When the music stops...
As a little kid, I always lost when I played musical chairs. Maybe I wasn't fast enough or big enough -- or perhaps I just was enjoying the music so much that I failed to anticipate when it would stop. In the three businesses I've been involved in founding, I've been lucky enough to catch a chair right before the music stopped.
- April 1996 – Infonautics Corporation goes public
“On July 11, 1996 a speculative bubble burst…” – Red Herring
- June 2000 – Half.com is purchased by eBay
“…by the summer of 2000, you could hear the air coming out of the balloon…” – Business Week
- May 2004 – Turntide is purchased by Symantec
“…we've predicted that the spam bubble will be short-lived. If you're in the anti-spam market our advice is simple -- move quickly for a liquidity event -- your valuation is high now but it won't last long.” -- NetsEdge Research Group (March 19, 2004)
I recently returned from Etech (O'Reilly's Emerging Technology Conference) where, just like at the last fall's Web 2.0 Conference, I participated in several discussions about whether Web 2.0 is a bubble -- and if so, when it might burst. I'll leave that topic for a future post...But, regardless, I think that it is very important for entrepreneurial CEO's to always be on the look out for signs that the "music may be stopping" - and make sure that their company is well-positioned for it. The funding (and M&A/IPO) market for startups is cyclical. What can you do to better position you to "grab a chair" if you hear the music stopping?
- Focus on adapting to change rather than predicting the future.
I've seen a ton of business plans over the last few years -- they all only had one thing in common: they all were wrong. Most understated costs and overstated revenues - a few actually beat their projections. But if you look at their five year forecasts, every single business plan was wrong. A business plan is a document that outlines your plans and assumptions at a specific moment in time – it is your prediction of the future based on what you know now. As soon as you hit print on the business plan, things change. Competitors emerge. Technologies shift. Regulatory changes effect your marketplace. Key employees quit. Macro-economic factors impact customer spending. Shit happens. I'd much rather invest in a founding team that shows an ability to adapt to change than one that claims to accurately predict the future. I believe that teams that are nimble, market-focused, and are willing to rapidly test/iterate/shift their plans are more apt to perceive the signals that the music may be stopping.
- Understand the unwritten term in the term sheet.
Almost every entrepreneur I talk to strives to get the highest valuation humanly possible. And often that is a valid desire. However, entrepreneurs should understand the “unwritten term in the term sheet”: few VC’s will willingly part with a “winning company (ie, a company that is executing/performing well) for less than a 10x return. Peter Rip of Leapfrog Ventures highlights the tradeoff:
”Lots of cheap capital, available at high valuations seems great, until you do the exit math. Raise $8M at $12M pre-money and your post-money valuation is $20M. Your investors want to sell for $200M. Raise $2M at $4M pre- and your investors get the same rate of return at $60M. But a $60M exit is 10X more likely than $200M. Few VCs will write the $2M check these days, precisely because a $20M return doesn’t move the needle in a $500M fund. That’s why valuations are moving up – the need to invest more money – not the intrinsic value of startups. Higher valuations and high venture rounds may feel good in the short term, but with IPOs as scarce as they are, they can price you out of the very exit you seek.”
There are often good reasons for taking a lot of money at a high valuation. However, I’ve found that all too often the entrepreneur did not fully understand the deal that they were making – specifically, they did not explicitly accept the fact that they were eliminating options for a shorter term exit. Again, there are plenty of good reasons to “swing for the fences” and raise a large round at the highest valuation possible – just make sure you've agreed to the trade-off.
- Build to last – with options.
I, like Ed Sim, believe that companies are not sold. They’re bought.
In every exit I’ve been fortunate enough to participate in – both big (Half.com or Infonautics) and small (Turntide, del.icio.us, Vamoose.com, e-Touch or Snapcentric) – the opportunity to exit was there only because we had begun to build a company that has differentiated technology, a strong team, offers customers real value, demonstrates traction in the marketplace, and/or solves a real need for the acquirer. You can’t build a company to sell it – I’ve never seen it work.
That said, I sometimes see entrepreneurs draw the wrong message from the “Built to Last” story. They believe that in order to build a company for the long term you need to make long-term commitments in short term. They enter into long term leases. They hire too many people too fast. They overspend on hardware. They lock into a product development roadmap without an iterative development/alpha/beta process. They sign long-term strategic partnerships before their model is fully baked. I’ve heard people justify doing all of these things under the “we’re in this for the long haul” rationale. However, I believe that the best way to insure that there is a long haul is to maintain flexibility. Things change. Mistakes are made. Keep your options open – including the option to look for a chair when you think the music is going to stop.