SOPHISTICATED FINANCE

Don't be Perfect

Many entrepreneurs have a noticeable case of OCD (obsessive compulsive disorder), which probably explains in part why they are not running GE and work for themselves. The OCD frequently manifests itself in an extreme case of perfectionism. No detail is too small to scrutinize, from the color of the office, to the holiday schedule, to twenty versions of the financial model. If you avoid the trap of perfectionism, there are several benefits:

• You will be able to iterate new products faster because you know there will be a next iteration to make it better
• Staff will be more highly motivated because they will not have to fear and dread the boss' perfectionism
• You will stop doing constant revisions to everything which will lead to the whole business running better and people having time to do what is important--focus on sales

How do you know how to draw the line between "good enough" and perfect? No two people ever review something more than twice!! Here is an example: the analyst and the CFO prepare a financial model; the analyst prepares the model which is reviewed by the CFO (1) and then the analyst prepares a second draft which is approved by the CFO (2); the model is then reviewed by the senior management team (1); these comments are then incorporated by the analyst into the final model which is sent back to the senior management team for final sign off (2). The model is then final. I am not saying that these steps might not each take 2 weeks but the final model is produced with only 3 versions and hundreds of man hours are not lost in constant meetings.

The ability to operate with only two reviews requires certain discipline:

1. You have to give clear, complete and thoughtful guidance at the commencement of the project (helps to really know what you are talking about)
2. The review focuses on substantive points and major issues; format, making it pretty, etc. can be done by the boss between midnight and 2pm because only the boss knows the required level of prettiness (and normal people are sleeping or clubbing)
3. If this approach does not work, you either have the wrong people and they need to be replaced or you should have shown the person an example of what you wanted (good technique with trainees and young employees)

You might be saying this approach does not work for my company because we only have 2 executives and nine programmers. That's the point. The smaller the management team the less reviews and revisions you can take the time to make. Be particularly wary of multiple reviews of sales brochures, websites, vision statements and other activities that might be called m--k----g.

This was post was inspired by a post on Ben Casnocha's blog.

The Financial Summary

Daniel Cohen, an Israeli-based VC, has a good post up on how to present summary financial information in a first meeting with a VC. I always find it comforting that good practices are the same all over the world when it comes to finance, investing, valuation and due diligence.

A few of Daniel's hints:

1. You have to have a financial summary
2. Round numbers off to a significant number of digits (for example, $55,834,671.54 could be presented as $55 million)
3. Forget the graphs because VCs as a group are quantatative and don't need the training wheels of pictures; (hallelujah, hallelujah, hallelujah--maybe we could ban all graphs for ever given that most people pick the wrong chart type, don't label the axis, omit the unit of measurement, use ugly colors, etc.)
4. Present a logical scenario and avoid the hockey stick forecast

The one point that I wish Daniel had made was that the financial summary should show the growth driver(s) in the business and perhaps their economics. For example, instead of showing just new or total sales people or revenue per sales person, perhaps show EBITDA contribution per sales person. For more on growth drivers, see this post.

And remember, forget the graphs!!

Interviewing

Lately I have been doing a lot of interviewing to fill finance and accounting positions at clients, which suggested a subject I have not covered here.

Everyone always tells start up entrepreneurs to hire the best and the brightest. The unstated premise is that you know how to interview effectively. Most executives have never learned to interview a candidate well, partly because it is a skill that is not used constantly. Ten tips for better interviewing:

1. Always define (understand) the job requirements in detail before you begin interviewing; a sample is here.
2. Screen prospective candidates for their experience with exemplary organizations (McKinsey, Price Waterhouse, World Bank, HBS, etc.) and interview these candidates first; 19 out of 20 times the new employee is in this small group
3. Always review a resume before the interview and prepare a short list of key questions to be asked; drill down with the candidate on their experience in the key skills the position requires
4. Always begin an interview with the question "tell me about yourself"; what the candidate emphasizes instantly tells you what is important in their life and it may not be work
5. Always ask "what type of boss do you work best with"; you are looking for the people who answer "the boss gives me a minimum amount of direction and then let's me work" because confident, self-directed people almost always make the best hires (rarely the answer given)
6. At the end of an interview ask the person "what don't I know about you from your resume"; once had a candidate say that she walked from Guatemala to enter the U.S. (she was a great employee)
7. Always split an interview up so you ask the questions for 2/3 of the time and the interviewee gets to ask questions for the remaining time; listen carefully to their questions because these are the things that are important to the candidate (no questions--no job offer)
8. Don't waste time trying to cleverly get information about subjects that are not legally permitted; you are just telling the prospective employee that you do not respect the law and discriminate in hiring
9. Always test for required skills--languages, Excel, programming, etc.
10. If you would not leave your children with the candidate for a weekend, don't hire them; after an hour you should know if the person is responsible, within the norms of social behavior and trustworthy

The most common mistakes people make in interviewing are:

1. They talk too much and do not listen carefully; interviewers like to show their "power", but the interview is not about the interviewer
2. They focus too much on whether they like the person and not enough on whether the person can do the job; this is not dating, this is interviewing
3. They hire people of the same nationality, race or gender; support for fellow immigrants is great but diversity brings different perspectives on issues and makes you more welcoming to others

My preferences in candidates:

1. I tend to hire people from the best universities; the smarter the better
2. I tend to hire people who began their careers with Fortune 500 type companies because typically they have been trained to do things properly and they may have good practices to impart
3. I tend to hire people who are self-motivated and do not need a lot of cheer leading (not one of my skills)

Know what kind of people you like to work with and it will help your interviewing.

Lastly, don't be afraid of people who "threaten" you by their qualifications, self-confidence and accomplishments. To build a great company you need some stars and some stars in waiting.

Audacious Goals

One of the common themes in venture capital is that you need a big, audacious vision to build a big company. When I built a billion dollar company in Indonesia the goal was "to be the Wal-Mart of Indonesia" or "to build 1000 stores", all of this in country with annual per capita income of US$ 600. Microsoft and Google both had big, audacious goals. Microsoft's goal was "to put a computer in every home". Google's goal was "to organize the world's information". None of these goals appeared realistic at the outset, but they definitely qualified as audacious and are well on their way to being realized in less than 20 or 30 years.

Lots of companies have visions but only the audacious goals inspire people by their special nature. These goals all put every one in the company on a journey. We may not know where we are going but it is going to be something "special". It is that mystery that moves us to join the project, to believe it can be realized and to put in super-human effort to achieve it. Not everybody needs to drink this Kool-Aid but the top people all should be addicted.

Large, resource rich countries like the U.S. or China also need audacious goals to give their populations a direction and something for the many to believe in. In my lifetime the U.S. has had two audacious goals:

1. to defeat communism
2. to put a man on the moon

"To defeat communism" was probably established by President Eisenhower.  It was a big, audacious goal that asked everyone to sacrifice to preserve our democracy, which had just been put at risk by Hitler and was then threatened again. In May 1961 President Kennedy made his audacious speech that we "need to put a man on the moon...and return him safely...within a decade". Both of these goals were achieved, although it took until 1989 for President Eisenhower's "defeat of communism" to be achieved.

Since 1989 the U.S. has had no audacious goals. We have become a country largely of self-interested politicians and citizens. Why has this happened? In part the reason is that no President since Father Bush has had any moral authority. Clinton squandered any moral authority he may have had and President Bush appears to not consider morality in his decision making or to think in terms of larger, national goals. Furthermore, the national dialog has focused on issues with no sense of a journey or a cause to take pride in or be motivated by. Despite people's keen interest in gay rights, abortion or gun control, none of these issues "move" a large part of the population to go on a journey which is moral and worthy of extraordinary efforts to achieve it.

The popularity of the Internet and Web 2.0 may also be making it difficult for the U.S. to find an audacious new goal. With these technologies commonly available, everyone is a spokesman and people are increasingly following the output of more and more minor functionaries (yes-there is a certain irony here). Consequently, it becomes more and more challenging for an audacious goal to be communicated and accepted by the general population. Never the less, the U.S. must adopt a new, larger goal that galvanizes the population. Failure to do so will leave this country at risk from countries with the ability to move their populations, achieve audacious goals and command the world's respect.

There are two reasons to be optimistic about the U.S. despite the 19 year hiatus in establishing a new goal:

1. Both Presidential candidates appear to have a moral compass albeit formed through very different circumstances and both are inclined to look at the bigger picture
2. Cleantech, alternative energy, or "green" America is the most obvious issue since World War II around which this country could come together to achieve a moral, audacious goal

Now all we need is for a President to recognize the need for such a goal, to articulate it and for this country to come together around the goal. Maybe there are other candidates for this goal but we can not succeed as a country without such a goal.

Understanding the Customer

I try not to use the "M" word on this blog because I think it confuses more than it helps. The best definition of marketing that I have seen is: "the acquisition and retention of the customer". I like this simple definition because it focuses on the customer--get the customer and keep them. To get the customer you have to understand the customer needs.

Gerald Zaltman, an emeritus professor at HBS, has just published a new book Marketing Metaphoria. While this book focuses on developing product innovation, Professor Zaltman's research interests are in the area of understanding customer behavior. Zaltman believes that there are seven metaphors, at the subconscious level, that explain 70 percent of human behavior (as quoted from HBS Working Knowledge):

1. balance (equilibrium)
2. transformation (changing states or status)
3. journey (as in life)
4. container (keeping things in and keeping things out)
5. connection (feelings of belonging or exclusion)
6. resource (providing survival)
7. control

While at first glance this list may look like Maslow's hierarchy of needs I think it formulates a better way to understand customer needs, as opposed to human needs. (Yes--I know the distinction may be subtle but this is not a biology blog). Given that defining the customer need is the first step in formulating a new business, it may be appropriate to pay attention.

Zaltman believes that 80 percent of new product introductions fail because they do not satisfy one of these seven needs. Simple interviewing only probes the conscious level and never reaches the real needs at the sub-conscious level, which is why customers do not behave the way they say they will. By probing at the sub-concious level one finds the metaphors that truly explain human behavior and define customer segments.

Examples of metaphors applied to successful product introductions might be hybrid cars (transformation), social networks (connection) and Crocs (balance). There are many techniques to identify customer needs. I like this technique because it requires deeper thinking to identify the metaphor (need).

Early Stage Financing Site

Through a post by Brad Feld I came across a very informative site on early stage investment, angel financing and venture capital. The site is Angel Blog and is written by Basil Peters. Mr. Peters is a former tech CEO who achieved sufficient success to become an angel investor and then started managing technology oriented hedge funds. He writes very coherently about seed financing in all of its variations. His current posts are on friends and family financing.

Before you bombard him with requests to finance your startup, please note that he is located in Vancouver and not likely to finance a startup very far from there.

Google's View of a Startup

ReadWriteWeb has a very good post in which they "interview" Tom Duterme from the New Business Development Group at Google. The theme of the post is what does Google look for in their acquisitions. Reading between the lines, Google is looking for things that bolt on easily to their platform, make use of large, cheap data storage and utilize high speed bandwidth effectively. If you are not doing these things correctly, don't call Google.

In order to commercialize an idea, Duterme had this advice, which I quote:

* Collaboration - get the right people on your team.

* Fulfilling user needs should be the focus - 70-80% of ideas that fail do so because of lack of user focus. Google places a lot of emphasis on this, said Tom.

* Iterate often ("Big will not beat small anymore. It will be fast beating slow"; quote from Rupert Murdoch).

This advice got me thinking about how do you manage collaboration to iterate often. The CEO who has to do everything their way, the quest for "perfection" and constant minor changes are all in conflict with collaborative iteration. Why hire the best people and then micromanage or nitpick or ask for multiple do overs. The time constantly reviewing the best thinking of a smart employee is time lost that could be used more productively. If a decision will not immediately severely impair the company (bring on imminent bankruptcy) why beat it to death. The only factor necessary to consider in most decisions is whether it advances or is consistent with the strategy. Otherwise, remember this management principle which is little publicized: there is usually more than one right way to do things .

Follow this principle and your company will generate product iterations much more quickly. If you do not trust your employees enough to follow this principle, you have a recruiting problem or you (the CEO/manager) are the problem. The two problems are probably interconnected. People that do not trust typically are lousy recruiters who hire mousy people without initiative who do not challenge them.

A few signals that your corporate culture is not conducive to collaborative iteration:

1. You spend three months developing a product brochure because it's not "right"
2. Nobody can make the decision on when the next product version is ready or when it is finished
3. Nobody has the time to recruit the new sales people, programmers, ....
4. The mood in the office improves noticeably when the CEO goes out of town

Note: Duterme believes that 70-80 percent of ideas/businesses fail because there is insufficient focus on the customer. I think the percentage is correct. As I have said countless times on this blog, focus on the customer and their needs and don't waste time over thinking decisions, nitpicking the staff and re-doing things that are not key to the strategy.

Controllers

In response to yesterday's post where I asked if anybody knew a good controller looking for a job in South Florida, a reader posted a comment to say "not being able to find an employee in South Florida is like not being able to find a prostitute in Thailand". I have not been to Thailand in a few years so we will have to trust the reader on the availability of companions in Thailand, but I can tell you that good controllers are not plentiful in South Florida. The accounting industry in South Florida is very understaffed, jobs are plentiful and people easily choose smaller firms until they find the lifestyle they want.

The minimum requirements that I set for a controller also narrows the field:

1. Public accounting experience (2-4 years), preferably with one of the ten largest accounting firms in the U.S.
2. CPA
3. At least two years experience working in a company as a controller
4. Current knowledge of GAAP, FASB, etc.
5. Strong Excel skills and model building experience
6. Self-directed
7. Speak English (the reason they need to speak English will become apparent)

This type of person would earn $80-120,000 per year in South Florida depending on experience.

Many company owners confuse controllers with bookkeepers and save money by hiring the wrong type of accounting personnel. Then they realize that they "need" a CFO to do capital raising and spend $120-150,00 to fill this position. A better alternative for an early stage company is to hire a strong controller and forgo a CFO. A good controller should be able to model the company and provide any schedule required in due diligence. The CEO should be able to write a good Executive Summary in a weekend. Between them they should be able to handle the meetings with capital sources, many of whom will not speak Spanish.

I consistently see owners of early stage companies saving money by hiring bookkeepers instead of qualified controllers. They typically end up with non-GAAP accounting, poor accounting information and no management reporting. They typically never realize that they hired the wrong accounting personnel.

Note: if you had two strong executives in the company who could both actively participate in capital raising you might get away with a Spanish speaking controller but they still have to meet all my other requirements and prove they can stay current on U.S. GAAP (which I believe is only available in English).

Business Plans for 13 Year Olds

With the popularity of Web 2.0 and clean tech I am seeing more and more business plans in these areas.

The Web 2.0 plans almost all involve some form of social networking site and increasingly these sites are targeting more defined and narrower customer segments. This is a good trend, but fewer and fewer plans make clear why anybody would want to come to the site and more importantly use it. Everybody believes their site will go viral or Google ads will make the site a success. If it were this easy I would have already launched my social networking site for television animal personalities (I am particularly fond of the beaver with the blackberry that drinks lattes and promotes sleep medicines). Few entrepreneurs ever explain why a particular marketing plan matches their target customer or how their site will specifically match the particular needs of a target customer. Another way of looking at the issue is-- why should somebody come to your site instead of creating a group on Facebook or a social network on Ning. If you can answer these questions maybe you have a real business idea, but if all you can say is "we are going to offer better customer service, better security and videos"-- then maybe you should go back to the drawing board.These factors are not a sustainable advantage for very long, if at all. Most of the new social networking business plans I have seen recently never describe any real differential advantage. They lack this critical component because they have not developed a very profound understanding of their target customer. They have correctly picked an underdeveloped market segment but they have not really understood the customer.

The clean tech plans typically have a completely different problem. Many of them are based on carbon credits related to the Kyoto Protocol. I have yet to read a plan that relies on carbon credits and can intelligently explain how these credits get turned into cash. Last week I met with an experienced equity salesman. After my client fumbled around for ten minutes trying to explain a simple business, this old pro asked a simple question--how would you explain this business to a 13 year old. While many clean tech entrepreneurs do not yet have 13 year old children to practice on, maybe they could use this concept anyway. (Note: 13 year old rule is a good test for any business concept.)

If people can not understand the business they will not fund you.If you can not explain the concept in terms a 13 year old can understand then you have not achieved the level of simplicity required.

Tommorow I will be judging the final round of the business plan competition at the FIU Entrepreneurship Center. When judging these competitions I almost never read the financial plans unless the business concept is sufficiently well explained to merit the extra effort. Hopefully someone's presentation will inspire me to take a look at their financials. I hope so or otherwise it is going to be a long day.

Financing Fees

Ask the VC is a blog written by some savvy guys who are all VCs, including Brad Feld from Foundry Group. Today's post deals with a real case where a founder gave up ten percent of his company to get an advisor on board with connections to VCs. I recently saw a case where a founder paid 30 percent for a 90 day bridge loan involving warrants (120% per annum). While obviously both founders were stareing a death spiral in the face, or at least I hope they were, why do so many startup entrepreneurs overpay for capital. There are several reasons:

1. There are a lot of unscrupulous advisors out there who will overcharge; that's why you do background checks and get multiple proposals
2. Entrepreneurs do not consult their advisors and attorneys; mentoring reduces the risk in startups partly because it stops you from doing stupid things and anybody can afford a five minute call to an attorney/accountant/mentor to ask what market fees are
3. Entrepreneurs do not know how to calculate the value of the equity, warrants and options they are giving up; if you do not know how to calculate the value of these instruments you should not be trading them like baseball cards
4. High stress makes for poor decision making; plan ahead

A couple of guidelines to avoid overpaying to raise capital:

1. Loan sharks charge 4-8 percent per month. If the interest rate you are paying approaches these levels (after imputing the cost of any equity you are giving up), then you can be sure you are overpaying
2. The highest fees I have ever seen to successfully raise equity was for a company with eight years of losses. The fees were 10 percent in cash and 10 percent warrant coverage (1 warrant for every 10 shares sold). I would like to point out that these fees were 100 percent contingent on the capital being raised and there was no upfront fee.
3. Upfront fees to raise capital range from 0-$25,000 and the arranger should be putting some real effort into improving the business plan and/or financial model. Fees may vary based on the city where you are located but not by too much. Anybody short of a well known investment bank does not get a six figure upfront fee. (Remember that these fees are for early stage companies and not for a $100 million private equity deal.)

The more you need the capital, the more likely you are to make a mistake. Start the capital raising process early and do not overpay.

A thank you to loyal reader, Kendall, for pointing out the Ask the VC post.

A Collection of Excel Posts

In an effort to make it easier for Google searchers and readers to find the correct post they need on Excel or financial models, I have collected them here.

A reader wrote to say that they had not seen anybody give away for free so much help on Excel. Hopefully my small contribution helps.

I have also added some new sites to the custom Google search engine--Sophisticated Finance Excel--which may prove useful to readers.

Target Customer

A short post entitled Build Value in a blog called Peter's Thoughts got me thinking about the all important and often neglected concept of target customer. The key point in Peter's post was that you create value by satisfying the customer need. He goes on to say that management should never define the product features, but instead management should talk to a lot of customers. I agree 100 percent with what he says, but here is the problem. Who is the customer and more precisely who is the target customer. Most business plans, start ups and troubled companies lack an understanding of their target customer, which is usually demonstrated by their inability to fully describe the customer. Let's take an example. Here are five descriptions of a target customer:

1. A woman
2. A woman with children
3. A middle income woman with children
4. A low middle to middle income woman with children
5. A single, low middle to middle income woman with children

Notice how your perception of the woman changed with each additional descriptor. As your perceptions changed so did the probable needs of the woman.

Probably the most important concept in business after cash flow is target customer. Target customer defines the product, targets the selling strategy, refines the pricing and most importantly gives a concrete reality to the customer by defining their needs. Target customer is not a theoretical concept and is defined and refined by reviewing sales data, meeting customers, analyzing product sales trends and talking with the sales force for their feedback. Understanding the target customer, who may be in a state of constant change, such as for a retailer, is a continuing, constant process. Through this constant process of analysis you insure that your definition of the customer's needs is current, that you have not overlooked a key need which may still be unsatisfied and perhaps most importantly you keep management focused on the customer.

In many of the business plans that I see for new social networking sites I see detailed lists of site features but never get an idea of who would use the site. Most social networking sites are now oriented toward a particular vertical market, but this approach actually places a greater importance on understanding the target customer. If ten sites target photographers, the site that wins is the site that better satisfies the needs of photographer. This will probably be the site that has the most profound understanding of their target customer and not necessarily the site with the longest feature set.

In summary, a target customer is defined by their needs which provides the concrete information that fleshes out the standard demographic or segment analysis. While a target customer will undoubtedly evolve, particularly in a start up, one is well advised to define a target customer early in the business plan process in order to provide a concrete reality for the market you propose to serve. Otherwise you may end up with a product or feature set that does not match a customer need.

Understanding Auditors

Every audited financial statement has an auditor's opinion which includes in the first paragraph the statement "these financial statements are the responsibility of the company's management". Many auditors draw the conclusion from this statement that the client must prepare their own accounting entries in order to preserve the accountant's independence.

Now let's look at the purpose of an audit. An audit serves two purposes:

1. To confirm that the financial statements are prepared in accordance with GAAP (Generally Accepted Accounting Principles)
2. To establish whether there are sufficient financial controls in place to confirm the accuracy of the financial statements.

The paradox arises because if the auditor prepares an accounting entry then they supposedly compromise their ability to determine the integrity of the financial statements. This is hogwash. One of the benefits of a good accounting firm is that they can provide the accounting entries for complex transactions, such as employee stock options or mandatory redeemable stock. When your auditor tells you that you need to prepare the accounting entries and they will review them, what it usually means is that the auditor has exceeded the man hour budget for the audit. Nothing to do really with financial statement integrity.

Why do auditors end up exceeding their man hour budgets. Simply put--the client's accounting is terrible. No financial controls, no reconciliation of key balance sheet accounts, significant transactions not accounted for, etc. I see poor accounting practices all the time with early stage private companies. The reasons companies have so much trouble with accounting are:

1. Owners hire inexpensive bookkeepers and think they have accounting professionals
2. Owners focus on cash flow and tend to ignore accounting
3. Owners do not appreciate the value of an audit and see it only as an expense

If you are having trouble with your auditor, it almost always means you have problems with your accounting, accounting management and most importantly the financial statements. Get some outside help with your accounting and the relationship with your auditor will definitely improve.

Outsource IT-Amazon Web Services

Any new business should review its business model and look for ways to replace fixed costs with marginal costs. One way to achieve this is to outsource as many functions as possible, which allows you to convert upfront investment into pay as you go monthly charges. Examples of available outsourced services include the online version of QuickBooks, the enterprise version of Gmail, salesforce.com and ADP payroll services, to name just a few.  All of these services eliminate the investment in people, overhead, IT and computer support. I think concerns about the security and privacy of data stored on the web are overrated. Most of these companies referenced know more about data security than anybody you are likely to hire. Also, I assume the U.S. government is capturing every voice and data communication in the U.S. (if not the world), so concerns about privacy are somewhat mute.

At this point you are probably thinking that Hacker's outsource model may work for a small business, but not for a fast growing business such as an Internet application or social network. To achieve fast growth, typically the biggest challenge is learning to scale the business whether it be adding stores for a retailer, adding data storage for a website, training staff for a call center or addings POPs for a telecom company. Only 1.7% of startups achieve sales in excess of $5 million by the fifth year. A large part of the reason is that the entrepreneurs can not manage scaling the business.

Increasingly, the inability to manage IT and the related services is becoming a primary reason for the failure to successfully scale. Large customers expect their smaller suppliers to be fully integrated electronically. Customers expect their sales person to have complete information about their order, complaints, disputes, etc. 24/7/365. On top of all this, employees are finding better, free applications on the Internet than their employers make available and are surreptitiously introducing them into the corporate IT environment.

The good news is that Amazon is providing a solution to some of these issues through its Amazon Web Services (AWS) offering which began in 2006. I have been following AWS for awhile and a couple of weeks ago I read in a blog that AWS uses more broadband capacity than the Amazon website for books and merchandise. To use this much broadband capacity, AWS must already be serving a large customer base with large data requirements. Today in a blog called Amazon Web Services they describe a project by AWS for the New York Times. Through AWS the NYT processed "4TB of raw image TIFF data (stored in S3) into 1.1 million finished PDFs in the space of 24 hours at a computation cost of just $240". (TB are terabytes or 1024 gigabytes; huge amounts of data.) I believe this may be part of the recently announced project where the NYT converted its entire historical archive into a searchable, web-accessed database. For AWS to have handled this project, we are talking about serious outsourcing resources.

AWS includes three major services--EC2,S3 and Hadoop (maybe these names make sense to someone more geeky than me :)).

• EC2 provides resizable computing capacity or more specifically "EC2 presents a true virtual computing environment, allowing you to use web service interfaces to requisition machines for use, load them with your custom application environment, manage your network's access permissions, and run your image using as many or few systems as you desire".
• S3 is expandable online storage or more specifically "S3 provides any developer access to the same highly scalable, reliable, fast, inexpensive data storage infrastructure that Amazon uses to run its own global network of web sites".
• Hadoop provides distributed data processing (on a large scale) or more specifically "Hadoop distributes the data and processing across clusters of commonly available computers" for parallel processing.

In summary, through AWS one now can dynamically resize the data, applications and processing resources of their company and pay only the marginal cost for the resources used. Effectively, everything but applications development can be outsourced. Very, very cool!

There is one other important point about strategy that should be noted from the AWS example. In developing a strategy one should focus on using the company's core competencies. Many companies do not do this and many more do not even know what their core competencies are. Amazon ran a large distributed IT infrastructure for many years to support its books and merchandise business. Very few organizations run a bigger infrastructure--maybe Google, NSA and a few others. AWS grew out of Amazon's recognition that they had a core competency in distributed IT infrastructure on a very large scale and there were few potential competitors. Build your business by focusing on your core competencies and when the competency is unique you have something special.

Note: I think AWS is going to be a special company that we should all follow (think Google) and an easy way to do it may be to read their blog.

 

Start a New Web Business?

Many people tell me that they want to leave their jobs and start a new business, and, of course, a web-based business is a frequent choice. There were two good posts recently on starting a web business, but before I discuss them I need to set the stage.

Two important facts need to be kept in mind:

• 55 percent of new businesses do not survive the first five years
• There is about a 1.7 percent chance that your business will achieve revenues in excess of $5 million by the fifth year

The key factors to overcome the odds and succeed in a new business are:

1. Pick the right industry. Ever wonder why venture capitalists do not back restaurants and retail concepts and strongly prefer computer related businesses. Restaurants and retail have an over 70 percent likelihood of failure and computer related businesses have the highest likelihood of success.
2. Use mentors and advisors. Chosen well, they can help you avoid the fatal mistakes. An investment group in Latin America uses world class mentors for each company they invest in, and 87 percent of their companies have revenues over $5 million and are still in business after 7 years. (The investments are startups and early stage companies in emerging markets, which in many ways is even more challenging than the U.S.)
3. Have adequate capital. We have talked about adequate capital here so many times I will not repeat myself, but I would like to remind you that web-based businesses are comparatively capital efficient. See this post to read more on capital efficiency.

(Note: I have not listed the size of the market opportunity as a key factor. This is not a post on raising venture capital (although the three success factors above sound like an advertisement for venture capital funding). A lot of people start new businesses as a means to be able to work for themselves and have no intention of building the next Google. Makes no sense to me to put all that effort in to build a small business, but a lot of people do it.)

Now to the two posts, which I thought were very helpful to the aspiring entrepreneur. Paul Buchheit built Gmail for Google and then left to start FriendFeed, which is a site that allows you to follow the content of your friends on their blogs, delicious, flickr, etc. Suffice it to say, the man knows his technology and how to write code. In a recent post he basically makes two points:

1. It is more important to get your product in the market and get feedback from customers than it is to perfect the technology. He cites as two example of so-so technology and commercial success YouTube and Facebook.
2. Do not get hung up on perfecting the design of the website. His examples of commercial success with so-so design are Myspace and Google.

Buchheit believes the market is moving so fast that you need to stake out your space (application) before somebody with so-so technology and design becomes the market leader (and it is too late). The full post is well worth reading, except for the part about models not being important :).

To summarize so far, we have chosen to start a web-based business in part because it is a capital efficient model, found an excellent mentor and we are not spending all our time perfecting website design and technology. So where should we be spending our time? Dan Rua, Managing Partner at the venture capital firm Inflexion Partners (based in Florida), provides a good answer.

In a post titled "Nice idea, but how will you get visitors?", Dan talks about all the web investment opportunities he sees where the founders have given inadequate attention to developing website visitors (which makes it nearly impossible to believe there will be a commercial success). Rather than just stopping at the point where he tells you to focus on sales (a VC mantra), Dan goes on to list the seven ways to develop visitors for a website. I should force you to read Dan's full post (by not providing the list), which is well worth reading, but here are Dan's seven ways to build traffic:

1. organic search
2. sponsored search
3. viral adoption
4. referral tools
5. affiliate marketing
6. display advertising
7. distribution relationships

Dan closes the post by saying that the key point is to show how the traffic building strategy matches the target customer's behavior toward the website. For example, people looking for research on a topic may  not be likely to respond to viral marketing techniques.

If you do not fully understand Dan's closing point, you may not be ready to start investing in code. If you fully understand Dan's point, remember what Buchheit said. Perfect technology and design is not the objective. Traffic and customer feedback is the first goal. Which brings us back to Dan's advice.

After you get the traffic, then you need to monetize the visitors, but that's a whole new subject for another post.

Startup Excel Model

About half of the readers of this blog originate from Google searches. The most popular searches involve Excel, financial models for startups, sources and uses, CAPEX and headcount plans. In an effort to fill the apparent void on the Internet related to complete financial models built with Excel, I have posted a  model which includes examples for all of the frequent search terms that bring readers here (cash flow, CAPEX, sources and uses, headcount, etc.) The model is complete and a good example of what to send to a venture capital or private equity firm or a hedge fund to raise any type of financing.

A few words about this model:

1. It is a real model that I built for a client (prospective clients you can see my work)
2. It is not a template for you to use (I suppose if you changed all the assumptions it's usable, but...), but the component parts are recommended for capital raising
3. The model is for a "triple play" telcom business (cable, voice and data) so the cost of sales part of the model is over 100 assumptions and the CAPEX is fairly involved including physical constraints; this "complexity" is designed to show industry knowledge to financing sources; for more on the purposes of financial models see this post
4. The model includes the following tabs:
   • Sources and Uses
   • Assumptions (which also includes the Financial Summary--P&L and balance sheet information)
   • Financial Statements (which includes the P&L, balance sheet, revenue detail, COS detail, CAPEX row 178, and debt schedule row 251)
   • Cash Flow Statement
   • OPEX (operating expense detail and the headcount plan)
5. The model makes extensive use of named fields (after you open the model press F5); named fields make it easier to understand formulas because you use a name instead of a cell reference in the formula
6. In addition to being a startup, the strategy called for a  series of acquisitions (a rollup) which are modeled
7. The model uses a customer acquisition cost driver for the organic growth of subscribers

A few things that would have changed the model design include:

1. If I had a complex debt structure (combination of a line of credit, term loan and mezzanine debt) I would have used a separate tab for the "debt schedule" to make it easier to find
2. If I had an operating company (instead of a startup) I would have included historical information for at least three years in the "financial summary" and probably have given it a separate tab; if you have a good operating history of revenue growth or a turnaround I would include five years of historical data
3. If I had historical information on each acquisition, I would have forecasted/modeled each acquisition on a separate named tab (with a separate P&L and a balance sheet) and then consolidated them; such a presentation would have made it easier to understand the economics of each business unit and to evaluate the reasonableness of the purchase price
4. If the headcount additions were based on time instead of capacity requirements (as shown in the model) I would have used date triggers to drive headcount additions

Click the following link to download a copy of the model. Download sf_blog_model.xls
The auditing tool bar in Excel may aid in understanding. Click View>Toolbars>Formula Auditing

Please remember that the complexity of the model serves a purpose--to demonstrate knowledge of a complex industry. Most models can be successfully built with fewer assumptions about revenue and cost of sales. Some additional thoughts on detail in models are here.

Lessons from Retailing

Yesterday Sears announced that it was replacing its CEO, Alywin Lewis. Seems like just yesterday Home Depot replaced Robert Nardelli as CEO (actually it was January 2007). Both of these executives had distinguished careers prior to their appointments as CEO, but both of them failed in a relatively short time. What do these two men have in common?

1. Neither man had any experience in retailing. While Lewis had been in the restaurant industry, restaurant operations are to retailing like mathematics is to software coding. Close but no cigar!
2. Neither man had any experience in merchandising (selection, assortment and inventory level of goods). Merchandising is the key to successful retailing and no other industry except retailing develops the requisite skills. While "location, location, location" is the mantra of retailing, merchandising is the critical success factor.
3. Both men focused on non-critical priorities in retailing. Lewis focused on cost reduction and Nardelli focused on improving IT systems. Both priorities are important in any business, but neither priority builds store traffic, increases average sales per customer or improves gross margin. Each man focused on the wrong area and clearly communicated to their thousands of employees that they did not understand retailing....and would be short term CEOs.

An interesting contrast to these examples is the CEO succession at Wal-Mart since Sam Walton. Both succeeding CEOs spent time running merchandising at Wal-Mart and David Glass, the immediate successor to Walton, was a world class merchant (industry speak for a merchandiser). Lee Scott, the current CEO, began his career in logistics and distribution but he ran merchandising before he became CEO. He was undoubtedly put in charge of merchandising as his last "test" before becoming CEO. Both Glass and Scott also spent almost their entire careers at Wal-Mart.

The points to take away from these examples include:

1. In complex industries such as retailing (telecom and pharmaceuticals would be other examples), the CEO should come from the industry.
2. The CEO must have real experience in the critical success factor areas of the business. Industry experience alone is insufficient if the CEO candidate spent all their time raising capital or doing acquisitions or other non-critical activities.
3. Promote from within. Internal promotions insure industry expertise, knowledge of corporate culture and a motivational example to all employees.

While these points are directed toward hiring CEOs, I believe the advice applies to all hiring. Hire from the industry, make sure candidates have real experience in the critically important areas of the job and look inside for candidates before going outside.

The BOGO Business Model

I have written about business models eight times in the first 100 posts on this blog and most recently here. (If you are counting, this is my 100th post.) Business models obviously interest me, in part because they are so important for sophisticated investors (VCs, hedge funds, etc.) to understand. They also interest me because so many entrepreneurs fail to think through in detail the key parts of the business model:

1. Revenue model
2. Pricing model
3. Sales and distribution strategy

The BOGO model is a relatively new business model popularized by OLPC and Sun Night Solar. In this model when you buy one you get one additional unit which is sent to the third world to be given free to a needy soul. OLPC sends a proprietary PC and Sun Night sends a proprietary photovoltaic flashlight. While both companies use a marketing pitch targeted at helping the third world, I think that most people evaluate the price they are paying against the value of the single product they themselves receive. In both cases a single unit of the proprietary product has sufficient value to justify a price that permits two units to be manufactured at a profit (or positive cashflow).

In both cases the companies decided that:

1. They were developing products for the third world
2. Realized that the third world could not afford to pay for the product
3. Opted for the BOGO model
4. Engineered the product to match the costs for BOGO to work

The entire logic here is based on a profound understanding of the pricing model. One might say that the pricing model drives the entire business strategy. For example, the pricing also has to cover the entire cost of distribution in the third world, which lead both companies to low cost distribution strategies. (OLPC uses local governments and Sun Night uses local charities that are paid to distribute.) Without an in depth understanding of the value of the product they would not have been able to establish a price that would support BOGO.  Perhaps every startup should consider BOGO as a business model, not to help the third world necessarily but to force the entrepreneur to better understand the value of their product and the appropriate pricing.

A case in point is my online backup service, Fabrikinc.com. The first gigabyte of storage is free and the second gigabyte costs me 89 cents a month (yes-I do keep my overhead low). Why does Fabrik not offer me an extra gigabyte of storage for $1.78 per month and allow me to give a one gigabyte backup service to a friend or family member (whose computer always dies). The extra 89 cents a month is insignificant, would not change my decision and Fabrik would benefit from a zero customer acquisition cost for the new customer. A variation on this logic, which relates to sales and distribution strategy, is why when you sign up for a web service, such as Clipmarks, they do not offer you the option to enter a friend's email so they can be told about the neat new application you are using. (Clipmarks copies web images and allows you to email them, post them to a blog, archive them online and put them on your Facebook page.)

On a related theme, NewsGator announced a change in its business model this week. NewsGator is an application-based RSS feed reader, as opposed to a web service such as My Yahoo or Google Reader. (Only about 30% of the readers of this blog use a feed reader and you may want to check out any of these three products.) NewsGator will no longer charge for their consumer version of the application-- FeedDemon. Their logic is that by increasing penetration in the consumer market, this popularity will increase the likelihood that FeedDemon will be chosen as the enterprise version feed reader in corporations. NewsGator's strategic focus is on the corporate market for the enterprise version of the product. FeedDemon also resells the data related to your blog reading, if you permit it, so a one time fee for the application may be interfering with maximizing the data sale revenue. Obviously NewsGator has changed its pricing model but in doing so they support a change in revenue model to focus on data resale. They also support a change in sales and distribution strategy to support their focus on the enterprise market.

This post hopefully points out the relationship between the revenue and pricing model and sales and distribution strategy.  Both examples above, BOGO and NewsGator, hopefully also make clear that there is no "normal" business model. A new business model may provide a competitive advantage, at least for a time, but it requires detailed analysis and a bit of courage.

Picking Partners

No--this is not a post on how to select a spouse, although in honor of my 33rd wedding anniversary yesterday maybe it should be. Instead, I am going to discuss how early stage companies should select their partners for business development. The post was prompted by the story that Intel is leaving the OLPC (One Laptop per Child) board and will not be involved in Nicholas Negroponte's project to provide cheap computers to third world children (previously blogged here). This has been an on again, off again saga between the parties and the final straw was reportedly Intel's continuing efforts to sell a competing PC for $350 to the same potential customers for OLPC.

This situation is one I saw frequently when I worked in Japan in the 1980s. Young technology-driven company partners with large, global, multi-billion dollar Japanese company to gain entry to the Japanese market. Results from the joint venture, distributorship, license agreement (fill-in the blank) were zip--no sales and no real cash flow from the project. (This is not a commentary on Japanese business practices.) The mistake that was constantly made, and OLPC repeated it with Intel, is that if you do not confirm the strategic commitment of your partner to the project you do not really have a partner. OLPC could probably have saved itself a lot of trouble and lost time by merely asking Intel what its plans were for the $350 PC. As soon as Intel said they plan to continue selling it, OLPC should have moved on and looked for new partners. Perhaps OLPC was distracted by the planned $18 million dollar contribution from Intel, and cash frequently distracts young companies, but to take the cash and forego a large market or a large opportunity is usually shortsighted. In OLPC's case perhaps it was wishful thinking.

The second mistake that young companies make is that they enter into partnerships (joint ventures, license agreements, distributorships, equity investments) too early.  Large, billion dollar companies are run by what I like to call "adults"--experienced professionals that believe in systems, procedures, planning and successful execution. If your company has not yet developed these disciplines, you would be well advised to wait until you are ready. "Adults" are not very forgiving when you jeopardize their bonuses or pensions.

The third mistake young companies make is that they fail to accurately estimate the resource commitment or capital requirement for their new partnership. A multi-billion dollar company does not enter into a venture to achieve $3 million in new sales. These companies are looking for home runs or at least a $100 million double. To support your new partner can easily exhaust the management resources or working capital of an early stage company.

The best advice would typically be not to partner with a billion dollar domestic or foreign company until you have achieved at least $100 million in annual revenues. At that point you have the management, scale and financial resources to go and play with adults, but most importantly make sure to confirm the partner's strategic commitment to the new venture.

Building Great Companies--Six Principles

I rarely read books on leadership because I find them confusingly similar to good books on management and strategy. Whether you wish to consider it a matter of leadership, strategy or management, the six principles below are what I believe are necessary to build a great company (such as Coca Cola, Sony or Intel):

1. Vision  A large, panoramic view of how to serve a customer need or how to realize value from an unappreciated asset. This view is almost always based on an asymmetry of information wherein the founder develops an incredibly in-depth knowledge of his subject matter and an intense passion to pursue the goal.. Case example: Amazon
2. Focus   Dedication to a simply defined business concept which stands the test of time (and markets) without the need for diversification, acquisitions or "financial engineering" to generate above average growth. Investment in growth drivers alone is typically sufficient to achieve growth and market share objectives. Case example: Wal-Mart
3. Values  Large groups of people can only succeed where a clear value system is articulated and practiced by the senior management. The key values are honesty, fairness and respect for all people (whether they be employees, customers, shareholders or the community). Case example: JP Morgan
   
4. Customer Focus   Great companies have a unilateral focus on serving their customers and do not place a higher priority on investor expectations or competitor moves. Case example: Johnson & Johnson
5. Low Cost   Capital is invested in the growth drivers of the business and not frittered away on overhead and there is a constant effort to provide the customer with a cheaper, higher value product(s). Case example: Wal-Mart
6. Exceptional People   Great people are hired and retained in the key disciplines for the particular business, such as programming, merchandising or research. Today, almost everything else can be outsourced. Case example: Goldman Sachs
   

The most common mistake I see in entrepreneurs is a lack of focus, usually brought on by a lack of self-discipline. When growth or earnings expectations are not met, too many business owners resort to diversification into new businesses or use acquisitions as a means to improve expected results. Great companies grow organically because they constantly find ways to generate growth in their core business. Successful companies assume there is organic growth and then find the way to achieve it. Such an approach allows them to leverage their strengths and expertise and consequently typically results in lower risk, less capital intensive strategies.

The second common mistake is that the founder is not a good recruiter and ends up with mediocre people in key positions. Founders tend to recruit the wrong people because they fail to give recruiting sufficient priority (usually because they are wasting time micro-managing) or they lack the confidence to recruit people that may challenge them. A founder's vision is improved by the input of other exceptional people.

The most difficult deficiency to overcome is a lack of values, which comes about due to a lack of respect for other people. Without the proper value system a founder can not retain good people and no great company was ever built by just one exceptional founder.

In my experience a lack of customer focus can be overcome by a clearly articulated vision and a relentless pursuit of lower cost, higher value product. However, this approach may only work temporarily if your target customer develops new requirements and demands better quality products or a different type of product value (in which case you better become customer focused).

Many pundits typically list 8-10 qualities of great leaders and then say that no leader has all the qualities.  This type of conclusion suggests to me that the pundits gave up on the analysis half way through. I worked for over ten years with the founders of two great companies--one in Indonesia and one in Japan and have met several other founders who built great companies with revenues in the billions. There is a simple set of key principles to follow to build a great company.