One Surefire Way to Screw up Your Lifestyle Business

Some businesses are designed – maybe even destined – to be owner operated. Industry parlance often refers to these businesses as lifestyle businesses. Wikipedia has a nice definition. They are typically small, profitable, generate cash and enable their owner-operator to sustain a well-above average lifestyle. In some circumstances, they may even make their owner-operator filthy rich over time.

Some people may think that the term lifestyle business is an insult. I couldn’t disagree more. Being the owner-operator of a lifestyle business should be a source of pride; a badge of honor.

As a growth stage investor, I see quite a few lifestyle businesses in our deal log. This type of opportunity finds us because they often meet our high-level screening criteria. They have paying customers, generate meaningful revenue and produce EBITDA and cash every year. They “fit the profile”.

But when I meet with an entrepreneur who is running a lifestyle business, I’m not shy about asking a most important question. It usually goes something like this:

I understand you wish to raise capital to grow your business. But if I’m hearing you correctly, today you own and control nearly 100% of your company. This enables you to lead a balanced life, generate meaningful personal wealth and take great satisfaction from your work. Why would you want to screw all of that up by raising capital?

I mean it too. Raising capital comes with loss of control, changes in lifestyle (read work flexibility) and other issues. More importantly, lifestyle businesses tend to lack one key ingredient that institutional equity investors (particularly growth equity investors) need to generate returns; rapid scalability. Bringing in institutional capital creates an incredible amount of pressure to generate top-line growth. In the context of most lifestyle businesses, that kind of top-line growth is either not achievable or if it is, will so fundamentally alter the character of the business that it will be unrecognizable to the entrepreneur at the end of the process. In short, that pressure will probably do more damage than good from the owner-operators point of view.

So if you are an entrepreneur seeking capital from me and I say something like “You own a great lifestyle business; why on earth would you want to raise capital and screw it up?”, please know I’m coming from an honest place. I’m not insulting you.  I am, however, trying to get you to come to grips with the fact that raising capital may be a surefire way to screw up the good thing you have going.

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Meet Your New Role Model: The Workhorse

I never liked the term Unicorn. It never made sense to me to aspire to something mythical and therefore of theoretical value.

I’ve written before about the risks associated with trying to make unicorns and the fact that entrepreneurs are the ones who bare the burden of the risks associated with a go big or stay home company building philosophy. Unfortunately, over the past several years, tech-entrepreneurship seemed to become synonymous with making unicorns. If you weren’t working toward a billion dollar valuation in short order, you were wasting your time and the time of all of the investors to whom you were pitching your business plan.

For entrepreneurs who – for the past five years – have been enamored to achieve unicorn status, it may be time to leave the horn envy behind. The Great Reset is on and tech CEO’s need to adapt their value creation philosophy to the constraints of the current financing markets.

Perhaps it is time for us to re-imagine our role model. Several of the doom and gloom articles I’ve read have proposed the cockroach as the new role model for tech-entrepreneurs. Having reflected on this a bit, going from unicorns to cockroaches feels like a bit of an over-steer to me. I understand there is a survivalist instinct triggered by the kind of valuation correction the markets are experiencing. But cockroaches are disgusting and while they are certainly master survivalists having been around for 340 million years, they aren’t a particularly appealing role-model with which to affiliate.

I also don’t think that the Great Reset is an “end of times” scale event. The Great Reset is more a calling back to fundamentals than a mass extinction.

WorkhorseA less extreme change in role model is called for.

Out with the Unicorns.

In with the Workhorses.

I like the workhorse as a role-model that is appropriate for the current state of the private financing markets. Workhorses are smart, tough, sturdy, dependable, docile and patient. They are strong, even in the presence of a storm. Workhorses are durable and adaptable. Oh, and workhorses aren’t mythical.

Think of the workhorse as an evolved unicorn. The unicorn is of mythical value. The horn was useless and the magic isn’t real. Workhorses are are evolved in that they are producers of fundamental value. They do real work and solve real problems.

Don’t mistake me for suggesting that the companies that have been anointed with unicorn status aren’t of value. Quite the contrary, I think that most of the “unicorns” are actually workhorses in disguise and most are phenomenally valuable. It is the mythology surrounding the unicorn craze and the resulting disconnect between valuation and fundamental value that has been the problem, not the unicorns themselves.

Unicorn mythology has warped investor sentiment and entrepreneur behavior and expectations in unproductive ways causing all to take the collective eye off the real task at hand – building fiscally disciplined businesses with sound unit economics that are of fundamental value.

Shed the horn-envy; turn your unicorn wannabe into a workhorse.

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Unicorpse and The Moral Hazard of Making Unicorns

UnicorpseI’m sure that many more thoughtful than me has written about the moral hazard of venture capital. In economics, moral hazard occurs when one person takes an unreasonable risk because someone else will bear the burden of the negative consequences. In the age of unicorns, the moral hazard in venture capital has never been greater. Moral hazard and exuberance to make unicorns leads to unicorpses. I was reminded of this today during a conversation with an emerging growth business run by capable, but  young entrepreneurs.

The Situation

The 20 something entrepreneurs with whom I was talking have built a solid, already profitable business generating $4.3 million ARR. The company has taken a total of $200k of outside financing. With a modest amount of incremental capital, the business has the potential to be a $30 to $50 million revenue business in 5 years and to be meaningfully profitable. Such a business could easily fetch $100 to $150 million in exit value, producing a significant amount of wealth for the entrepreneurs. In addition to producing personal wealth, after such an exit the entrepreneurs will have built a successful company, made money for their investors, established a reputation for themselves and find themselves with the personal wealth necessary to finance the start of their next business. They would be imminently “back-able” and set up nicely for a long and productive career.

Objectively, a $100 to $150 million exit in three to five years is possible for this company. Objectively, a unicorn type multi-billion exit isn’t possible. But sticking to the straight and narrow of building a solid profitable business is hard. Bad influences abound. Entrepreneurs, like the ones running this company, are flooded with tech-centric news about the birthing of a unicorns and are shielded from the harsh reality of entrepreneurial failure. The infrequent unicorn gets lots of press where the 40% failure rates that plague venture capital fade to black. It is no wonder then that many entrepreneurs (particularly young entrepreneurs) fall victim to the instinct to try to make their company into a unicorn. Lets go raise $[fill in the blank] and pursue [fill in big hair audacious goal] becomes the mantra, whether or not the opportunity has unicorn characteristics or the use of proceeds is well aligned with what the business is. Raising all of that capital leads to spending, and higher burn. After all “we’re not giving you the money to have you save it” and “you can’t save your way to success” are common refrains. In most situations, higher burn rate equals higher risk of failure. High risk, but not necessarily higher reward.

Who mourns the unicorpse?

With high-loss rates and returns concentrated in a small number of investments that go full unicorn, venture capital is more fraught with moral hazard than ever. Venture capitalists have portfolios and their performance is generally evaluated at a portfolio level. This portfolio level evaluation applies whether the evaluation is of a firm or an individual investing partner. Venture capitalist cares less about the success or failure of any single investment than the success of his/her overall portfolio. Knowing that loss-rates are high and returns are concentrated in a few large deals, venture capitalists have an inherent incentive to swing for the fences on every investment, increasing the risk and potential reward of each investment.

Who bears the cost? The entrepreneur.

Pragmatically speaking, an entrepreneur can manage only one entrepreneurial endeavor at a time. In fact, we investors often tacitly, if not explicitly, require this. We want the entrepreneur single-threaded, we need the entrepreneur single-threaded. I’ve got a portfolio, but you put all of your eggs in one basket…

To make ourselves feel better, we have lots of platitudes for entrepreneurs who experience failure.

It is better to have tried and failed that never to have tried at all.

You learn more from failure than you learn from success

There is no shame in failure.

All true; but when push comes to shove, venture capitalists are master pattern matchers and a tried and true heuristic is that past entrepreneurial success is a predictor of future entrepreneurial success.  Many investors would prefer to back an entrepreneur with a successful track record and a mediocre idea over an entrepreneur coming off a failure with with a good idea. A 20/30 something entrepreneur coming off of a failure is going to have a very difficulty time getting his/her next business financed. Conversely, a 20/30 something entrepreneur coming off of a successful exit is with a successful exit under their belt is much more likely to get financed.

No Villains Here

To be clear, I’m not vilifying venture capital or venture capitalists. There is nothing untoward about the economic motivations of investors.

I’m also not suggesting that intentionally increasing the risk of an investment is risk-free for the investor. Higher operating  risk implies a greater chance of capital loss. There isn’t a moral hazard in every venture capital investment situation. For example, some businesses operate in winner takes all markets. In such situations the motivations of the investor and the entrepreneur are nicely aligned because the go big or go home philosophy of company building is the right approach due to market structure.

I am, however, suggesting that the entrepreneur bares a greater proportion of the risk associated with venture capital investments; or at least that the consequences of failure are greater for the entrepreneur than the investor.

An Alternative Approach

When you swing for the fences, you strike out a lot. No manner of platitudes for the entrepreneur who tried and failed can remove the moral hazard.

Entrepreneurs in growth stage businesses face different calculus. In a situation like the one I described, the entrepreneurs have already created value for themselves. Taking a bigger than necessary financing round and swinging for the fences puts that built in value at risk and buries it under a larger preference stack than is necessary.

Making unicorns is risky business. There is another way.

Consider taking less capital. Consider staying laser focused on your core market and building a defensible position that is resilient to attack. Win narrowly and then exit. This may mean taking a more risk averse path to unlocking the value of the business. Raise less capital. Moderate burn. Get profitable as soon as possible and exit sooner. If that means not raising capital or raising less capital (and taking less dilution) all the better.

Young entrepreneurs operating an already successful business would be wise to remember that some unicorns end up unicorpses. It is better to be modestly valuable and alive than to have had the potential to be wildly valuable and dead.

Call me old fashioned. Call me risk averse. I’m guilty as charged.

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Negative Churn

class=”wp-image-1163 alignright” src=”×200.jpg” alt=”melting-ice-psd (1)” width=”218″ height=”145″ />In a board meeting yesterday, we had a brief discussion around “negative churn”. Negative churn is a catchy phrase and apparently a hot-topic in some SaaS circles. I like some of the concepts and disciplines that an understanding of negative churn implies, but I also think it is an unnecessary concept that actually makes it more difficult to understand the inner workings of an MRR based SaaS business. Some background…

What is Negative Churn?

Negative Churn is an increase in revenue which occurs when the change in revenue within an installed base of customers is net positive from one period to the next. Negative Churn implies that the revenue gained from existing customers who purchase more over time exceeds revenue lost from existing customers who purchase less over time, including customers lost outright.

The term “negative churn” is an attempt to understand net organic revenue growth within an installed base of customers in the context of churn. Understanding the change in revenue within an installed base of customers is really important. But seeking to understand organic installed base growth in the context of churn begs a question: What if the revenue gained from existing customers who purchase more over time is less than revenue lost from existing customers who purchase less over time. Such a scenario would indicate that Negative Churn is NEGATIVE! Can Negative Churn be negative? Should we call this scenario Negative, Negative Churn? Of course not.

Conflating Churn and Revenue Lift

The fact that Negative Churn is a double negative is the first reason to not like it. Further, Churn is always and unambiguously revenue reducing. Therefore, Churn is always negative. Churn is never, ever positive.

Churn should be analyzed independently from the revenue lift from upsell (or extension) that has the potential to drive organic revenue growth in an installed base of customers. Conflating the two is dangerous. To some degree, the concept of Negative Churn is a response to companies having difficulty calculating a churn rate. Calculating churn is never as easy as it seems it should be. There are two types of churn that are critical to measure and analyze, each separately.

Customer Loss Churn

Customer loss churn is the easiest type of churn to understand and measure. Customer loss churn occurs when a customer is no longer a customer and all of the revenue (MRR and otherwise) that the company earned from that customer is no longer.

class=”mathtex-equation-editor” src=”” alt=”Customer\,Loss\,Churn = \frac{MRR\,Lost\,From\,Customers\,who\,Terminated\,Services}{MRR\,at\,the\,End\,of\,the\,Prior\,Period}” align=”absmiddle” />

Customer loss churn can be measured in terms of either customer count or revenue; the revenue version used above. Unless your customers are homogeneous in terms of their monthly revenue, the revenue-based version of Customer Loss Churn is a far better indicator of the impact of churn on your business.

Revenue Churn

Revenue Churn occurs when the revenue you receive from a customer falls in total dollar amount. Several factors drive Revenue Churn. Common examples including a customer using less of your service (fewer seats, lower utilization, etc.), and a customer renegotiating the rate at which they buy from you downward. The customer is still a customer, but you’ve incurred a revenue reduction. I recommend that for each period over which you are measuring churn that you capture all of the Revenue Churn from customers whose revenue declined during a period and state it as a % of the MRR at the end of the prior period.

class=”mathtex-equation-editor” src=”” alt=”Revenue\,Churn= \frac{MRR\,Lost\,From\,Customers\,who\,Decreased\,in\,Revenue}{MRR\,at\,the\,End\,of\,the\,Prior\,Period}” align=”absmiddle” />

Once you have each of Customer Loss Churn and Revenue Churn nailed, you can add them together and derive Total Churn.

class=”mathtex-equation-editor” src=”” alt=”Total\,Churn = Customer\,Loss\,Churn + Revenue\,Churn” align=”absmiddle” />

Installed Base Growth/Decline

So now that we’ve got churn nailed, lets turn attention to the organic growth/decline conundrum that the concept of Negative Churn was designed to address. One of the great facets of SaaS businesses is that they have the potential to capture more share of wallet from their customers over time. In my experience greater share of wallet comes from three primary sources:

  • Higher Utilization: Many SaaS models have a utility based component to their pricing model. Utilization can be based on an unlimited number of factors including, but not limited to the number of transactions processed, cpu/storage utilization, etc. Higher utilization means more revenue.
  • More Seats: Most SaaS models have a seat-based component to their pricing. The more seats (users), the higher the cost to the customer.
  • Cross-Sell: SaaS companies should strive to capture greater share of wallet by selling other services that are adjacent to the core service offering, thereby capturing additional revenue per customer by providing a broader array of services those customers demand.

Whatever the source, it is important to measure and maximize revenue increases that are attributable to these sources. One can capture these revenue increases in a factor I refer to as Revenue Lift.

class=”mathtex-equation-editor” src=”” alt=”Revenue\,Lift = \frac{MRR\,Gained\,From\,Customers\,who\,Increased\,in\,Revenue}{MRR\,at\,the\,End\,of\,the\,Prior\,Period}” align=”absmiddle” />

Revenue Lift is the opposite of Revenue Churn. Just like Churn can never be a positive, Revenue Lift can never be a negative number, because the numerator includes only those customers whose revenue increased during a particular period and is therefore a positive number.

Organic Growth/Decline in the Installed Base

Now we can answer the question that Negative Churn is trying to address: What is the organic growth/decline in revenue from our installed base of customers? Given that we’ve done the work to parse apart Customer Loss Churn, Revenue Churn and Revenue Lift, the remaining work is a snap.

class=”mathtex-equation-editor” src=”” alt=”Organic\,Growth/Decline = Revenue\,Lift – Revenue\,Churn” align=”absmiddle” />

Stated as a percentage:

class=”mathtex-equation-editor” src=”” alt=”Organic\,Growth/Decline\,Rate = \frac{Revenue\,Lift – Revenue\,Churn}{MRR\,at\,the\,End\,of\,the\,Prior\,Period}” align=”absmiddle” />

If the Organic Growth/Decline calculations results in a positive number, congratulations, the revenue from your installed and continuing base of customers is increasing; you have organic growth in your installed base. Lets also hope that your new logo bookings more than offset your Customer Loss Churn. If the Organic Growth/Decline calculations results in a negative number, you have Organic Decline in your installed base. In order to fill the hole, you need to book an even greater amount of MRR from new logos to offset your Customer Loss Churn and Organic Decline in revenue from your installed base

Note that I prefer to exclude Customer Loss Churn from the Organic Growth/Decline calculation because I prefer to evaluate the revenue trend for customers who have made the choice to continue to be customers in isolation from Customer Loss Churn. I’m not suggesting ignoring Customer Loss Churn; quite the contrary; by isolating it, you have to focus on it. In fact, you need your bookings from new logos to fill the hold from Customer Loss Churn and then some, if your business is going to grow.

Organic Growth/Decline vs Negative Churn

For me, Negative Churn tries to accomplish too much with one statistic. And because the results of the Negative Churn calculations can actually be a negative number (i.e. Negative, Negative Churn), I strongly prefer the Organic Growth/Decline calculations above to the Negative Churn construct.  I don’t argue with the intent behind the concept of Negative Churn; the intent is good. I just believe that looking at Organic Growth/Decline in revenue from an installed user base and each of its component parts can yield far greater insight and understanding.

I should add that the statistics presented here aren’t comprehensive for understanding Organic Growth/Decline. It is important to understand the distribution of where both Revenue Churn and Revenue Lift are coming from. If Revenue Churn is highly concentrated among a small set of customers, it is important to understand but perhaps not a crisis. On the flip-side if Revenue Lift is concentrated among a small number of customers it might not be repeatable, so you should stop the high-fives immediately. You should always take a look at the distribution and dispersion of Churn and Revenue Lift across your customer base as well as the root causes behind the results.

Other Negative Churn Resources

Much has been written about negative churn. From what I can gather, Dave Skok of Matrix Partners first coined the term in a 2012 post about <a
title=”Why churn is SO critical to success in SaaS” href=”” target=”_blank”>Why churn is SO critical to success in SaaS. Tomasz Tunguz of Redpoint wrote a piece focused on <a
title=”Negative Churn” href=”” target=”_blank”>Negative Churn as did <a
title=”Negative SaaS Churn” href=”” target=”_blank”>Lincoln Murphy of Sixteen Ventures. There is a lot of good stuff in these posts and others that I’ve read. They key take-away is that if you can drive net positive organic growth in your installed and continuing base of customers, you win, particularly if you continue to acquire new customers at a rate that exceeds your Customer Loss Churn.

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Throw Out Your 2015 Strategy and Budget Right Now

The arrival of a new year (and the beginning of a new one) brings a flurry of cognitive churning. As individuals, we 1/ reflect on the year passed, 2/ ritualistically write and read predictions for the next year, and 3/ make resolutions and set goals that are intended to inspire us to greatness during the next twelve months.

I’ve come to see this all as distinctly human but also quite strange. 1/ We can’t do anything about what happened in the past, and many of our “reflections” end up being revisionist history. 2/ The predictions we make – at least the most interesting of them – are almost invariably wrong, but we make them anyway as a way to either “exert control” on our world or to show others how smart we are. 3/ Resolutions simply <a
title=”Resolutions don’t work” href=”” target=”_blank”>don’t work. Most are actually a mild form of self-flagellation. We list the things we “should” do that we didn’t do during the last year as if beating ourselves up for not having done them will result in a desired behavior modification. My sense is that for most people, little good comes of this, yet we repeat the rituals annually.

Companies go through a similarly strange year-end rituals. In the case of companies, the effort is focused on strategic planning and budgeting. The same reflection on the prior year, prediction of future events and goal-setting ensues and in many cases, with equally predictable results. Companies that simply go through the motions often rationalize prior years results, 2/ Make unreliable and sometimes unfounded predictions about the future and 3/ Set goals and objectives that are “shoulds”, rather than will-full organizational commitments.

I’m in search of ways to have these individual and corporate year-end rituals be more productive. I don’t yet have all of the answers. On the corporate side of the ledger, I know that I’ve seen the strategic planning and budgeting process executed well and very poorly. It really comes down to how the strategic planning and budgeting process inform the Company’s direction during the following year. Getting it right takes patience and intention.

Patience Over Rigidity

Patience is critical. January 1st is one of 365 days we could have chosen to begin our tracking of earth’s orbit around the sun. There is nothing special about January 1st, yet we treat that date as if it is fundamentally different from December 31st, 2014. The whole planning and budgeting calendar gets calibrated around delivering an approved budget by the start of a the new year. There is some merit in having deadlines for sure. But I’ve also seen too many companies rush through the planning and budgeting process because of arbitrary deadlines. I’m not suggesting that the planning and budgeting process shouldn’t have a sense of urgency; they should. But lets not pretend that the arbitrary dates we set for the planning a budgeting cycle are fundamental at the expense of thoroughness and solidarity. A management team must spend a lot of time together before they can gel around a strategy, developing the buy-in that is necessary for unified action. The process or driving organizational alignment doesn’t always fit into or nice, neat planning calendars.

I’ve also seen many occasions where a management team tries to force a breakthrough during the strategic planning process. My experience is that breakthroughs don’t happen during formal planning processes; they happen organically when they happen. Breakthroughs are inherently unpredictable. Companies need to be open to breakthroughs occurring organically outside of the formal planning process, rather than trying to force them according to schedule.

Seeing the flaws in the formal, calendarized planning and budgeting ritual leads me to think of strategy and fiscal management as an every-day activity, not a once a year activity. Strategic planning should come out of its “off-site” conference room hiding place and into the light of the every-day discussions between the members of a management team. When strategy is an every-day activity, the planning process becomes about tweaks and alignment rather than major breakthroughs.When strategy is brought into every-day discussions, there is no need for a forced breakthrough during a scheduled planning season.

The same goes for budgeting. Budgeting is worthwhile because it forces companies to think about resource allocation, that resource allocation needing to be aligned with a strategy. But budgets are of little predictive value. This is why I vastly prefer twelve month rolling forecasts, updated monthly. It is taboo to call each new monthly forecast a budget, but it is also incredibly constructive to take a renewed look at resource allocation every single month throughout the year. After all, there is no way your budget can account for everything that will happen (both within and outside your control) throughout the next twelve months.

I’ve seen too many cases where the budget becomes the numerical representation of the script. The rigidity of the traditional strategy and budgeting process can actually be counter-productive, creating a box that makes it difficult for a management team to navigate the year in a flexibly opportunistic fashion. It is hard to stay true to an intention when the numbers have you in a box.

Intention over Tactics

style=”line-height: 1.5;”>Intention is hard to describe but easy to identify; but I increasingly feel it is imperative in both a corporate and personal setting. It’s akin to purpose. Some of the best descriptions of intention come from mindfulness practice. Deepak Chopra’s describes intention as follows:

style=”color: #333333;”>Intention is the starting point of every dream… Everything that happens in the universe begins with intention… An intention is a directed impulse of consciousness that contains the seed form of that which you aim to create.

Powerful stuff. I want some of that in my day-to-day personal life and embedded in every company in which I’m an investor. Imagine what would be possible if a management team went into every work day with alignment on “a directed impulse that contains the seed form of that which you aim to create.”

The formal strategic planning literature would probably refer to this as <a
title=”strategic intent” href=”” target=”_blank”>strategic intent, popularlized by Hamel and Prahalad:

Companies that have risen to global leadership over the past 20 years invariably began with ambitions that were out of all proportion to their resources and capabilities. But they created an obsession with winning at all levels of the organization and then sustained that obsession over the 10- to 20-year quest for global leadership. We term this obsession “strategic intent.”

At the same time, strategic intent is more than simply unfettered ambition. (Many companies possess an ambitious strategic intent yet fall short of their goals.) The concept also encompasses an active management process that includes focusing the organization’s attention on the essence of winning, motivating people by communicating the value of the target, leaving room for individual and team contributions, sustaining enthusiasm by providing new operational definitions as circumstances change, and using intent consistently to guide resource allocations.

What I like about strategic intent is that offers a clear statement of purpose for an organization without delving into the specific tactics that should be employed to achieve that purpose. But it is very hard for an organization to keep its attention on purpose, allowing the tactics to evolve as necessitated by circumstances. But rigidity in tactics is a death-knell in fast-moving markets. And this is the core of my beef with traditional strategic planning; I’ve seen too many cases where strategic planning becomes tactics planning where each and every move to be executed by a company throughout the year is “scripted”. Scripting tactics might work in a 30-90 day window, but beyond that, it is a futile effort. Worse, it is damaging if a management team and/or board feel obligated to have the company follow the script despite changes in circumstances.

Alignment and Flexible Opportunism

I don’t have all the answers for how to build more patience and intention into the strategic planning and budgeting process. But I know the desired outcome. I want a process that results in the organization being aligned on a core sense of purpose and creates a platform for the organization to be flexibly opportunistic. I’m not convinced that traditional strategic planning and budgeting are the right tools for the job. And so my search for the right tools, both in my personal and corporate life goes on.

In the meantime, be purposeful and adaptable in 2015. No matter what your strategy and budget say, the year will end well if you and your organization are purposeful and adaptable each and every day throughout the year.

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Kindred Disciplines: Growth Equity and Growth Hacking

Growth hacking is now a mainstream term in tech circles, particularly those that are consumer-focused. Growth hacking definitions abound, but generally emphasize a data driven, creative and flexibly opportunistic approach to customer acquisition. Many would argue that growth hacking is simply a new term for an old concept – marketing. While the functions, tools and skills require for growth hacking may be essentially the same as “marketing”, the psychology and mission of growth hacking feel totally different to me. When I hear “marketing”, I think soft, fuzzy, ambiguous, and cost center. When I hear “growth hacking”, I think maniacal focus on growth, scrappy, data driven, tech/tool savvy, and creativity bordering on irreverence. The difference in psychology isn’t an indictment of traditional marketers; most of the marketers I know have a growth hacking mentality. But in the broader context of what it takes to be successful in a growth stage businesses, the difference in psychology and mission matter.

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Vulnerability and Entrepreneurship

I was browsing through the new Tattered Cover store in the recently renovated Union Station in Denver a few weeks back and found myself standing in the Business Psychology section of the store. For some reason, I have a habit of finding that section without trying – gravity seems to pull me there. In any event, I started thumbing through a book by Brene Brown, named Daring Greatly. The subtitle of Daring Greatly reads: “How the courage to be vulnerable transforms the way we live, love, parent and lead.” There aren’t many books that stand-out to me as having altered my world view; Daring Greatly definitely did.

I had not heard of Brene Brown’s work before I picked up the book. Brown is a researcher professor at the University of Houston Graduate College of Social work and has spent the past the past ten years studying vulnerability, courage, authenticity and shame. This is pretty delicate subject matter; the kind of stuff our culture causes us to fear talking about an open, authentic and empathetic way. But her work strikes me as incredibly important as we struggle to counter-balance cultural cues which cause us to suppress self-doubt and hide insecurity in favor of bravado (false bravery). The book also includes important insights for entrepreneurs and leaders.

There are so many great takeaways from the book and one has to read it to get the full picture. For me, several concepts stood out.

  • Vulnerability and weakness are not one in the same, despite the fact that our culture confuses the two. Expressing vulnerability is a constructive process, not a character flaw.
  • Shame is the greatest barrier that impedes our willingness/ability to make ourselves vulnerable. Fear of shame causes us to hide our vulnerability from others.
  • Shame and guilt are not one in same. Shame says: I am [bad, lazy, fill in the blank] and there nothing I can do about it. Guilt says: I did something bad and, I don’t want to do it again and it is within my power to change the behavior that led to the bad act. Shame hides in a corner trying to stay out of sight, guilt is self-correcting.
  • We admire vulnerability when we see it in others, but we abhor seeing it in ourselves. We are blind to the fact that coming to grip with our vulnerabilities makes us stronger.
  • We all have shame… yes you too. Shame is the enemy. The way to defeat shame is through dialogue. Shame hates being outed, so in order to defeat shame, we have to talk about it.
  • One cannot be courageous until they are willing to make themselves vulnerable. Vulnerability is the root of courage. You have to be willing to make yourself vulnerable before you can dare greatly.

It helps to look at this through the lens of an entrepreneur. Entrepreneurs take on incredible risk when they start a business, because the risk of failure is so high. Our society abhors failure and as a result fear of a failure is a huge shame trigger for most people. Entrepreneurs must to overcome this fear of failure (and the social stigma associated with failure) before they even start. They must be able to say to themselves:

I am passionate about what I am doing. Although I will strive to succeed, I might fail. But if I fail, I will do so knowing that I have the pursued my passion, given my best and that is enough for me, regardless of what others think.

IMHO, there is no shame in failure for an entrepreneur. Quite the contrary, entrepreneurs should take great pride in their accomplishments regardless of the eventual outcome of their work. This philosophy which permeates healthy entrepreneurial cultures is well summed up by a quote from President Theodore Roosevelt’s Man in the Arena speech.

It is not the critic who counts; not the man who points out how the strong man stumbles, or where the doer of deeds could have done them better. The credit belongs to the man who is actually in the arena, whose face is marred by dust and sweat and blood; who strives valiantly; who errs, who comes short again and again, because there is no effort without error and shortcoming; but who does actually strive to do the deeds; who knows great enthusiasms, the great devotions; who spends himself in a worthy cause; who at the best knows in the end the triumph of high achievement, and who at the worst, if he fails, at least fails while daring greatly, so that his place shall never be with those cold and timid souls who neither know victory nor defeat.

– Theodore Roosevelt

If you don’t have the time or inclination to read Daring Greatly, I’d encourage you to listen to Brene’s TED talk on vulnerability. I’m betting hearing her speak will cause you to want to read the book.

Kudos to Brene Brown for going to the uncomfortable places in human psychology. It is no surprise that a thoughtful look at what makes us most uncomfortable can lead to so much insight.

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Founder Liquidity and Growth Equity

class=”size-full wp-image-937 alignright” style=”line-height: 1.5em;” alt=”Founder Liquidity” src=”” width=”192″ height=”191″ />I’m seeing more and more growth equity financings come to market with an over-sized <span
style=”line-height: 1.5em;”>component of the <span
style=”line-height: 1.5em;”>financing allocated to existing shareholder liquidity. I’ve seen enough of thes<span
style=”line-height: 1.5em;”>e transactions to consider it as a trend and to wonder what is motivating it.

Founder Liquidity in Context

style=”line-height: 1.5em;”>Whereas liquidity isn’t typically a feature of venture financings, it is  often – but not always – a feature of <a
title=”Ready For Growth Equity” href=”” target=”_blank”>growth equity financings. A modicum of liquidity for key management team members or founders can act as lubricant for a growth equity investment, particularly where the management team founded and has successfully bootstrapped a successful business. The founder liquidity component of a financing can de-risk a management team’s personal balance sheets, enabling the team to rationalize the dilution and loss of control that are inherent in taking growth equity capital. So, how much liquidity is reasonable?

How Much Founder Liquidity Isn’t Too Much?

The answer depends on whether the management team wants to be part of the Company going forward. Presuming that management desires to be involved or is required to be involved, then it is reasonable for the founders to pursue an amount of liquidity that de-risks their personal balance sheets, subject to ownership considerations. I like to look at the specific use of proceeds for the founder liquidity component of a financing. A short list of good and reasonable uses of proceeds follows:

  • Pay off the mortgage, second mortgage;
  • Pay for kids college education; and
  • Pay off credit card debt.

The logic behind this short list is that a management team member that doesn’t have to think about providing shelter or education to his/her family will be happier, more productive at work and able to dedicate the time, attention and effort to the business that is required of growth-stage entrepreneurs. A modicum of founder liquidity in the context of a true growth equity financing can serve the entrepreneur and investors well.

That said, the amount of liquidity that is reasonable must be measured in relation to the seller’s total ownership stake in the business. It is imperative that a management team member who is critical to the business’ ongoing success retain the majority of their ownership in the business. In some cases, this requirement may limit the amount of liquidity that can be made available. In general, I feel it is reasonable for a founding management team member to sell between 5% and 25% of their ownership stake in the context of a growth equity financing. If a founding management team member wants to sell more than 25% of their stake, one has to wonder how much the team believes in the business future.

If the founding team wants to sell more than 25% of their stake and a $ value that exceeds the de-risking level outlined above, the transaction may be best structured as a control transaction, rather than a classic growth equity investment. There is nothing wrong with a founder pursuing a full control sale; it just means that institutional growth equity firms aren’t the right target investors for the opportunity.

What is Driving the Drive Toward Liquidity?

As I said, recently I’ve seen more and more investment opportunities positioned as growth equity financings with unusually high founder liquidity requests. It is my sense that this trend is driven by increasing – and in some cases unrealistic – expectations on the part of founding management teams. More often than not, the unusually high liquidity requests are associated with opportunities represented by investment bankers. Perhaps there is some self-selection bias here – entrepreneurs who desire liquidity see the need to engage a banker. Or, perhaps the bankers – seeing a hot market – view founder liquidity as a way to increase deal-size and their transaction placement fee. I can’t say which – if either – of these dynamics is at work. My best guess is that both dynamics are factors and that they are mutually reinforcing.

For the most part, the market is remaining disciplined, at least in the segment and company size range where my firm, <a
title=”Growth Equity Firm | Meritage Funds” href=”” target=”_blank”>Meritage Funds, is operating. Regardless, the frequency with which I’m seeing unusually high requests for liquidity can’t be interpreted as anything other than hot market conditions exerting their influence on banker and seller expectations.

First Thing First

The focus of growth equity investments must, first and foremost, be on providing the company with adequate capital to execute an accelerated growth plan. Founder liquidity can be an important, albeit secondary, consideration in such a financing. The company’s capital needs come first.

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rel=”nofollow” href=””>Founder Liquidity and Growth Equity appeared first on <a
rel=”nofollow” href=””>Non-Linear.

What is an entrepreneur to do when restrictive covenants become restrictive

Restrictive Covenants - HandcuffsRestrictive covenants are standard features of venture capital, growth equity and private equity transactions although each investor type has its own standards. Restrictive covenants are the actions a company cannot take without investor approval. A short list of typical restrictive covenants includes:

  • A sale of a Company or sale of a majority of the Company’s assets;
  • Sales of new securities;
  • Changes to Articles or Incorporation that change the rights and preferences of existing securities;
  • Changes in Board Composition;
  • Payment of dividends or any kind of not previously agreed to distributions;
  • Changes to the size of option and other incentive plans;
  • Incurrence of indebtedness above a certain dollar threshold; and
  • Transactions with affiliates.

These covenants are described as “restrictive” because management and the board are precluded from taking these actions without the express approval of the required shareholder (or group of shareholders voting as a class). The purpose of restrictive covenants is not to “restrict” a Company from being able to operate. Rather, restrictive covenants are intended to protect investors from management/board actions that a) cause value to leak out to junior shareholders or managers without value accruing to the senior shareholders; b) change the terms of a previously agreed to investment documents, or c) cause dilution to the value of an equity holders position.

Where management and investors are aligned, these restrictive covenants are rarely (if ever) an issue. Only where a management team and investors are mis-aligned do these terms come into play. In my experience, this happens most often when an investor doesn’t want to participate in a financing and is facing a highly-dilutive financing as a result. The investor may seek to block such a financing even though they do not intend to provide the company with additional capital. A management team is totally handcuffed in cases like this and the business may be at risk of running out of money and hitting a wall. What is a management team to do if an investor is leveraging restrictive covenants as hold-up value?

  1. Get Re-Aligned: The best starting place is to work with your investor to re-align expectations. If your investor is of an institutional variety, chances are they will work to understand your issues and accommodate what you are working to accomplish. After all, the death knell for an investor is for word to get out that they are holding up one of their portfolio companies.  Likewise, it is critical that you take the time to understand your investor’s point of view. It is possible that they are protecting you from yourself. If you have already tried getting re-aligned and failed, try again!
  2. Give the Investor a Hard-Choice: For example, if an investor won’t approve a financing despite the fact that they won’t/can’t participate, the best thing to do is to put a term sheet in front of the investor and ask for their approval. Take the term sheet to the board first, have it approved and then seek shareholder approval. Most times, an investor faced with the decision to either bless a financing already approved by a Board or blow it up will make the right call.
  3. Offer to Buy-Out the Investor: In the worst of scenarios, it may make sense to buy the investor out of their position. This is a version of a hard-choice. You may not have the cash to pay a very high price, but that is exactly the point. The fact that you can’t pay much creates huge negotiating leverage for you.
  4. Leave: Working for an investor backed-company isn’t indentured servitude. If an investor is holding you up via restrictive covenant, you can leave. This is the hardest of all decisions because you probably have a lot of blood sweat and tears invested in the business. Don’t do this if your business is already successful and one of your investors is just being belligerent. In that case, try options 1, 2 and 3 again and again until you crack the code. This is also not permission to leave if there is a clear fiduciary responsibility that you should carry out before departing, like winding the business down if the business is insolvent.

I’d call out that nowhere on list is “lawyer-up and figure out a loophole” in the restrictive covenants. There is probably not a loophole to jump through in the first place. Even if there were, using a loophole usually makes matters much worse and gives leverage to the uncooperative investor.

I’m not advocating for bad behavior on the part of a management team and I don’t feel any of the actions recommended above can be characterized that way. An investor that is intentionally holding up a management team without a very, very, very good reason is exhibiting the worst kind of behavior. Sometimes the only way to get to a resolution is to escalate first. Having never gotten into a tussle with a management team over restrictive covenants makes it easier to make the recommendations suggested here.

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What Entrepreneurs Can Learn From Peyton Manning

I’m not a huge football fan. But I do marvel at the drama of professional football. 

In particular, I admire what Peyton Manning has done for the Broncos the past two years. His individual contributions are well documented. But what I’ve been most impressed by is the positive impact he seems to have had on the rest of the team. Sports are a great metaphor for many aspects of life. In this case, entrepreneurs could learn a lot from Peyton Manning and the leadership he’s brought to the Broncos.

  • Sense of Urgency: Manning has had one goal since he arrived in Denver and he’s pursuing it with maniacal focus. Set a goal and pursue it fervently.
  • Be Precise: In an era where many NFL quarterbacks are making an impact with pure athleticism (Cam Newton, Kapaernick, Russel Wilson), Manning makes an impact with precision. The  Bronco’s offense is a meticulous yardage producing machine. You can’t single-handedly carry your company and win consistently. Inspire execution precision across your entire team and your company will perform. Run your company with the level of precision that Manning runs the Bronco’s offense and your company will be a capital efficient value-creation machine.
  • Have a Contingency Plan: Manning is better than any other quarterback in the league at running through his progressions (the contingency) so that if the play does’t work as designed, he can check-off to another receiver. Always have a contingency plan; just in case your first attempt doesn’t work out as intended.
  • Peyton Manning hot tubWork Ethic: Manning has a reputation for working harder than anyone else on the team. This is a guy who, on his one-day per week off practice, can be found soaking his injured ankle in a hot-tub with his helmet on and iPad listening to his offensive coordinator call practice for the rest of the offense. With the level of success he’s had, he has every right to slack off every now and again, but he doesn’t. We should all set such a high bar for ourselves.
  • We not I: Listen to Manning at a press conference. This past week, all of the talk was about Brady-Manning. All Manning wanted to talk about was the team. Whenever possible, he accepts blame that shouldn’t be put on him and deflects praise directed toward him on others. Corporate leaders can/should do the same.
  • Be Selfless: What Manning does better than any quarterback in the league is take what the defense give him. If the defense wants to play 7 defensive backs, he’ll run the ball. If they want to crowd the line of scrimmage, he’ll throw it. He adapts, on a dime, and runs whatever play the circumstances call for. He’s not interested in how he looks when he audibles, but rather that the play is the “right” one for the situation. The point here is that more often than not he makes the right call regardless of how it affects his own personal stats. In the end, the only way to “look good” is to have your company perform. The selfless call is more often than not the right right call.
  • Set an Expectation of Greatness: You sense that Manning’s high expectations for himself extend to everyone around him. He doesn’t accept mediocrity from anyone. Remarkably, everyone around him seems to rise to the challenge. I’m a big believer that people will behave the way you expect them to. If you expect greatness, they will perform great, if you expect mediocrity, they will perform just well enough to get buy.

In full disclosure, I grew up a fan of the lowly Detroit Lions. They will forever be my “home-team” and rank ahead of my “adopted team, the Broncos. So this isn’t some kind of fan-boy post. I’m not sure Matthew Stafford’s leadership offers a whole lot of learning for entrepreneurs.

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