but you should also do a gut check on if your company is right for the venture business.
At the end of the day, venture capitalists want to invest in great teams going after billion dollar markets through which they can return 5-10 times their investment. If you cannot convince a venture capitalist that your idea will achieve these results, then trying to raise venture capital is an exercise in futility.
Startup Term Sheet Basics
But let’s assume you are a good venture capital opportunity. To start, a startup term sheet is just that, a sheet of usually only a few pages with various legal terms that serve as an outline for an investment in your company. Other than the confidentiality of the term sheet itself, it is not a legally binding commitment to invest. It is basically a letter of intent. This point is very important to remember. Getting a term sheet does not guarantee your funding since it is not a legally binding obligation to invest, but it is usually a big milestone towards completing a round of fundraising.
Give to Get
To get venture funding, you have to “give to get”. And your “give” is some amount of ownership and control of the company. The question of how much ownership and control is the essence of the term sheet. This first post will deal with the question of valuation and ownership. I will get into the topics of control in future posts, but it is important to remember a term sheet is primarily about legal control versus actual control. (Read Control Freaks Are Us on how success is the best way to stay in control.)
Ownership and Valuation
While VCs use terms like pre-money, post-money, option pools, etc, the general idea for valuing and subsequently selling a portion of your company is quite simple yet with one important twist. A VC offers to buy a percentage of your company at a certain price and valuation. The price they pay is determined by first figuring out what is referred to as the “pre-money valuation”. On the simplest (though not completely accurate) level, this is how much the company is worth before the investment. This is best illustrated with an example.
Let’s say you are running NewCo, Inc. and want to raise $4 million. If a VC wants to invest $4 million, they may offer to value the company at $6 million. The $6 million is what is referred to as the pre-money valuation.
Post Money Valuation
The post-money valuation is, as you probably already guessed, the pre-money valuation plus the amount that gets invested. In this example, it is a pre-money valuation of $6 million plus the $4 million investment that results in a $10M post money valuation.
Pre-money valuation + Investment = Post Money Valuation
So What Did You Have To “Give To Get”?
The first thing you have to give is some amount of ownership in exchange for the investment. This is similar to an initial public offering in which a company issues new shares that are bought at a certain price. The amount of the company you give up is referred to as dilution. To figure out the dilution those with some good math skills probably divided the amount invested by the post money valuation and it would seem you gave up 40% of the company for $4 million dollars, right?
Amount Invested/Post Money Valuation = New Investor Ownership %
$4,000,000/$10,000,000 = 40%
The Twist
Well, there is one twist that complicates this. That twist is called the option pool. The option pool is a set of shares that will be issued in the future to new employees, board members, advisors and others. And the way traditional Silicon Valley style investing works, VCs require the option pool for these future grants to be part of the pre-money valuation.
As a result, by having more shares, which no one currently owns, included in the pre-money valuation total the VCs lower what is the true valuation of the company before the financing. You are probably thinking, “Wait, say that again? The pre-money valuaton is not really how much the company is worth?” Yes, that’s correct and let me explain in more detail continuing with the previous example.
In the case of NewCo, Inc, the investors offer to invest $4 million at a $6M pre-money valuaton. In addition, the investors require the very typical early stage company option pool equaling 20% of all the shares issued to founders, employees as well as to the investors following the financing also known as the fully diluted number of shares.
That means that instead of splitting the $6 million pre money valuation evenly across all the existing company share holders (founders and employees), it is split between all the existing shareholders such as the founders and employees as well as the shares in the option pool set up for future use.
Below is a table which compares what happens to ownership stakes both without and with an option pool.
Ownership Without an Option Pool Ownership With an Option Pool Existing Shareholders 60% 40% Option Pool 0% 20% Investors 40% 40% Post Money Total 100% 100%
As you can see, the True Valuation (this is my term and not a common term used by VCs) is actually $4M before any effect of the financing which equates in this example to 60% dilution when you count all the shares being issued for the option pool. In other words the calculation should be as follows:
True Valuation + Option Pool Valuation + New Money = Post Money Valuation
$4M + $2M + $4M = $10M
The term should actually be the “pre-money, post option pool valuation” but at least now you know what it really means. When evaluating an offer for investment, be sure to calculate the option pool to determine how much ownership you truly give up, which is the company’s dilution.
Now many of you are probably thinking, “Well, why don’t we include the option pool afterwards?” This is one of those things that simply put “just is”. It’s the way terms sheets work and you should not spend time trying to change this. The place to focus your negotiation should instead be on maximizing the pre-money valuation and managing the size of the option pool to accurately reflect the future needs to distribute shares.
The Art of the Deal
Some of you are probably thinking, “Great, so not only am I totally confused by all this math, but you have not helped me to figure out how to maximize the valuation of my company!” Unfortunately (or fortunately?), there is no magic formula. It is part science but also lots of art.
The science part is that most VCs look at what has been accomplished at the current stage of the company and have valuation ranges for each stage. The further along you are and the more traction you have, then the higher your valuation.
The art part is economic supply and demand driven negotiation which occurs between the startup and VCs. The greater the perceived demand to invest in what is a fixed supply of your company will increase the valuation.
Therefore, the key to maximizing your valuation is first to demonstrate why you have the best team to solve a problem and then to get as far along in terms of customer, product and market leadership. This will help to maximize the investment demand from a set of great investors. The more investors that are interested in what is a fixed supply of your company will result in a higher valuation. You should not go talk with every VC under the sun, but start with a focused set and work to get several of them to put forth term sheets.
Interestingly, getting a term sheet from one VC can often trigger more demand from others. A few years ago, a friend of mine made this cartoon that jokingly illustrates this point. Experience has shown that once you have multiple term sheets, you are in a much better position to maximize the pre-money valuation with the knowledge of what is the true money valuation of your company.
http://thevc.com/strips/strip08.html
The next set of posts will cover startup term sheet items regarding control such as liquidation preferences (UPDATE: The next post Startup Term Sheet – Liquidation Preferences is posted!), board of directors, and others. If you like this and want an update for future posts, feel free to sign up below for email updates or follow me on twitter. And of course, if you like this, please use the links below and share it with a friend.
Lastly, feel free to leave a question or comment if this does not make sense. Thanks for reading.
UPDATE: I’ve posted a valuation and dilution calculator that should help make this A LOT easier!
Reference Materials
- Startup Term Sheet – Liquidation Preferences
- Startup Term Sheet – Anti-Dilution
- Startup Term Sheet – Voting Rights and Protective Provisions
- Startup Term Sheet – Dilution Calculator
- Download sample Startup Term Sheet from National Venture Capital Association
Previous post Control Freaks Are Us on how success is they key to control
Check out thevc.com for more comic stip humor on raising money
Money picture by TracyO
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Startup 123: Another Reason Startups Kick Corporate Butt
As a previous post discussed, some of the reasons startups win are people, freedom and failure. In addition to these cultural differences, there are some inherent challenges for “entrenched” companies which startups often exploit to ensure their success. One of the challenges (among others…) is that entrenched companies have a set of assumptions that become out of date and incorrect. That often leads them to confuse the product they provide with the value customers perceive. And as a result, they become blinded by their existing business model success until it’s too late.
It’s 2am, do you know what business you are in?
What does it mean to confuse your product with customer value? Basically, companies assume the product or service they currently manufacture or provide is what customers want. However, customers don’t want products perse, they want a solution to a problem. And when a better solution in the form of a different product or service becomes available, and I am not talking about a slightly better solution, but an order of magnitude change in benefit of a new solution, they are often ignored or dismissed by the entrenched players because they assume their successful business will continue based on the product they currently offer. This idea of assumptions about a product and business is similar to many that Peter Drucker refers to as the theory of a business. (You can buy the HBR article The Theory of the Business
This is not a recent business phenomenon. In 1900, there were 7,500 companies in the US selling horse drawn carriages. Those companies sold 1,500,000 carriages for a total of $121 million in sales. Does not sound like much does it? Only .6% of US GDP. Miniscule. But what if I told you that in 2007 new car sales were in the range of 1-2% of GDP? Horse carriages were actually a pretty big business.
So why does this happen?
It’s simple – the horse drawn carriage companies assumed they were in the business of selling horse drawn carriages and probably even dismissed the idea of the automobile – until it was too late. In reality, they were in the transportation business and their assumptions of what that meant and what were their core competencies were no longer valid. It’s a common problem for any entrenched company.
Of the 7,500 carriage makers, there were only two that made the shift to providing cars – Studebaker, who was making six carriages a minute in 1880, and Flint Wagon Works, who bought a company called Buick – which was a failing startup at the time.
(As an aside, I learned that Studebaker’s first two years of production were actually electric cars and Buick is failing again - Interesting? Yes, but I digress and you can read more about my thoughts on the car companies here)
Transportation was already a big business but the assumptions around the technology available to solve the problem changed. This is a classic reason why entrenched companies fail and startups succeed.
This is the challenge we see today for the newspaper industry. They built their business around, well, newspapers – the printing and distribution of newspaper. Think about the slogan for the NY Times “All The News That’s Fit To Print.” Printing is in their company mission. It’s part of their DNA. Yet, the internet has changed all that. Their value is providing news. And in the case of newspapers, not only is the internet an order of magnitude better distribution model than printing (real time, no geographic limitations, etc.), but it also turns out to be an order of magnitude less expensive which which is another assumption that has radically changed their business and that of many others.
Companies need to know their true business and as changes occur, keep checking their assumptions on what they provide to solve a problem or even if the problem continues to exist. The value is not necessarily the product they sell as was the case for customers of horse drawn carriages or the way in which people consume news today.
Lesson for startups
If you are a startup and you can find a a solution which radically changes the economics (and assumptions!) around an existing problem, then you have a great chance of succeeding because it will take awhile for the entrenched players to realize their assumptions are no longer valid. Your biggest threat from the entrenched players will most likely be they acquire one of your competitors. It’s not likely that the entrenched player will act fast enough to compete directly with you. And that’s the bar to hold yourself to, radical change to the assumptions of a business, because the flip side to this is that if your new assumptions are only a little better, then you’re unlikely to succeed.
If you like this, please click on any of the links below and please share it with a friend. I appreciate the support. And of course, feel free to sign up for email updates of new posts or follow me on twitter. Thanks.
Related posts and references
- Previous posts – Why Startup Innovation Kicks Corporate Booty and What if GM was a Startup?
- The Carriage Trade By Thomas A. Kinney
- Various data sources: http://www.measuringworth.org/datasets/usgdp/result.php# http://www.bea.gov/index.htm BTW, my new car sales as a % of GDP estimate excludes trucks
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Startup 121: Lessons for the Recession from Rice Krispies
The past few months have been, how shall I say, pretty crappy and have caused lots of cut backs for most startups (and companies of every size). Mostly, this has meant laying people off, cutting expenses, and generally “battening down the hatches to weather the storm”.
I randomly had several conversations with people on the topic of what a startup (or any organization) should do in times like these and some basic things came up each time:
- Measure to manage
- Mix it up
- Take calculated risks
Measure to Manage
Today, months into this recession, no one would argue that the economic outlook is negative. However, often times forecasting is challenging to say the least and usually only accurate in hindsight. I used to joke with our Board whenever I presented a financial plan that the only thing I could guarantee was that we would miss the numbers. That did not mean the results would be worse, but that I was positive we would not hit the plan to the penny. We would be roughly right, which in the words of Kenyes, is better than precisely wrong.
By Darren Hester
It turns that we were in good company as the record for long term forecasting of macro economic indicators by the “experts” is actually only roughly right in the near term and not so predictive in the long term. Just like a startup’s financial plan.
The Federal Reserve released a paper at the very beginning of the recession (coincidence? conspiracy? hmmm…), which analyzed historical accuracy of past economic forecasts such as the Gross Domestic Product (GDP see wikipedia).
OK, I admit, it’s little nerdy thinking that others would be interested in Average Root Mean Squared Forecast Errors but…
The report basically shows that most forecasts of growth are only good one or two quarters out, and beyond that, “…uncertainty about the economic outlook is considerable.” So if it’s hard to forecast a problem, what should a startup do?
In today’s world, measuring things is actually easier than it has ever been – Page views, Click Throughs, Conversion Rates, Leads, Registrations, Trials, you name it. Startups are actually pretty good at using data and all should have a set of good metrics to manage their business (See previous post If you don’t know where you are doing, well you’re lost).
In a startup this is usually easier than for big companies, but on a business by business basis, this should be possible even in the largest of companies but is something most don’t do well or at all. And it’s another reason why startups kick corporate booty. Let’s face it, startups are, well, smarter.
Now, all that being said, metrics need to be leading indicators for what will likely happen in the future as opposed to only lagging indicators. At Vontu, since we were doing enterprise sales (i.e. 9 months average time from a first prospect meeting to closing a 6 or 7 figure deal), even after having some of our best quarterly sales results, which is a lagging indicator, we were worried about the future because leading indicators, such as product evaluations (or as we called them, risk assessments), were not tracking to our historical averages. Team attrition is another example of a lagging indicator of a problem, that is to say if people are leaving, the problem already exists.
Now it sounds like I am talking out of both sides of mouth. And I am. Even though the Fed is not good with long term forecasting, having 6 months of visibility is still better than none. To know you have a problem (or an opportunity as the case may be), one can not focus enough on leading indicator metrics. And if you did not have the right metrics in place at the start of this recession, consider putting them in place now as you will also be a step ahead in predicting when to accelerate investment as things improve.
Mix It Up
Most startups (and large companies) made big people changes over the past 6-9 months typically in the form of cost cutting and layoffs and sometimes quite significant layoffs both in numbers and percentages. While layoffs are big changes affecting the lives of many people yet help in improving the health of the company for the short term, they are not about dramatic changes in leadership for the long term.
In my opinion, down turns are as good a time as any to make dramatic people decision that you have either been dreading or avoiding for whatever reason. First, there is already so much disruption that throwing some more into the mix won’t make much of a difference. Secondly, it is somewhat easier to hire great people given the macro-economic turmoil and increased unemployment. And lastly, everyone on the team already knows who is not performing. You as a manager and leader are usually the last to acknowledge the problem, yet the team expects you to make these tough calls.
Expectations for business results are low today so take the time to make the big people changes and if things get a little messy in the short term, but it’s all relative to the ongoing mess which already exists. And who knows, they may actually be better too.
Take Calculated Risk
My friend Phil forwarded me the New Yorker article “Hanging Tough” by James Surowiecki about what strategy some companies followed during the Great Depression. An example used two competitive cereal makers, Post and Kellog, and how chose very different market responses. Post did the standard cost cutting, yet Kellogg invested in advertising and new products and as a result, “Snap, Crackle, Pop!”, Kellogg became the dominant player it is today. For the same reasons it is a good time to start a company today (less competition, easier to hire, leverage the inevitable economic upswing), companies should be thinking about investments to be made today as the economy is at its lowest point.
In general, if one keeps an eye on the long term, one should always be making investments. Unfortunately, as the New Yorker article suggests, uncertainty overtakes risk taking. This short term uncertainty causes people to focus on what they can control, e.g. costs, as opposed to making smart investments for the future.
Yet history has shown that even during the Great Depression, companies that made good investments did well. Even the stock market came back more quickly than people remember.
At a recent presentation by Professor Jeremy Siegel from Wharton, he had a slide which stated, “On average, for the seven largest gaps [in performance relative to trends] over the past 145 years, the market has rallied 24% in the following year, 21.4% per year over the next 3 years, and 18.4% per year over the next five years.”
As suggested in the New Yorker, while most people are “battening down the hatches”, you might want to invest as the others might actually just might miss the boat.
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Startup 119: Why Startup Innovation Kicks Corporate Booty
I recently had coffee with David, a friend from college that was an advisor at Trio Development and an early employee at Connectify. As he now works in the incubation group of a large enterprise software company, he was lamenting about how hard it is for large corporations to innovate. That got me thinking about what it is about startups that leads them to “out-innovate” large corporations.
It ain’t about the technology
To start, I believe innovation is simply about creating significant new value though some combination of unique products, processes, and services. I do not think innovation is solely about creating new products or technology. That is simply invention.
While I am not an innovation scholar, my experiences suggest that innovation happens more easily inside of startup because they tend to have the right combination of:
- People
- Freedom
- Failure
It’s the people, stupid
Startups out innovate first and foremost because they build a complete team of dedicated individuals that eat, sleep and breathe the startups goals, which frequently include a goal to kick a large corporation’s you know what.
A complete team means “customer success oriented” engineers and product managers who spend lots of time working directly with customers; “take no prisoners” marketing people that are all about getting the startups message out and driving customer demand; “meat eating” sales people that make their quota solely on the success of the startups innovation; support and services people that are maniacally focused on making customers successful; human resources teams focused on hiring and engaging the best and brightest; and so on through the rest of the startup. It is also about a culture that is centered on the process of innovation as opposed to the vast majority of people in a corporation that are about the existing status quo.
Unfortunately, it seems that most large product and technology corporations think innovation is about having a team of engineers developing some new cool thing (again, that’s invention). And the thinking goes that once that new cool thing is developed then their hundreds or even thousands of sales people and vast marketing organizations will make it successful. The truth is that this rarely if ever leads to any new high growth businesses.
Corporate CTO’s organizations tend to be very disconnected from customers and only dabble in invention. Core product development teams are focused on improving or worse, fixing, their existing product. Corporate marketing teams love peanut butter too much. Yes, peanut butter. They take their marketing dollars and spread them thinly across lots of projects with little to no strategic thinking or accountability. And sales organizations rarely know how or are incented to sell anything but the company’s best selling products. The list of people challenges to innovation in a large corporation goes on and on. And when it comes to process, the place where lots of value can be created inside of large companies, the challenges are even more immense.
Startups are successful at innovation by first building a completely dedicated, funded and accountable team which takes something all the way from product or service creation through to selling and servicing the customer. And not only is that team focused but they have the freedom to execute in the best way possible to be successful.
Freedom
Teams need freedom to re-evaluate everything about a business from people, to process, to product and services. This freedom is often to do things that are radically different and often times competitive with the status quo of existing people, process, products and services with a corporation.
Salesforce.com is a great example for why giving a team freedom is unique in a startup and and hard to do inside a large company. Salesforce.com was started in 1999 at the height of the “dot com” bubble by a group of former Oracle executives who believed in a new way to deliver software applications. They were not trying to build some new product, but rather they thought that customer relationship management (CRM) software to manage sales process and customers was best provided not as a software application but as a service. (To learn more about software as a service, here’s some info at wikipedia.)
Their whole marketing campaign in the early years was “No Software”. They used that slogan everyone from their website, to advertising, to buttons they handed out at trade shows. And they were wildly successful because the time to value versus installing the market leader at the time, Siebel’s CRM software, was much greater for Salesforce.com.
It is unlikely they would have been successful with this innovation inside of a company like Siebel. Can you imagine one of the top software companies in the world giving a team the freedom to market a new way to deliver its services under the moniker “No Software” when the vast majority of the company’s revenue came from selling software?! No way. It turns out that Siebel did try software as service when they released a competitor sales.com though it ultimately failed and Siebel was eventually acquired by one of the largest software companies, Oracle. (Interestingly, Larry Ellison, Oracle’s CEO, has been an investor in some of the top SaaS companies which compete with Oracle including Salesforce.com and Netsuite)
The inability to give teams complete freedom is one of the reasons that innovation in a large corporation is hard. Once you are successful with an innovation, for example Siebel selling CRM software, it’s hard to put your own business at risk with new innovations such as Salesforce.com selling their solution as a service. Innovation can often not only threaten but require massive change to products, people, or processes.
Startups have the freedom to do things differently and that freedom often leads to innovation. While innovation can lead to massive value creation, more often than not, efforts to innovate actually fail. And failure is another reason why corporations do not innovate well.
Failure
We all know about the successful ones – the startups that go on to create new markets, big business and often times big companies. Some that come to mind are Google, Salesforce.com, VMWare, Amazon.com, and many more. However, the fact is that for every startup that goes on to create a new market, business or company, there were 10 or 20 times as many failed startups. And this failure is needed for innovation, yet it is not something corporations are set up to do. They are not likely to take hundreds of millions of dollars and have the majority of 50 some odd projects fail with the never-ending pressure of meeting the quarterly expectations of Wall Street.
The venture capital model basically is, for example, that out of a group of 50 investments over a 5-10 year period, there will be a few if not even just one big hit that provides for the vast majority of value creation. Think Google, eBay, Salesforce.com, etc. that end up with multi billion dollar market caps. Then there will be a few successful companies that are often acquired by larger corporations for several hundred million dollars. Think VMWave which was acquired by EMC before being spun out years later, Pure Digital, the makers of the Flip video camera acquired by Cisco and even Vontu by Symantec. Then there are basically the remaining 80+% that either simply fail or somehow return some small amount of the initial investment.
You need to invest money in lots of projects and only a few will succeed. Corporations cannot typically afford to do this. Which is why the most common route for successful innovation for large corporations is through acquisition of these companies. It is far less expensive and risky to acquire an ongoing business that has proven itself then to invest in the 50 different ideas to try and find one that works.
David and Goliath
While, there are lots of other needed ingredients for innovation to occur, having the right dedicated people with the freedom to try lots of things including the ability to fail, is a key foundation for startups – and something around which corporations are not organized. This foundation is one of the main reasons startups beat corporations in the innovation game and has been the case for decades. Until corporations figure out how to replicate this, my money is on startups to be the continued source of innovation for years to come.
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