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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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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Workhorse Capital Invests in Datavail

DatavailWorkhorse Capital is pleased to announce the completion of its first investment; a $7.2 million investment in Datavail Corporation. Datavail is the largest independent provider of remote database administration managed services in North America. Tahosa’s investment in Datavail is part of a $47.0 million growth recapitalization led by new investor, Catalyst Investors. New investor, Lumerity Capital and existing investors, Meritage Funds and Boulder Ventures also participated in the financing.

My relationship with Datavail started through my work at Meritage Funds. Meritage led Datavail’s Series C financing in 2011. I became more deeply involved with the company in 2013 upon my return to Meritage after having run a portfolio company for 16 months. At the time, Datavail had executed several acquisitions of smaller database managed services providers. The working thesis at the time had been to scale the business primarily through acquisition based growth. The acquisitions that the company made were certainly worthwhile, particularly in helping the business to achieve minimum efficient scale. However, it was clear that acquisition based growth strategy would ultimately become limiting and expensive and that the company would have to execute on other growth vectors if it was to achieve its highest potential.

Early in my involvement, it became apparent that Datavail had developed an under-appreciated core competency, the ability to predictably and profitably acquire enterprise class database administration customers at low cost. Datavail has always excelled in customer satisfaction and delivery. Adding a repeatable and scaleable organic customer acquisition capability to the core operating and delivery platform had the potential to create significant value. Through Mark Perlsetein (CEO) and the team’s superb execution, the Company proved its organic growth capabilities, and was able to garner additional internal financing to invest more aggressively in organic growth initiatives. The results is that the company has grown meaningfully over the past two years and with an attractive LTV/CAC ratio.

My relationship with Mark Perlstein, Datavail’s very capable Chief Executive Officer was cemented during our work on the organic growth strategy. We worked together to put the metrics, measurements and decision-tools in place to support the company’s organic growth aspirations. Getting the building blocks right on the front end has helped the business to direct its organic growth investments toward the most productive channels. It is great to see that work proving its worth.

As exited as I am about Datavail’s recent performance, I’m even more excited about the company’s prospect going forward. There are a number of reasons to be optimistic.

  • World-class Team: Mark Perlstein (CEO), Datavail’s CEO has put together an A-quality team across the board. Mark, Keenan Phelan (COO), and Andrew Evans (CEO) do a fantastic job making the business strategically relevant while also making sure the trains run on time. Robin Caputo (CMO) and David Boyle (SVP Sales) constantly improve the customer acquisition process and drive the revenue generation machine with a high degree of precision.
  • High Quality Scaleable Service Delivery Platform: Datavail has built a world-class service delivery operation and infrastructure. With 24×7, global delivery, the Company can meet its customers needs in any location and in any time zone. The company has really differentiated itself in the marketplace in its ability to serve a broad array of needs of mid-market and large enterprise customers.
  • Repeatable and Scaleable Organic Customer Acquisition: Datavail has not only built a world class service delivery platform but also a machine-like customer acquisition engine. With an LTV to CAC in excess of 5.0x, Datavail is poised to continue to grow as it enhances its investments in organic growth.
  • Great Partners: I’ve known the team at Catalyst Investors for many years. Tyler Newton, who led the financing on behalf of Catalyst is a capable and thoughtful investor. Matt Kim of Lumerity is also a long-time friend and colleague in the business. I’m pleased to have Tyler, the entire Catalyst team and Matt as a partners in this investment. I’m also looking forward to continuing to work with Jack Tankersley of Meritage Funds and Peter Roshko of Boulder Ventures. The investor group shares a common purpose to support this management team in taking Datavail to the next level.

I’m really pleased that Datavail is the first investment for Tahosa Capital. I’d go so far as to say I’m proud of it. The investment nicely fits Tahosa’s core focus of investing in growth-stage technology-enabled services businesses. Less than six months after Tahosa Capital’s launch, I’m grateful for the opportunity to be an investor in such a high-caliber company and with the quality management and investment partners around the table.

Congratulations to the entire Datavail team!

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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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A Success Story for Private and Growth Equity

The Minnetonka company Shock Doctor has just passed into the hands of its third private equity owner in the past 11 years, and the managing partner of the new owner couldn’t be more excited about the growth opportunity he intends to nurture.

And in talking about it, he sounded a lot like the partners of the last two private equity owners of this company, who bought the business with a similar plan for growth — and achieved their goals.

Building growth companies isn’t the kind of thing the private equity industry usually gets much credit for doing, but it should. The story of Shock Doctor shows there are other ways for the smart guys to make money in private equity besides leveraging an investment with a ton of debt or squeezing costs out of a company.  Read More…

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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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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Basics of Unit Economics Analysis

When an investment passes our first-screen at Meritage Funds, the first deep-dive we typically do is on the unit economics of the business. Unit economics are the fundamental financial building blocks of a business. If you can pin down the unit economics, you can determine contribution margins, break-even points and perform ROI calculations all of which can help to determine whether a Company’s economic engine works. Without an understanding of unit economics, predicting whether a business can be profitable in the long-term is all guess-work.

I’m a believer that every business – no matter the scale – should have a point of view on its unit economics. That includes you startups. However, the concept is not as easy to apply as most hope and is frequently mis-applied. Here are some basic principles I use when thinking about unit economics.

What is your unit?

The following is a master of the obvious statement; building unit economics requires you to first pick the unit. I recommend picking a unit at which the company has its most significant level of marginal investment.

For example, for consumer focused businesses the best unit is typically as single customer. The investment at the customer level is customer acquisition cost (CAC) and for businesses that deliver a physical good, the cost to deliver the product. A customer-level unit also typically works well for enterprise focused businesses.

Some businesses require multiple unit measures. For example, an infrastructure service provider that has a geographically distributed physical infrastructure (data centers, cloud, wireless towers, etc.) have significant marginal capital investment for each new deployment. As a result, these businesses should use each unit of physical infrastructure as their core unit and within each, use a customer unit as a secondary unit.

Key unit economic model assumptions

Identifying the level of unit economics is the easy part. Getting the calculations right is a different matter. On the outflow side, the inputs are:

  • Capital Expenditures: The up front capital cost to create the unit. For an infrastructure style unit economic model, this would be the capital expenditures required to build the unit.
  • CAC: The initial, pre-revenue cost to acquire a customer. For a customer unit economic model, this is the fully loaded customer acquisition cost, including variable sales, marketing, and implementation costs that can be directly attributable to customer acquisition and on boarding.
  • Marginal Operating Costs: This is the ongoing marginal cost to serve the customer or to operate the infrastructure over the life of the unit.
  • Maintenance CapEx: Physical assets degrade over time. As a result, for an infrastructure business, it is important to factor maintenance CapEx into the unit economic model. This is the amount of CapEx required over time to keep the infrastructure operating at a suitable service delivery quality.

On the in-flow side, the inputs include:

  • Revenue: No need to explain, although I do advocate that companies put together a fairly detailed set of revenue drivers in their unit model; a topic for a different post.
  • Duration: When building a unit economic model, it is important to know the usable life of the unit. In an infrastructure model this is the useful life of the asset, factoring in the maintenance CapEx. In a customer unit model, this is the average customer life. Duration or Average Customer Life in a customer-driven unit model is the flip-side of churn-rate, where the relationship between the two is captured by the following equation:

1/churn rate = average customer lifetime

It is important to note that the average customer lifetime will be in whatever time period you use for your churn rate. Input a monthly churn and get a customer life in months. The churn rate required for this calculation is a customer count churn rate, as opposed to a revenue churn calculation. I could spend several posts solely on how to calculate churn.

  • Growth/Decline: You may believe that revenue per unit will increase or decease over time. This is critical to reflect in your unit model.

Each of the inputs require their own set of calculations. Setting aside the details, what we’re driving toward is a unit economic model that helps us perform some business model viability calculations.

Does your unit hunt?

Once I have the unit economic model inflows and outflows set, I like to lay them out in a time series, showing each inflow and outflow on its own line item. Sum them all up and you get to contribution margin. Contribution margin is the amount of cash that a unit contributes to covering corporate overhead expenses. I look at is the number of months it takes for the unit to produce a positive contribution margin and the number of months it takes for the unit to return whatever up-front investment that was required to produce it. The month in which a unit generates a cumulative positive contribution margin is the payback month.

With some additional math you can calculate the number of units that are required to bring the entire business to profitability. To do so, simply divide the company’s fixed overhead by the unit contribution margin. Finally, for capital-intensive businesses, particularly infrastructure businesses, it may be useful to calculate a return on investment for a unit.

Again, each of these calculations has its own set of detailed mechanics behind it. The point I want to make here is that you can’t begin to know whether your business economic engine works until you’ve built a unit economic model. If you are considering raising growth capital, start building your unit economic model today. You’ll be thankful you did the work when a prospective investor asks to see it. Any growth stage investor worthy of investing in your business will surely ask.

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Growth Equity Investors are Hedgehogs; VCs are Foxes

Growth equity is increasingly being recognized as an investing discipline that is separate and distinct from venture capital. That being the case, how does one distinguish between a venture capitalist and a growth equity investor. In my mind, growth equity investors are hedgehogs; venture capitalists are foxes. Allow me to explain.

Ever since I read Jim Collins’ book Good to Great, I’ve been fond of Isaiah Berlin’s parable of the Hedgehog and the Fox. The story of the Hedgehog and the Fox revolves around a quote fragment attributed to the Greek poet Archilochus:

The fox knows many things, but the hedgehog knows one big thing.

Long-story short… the fox is cunning, sly, creative, etc. and out to get the hedgehog. By contrast, the hedgehog is – on the surface – mundane, plodding, un-inspiring and looks like easy prey. However, every time the fox tries to attack the hedgehog, the hedgehog responds consistently and effectively by turning into an impenetrable ball of quills, rebuffing the fox time and time again. No matter what tactic the fox tries, the hedgehog “wins”. Hedgehogs don’t do a lot of things; they don’t have the broad repertoire of skills that foxes have. However, they do turn into an impenetrable ball of quills really, really well.

Collins applies the parable to a business context, arguing that companies that are Great (as opposed to good) have hedgehogs as their leaders. Those hedgehogs are able to make a complex world simple, by creating a unifying view of the world and driving single-minded execution in their organizations. Long-term success in these hedgehog businesses comes from relentless and effective pursuit of that execution focus.

Venture capitalists are foxes

Venture stage businesses experience significant uncertainty. That uncertainty necessitates frequent strategy shifts and changes in execution focus. Rare is the case where an early stage business gets the formula right the first time. The skill-set and mindset of venture investors must accommodate this reality. I’d make the case that successful in venture investing requires a skill-set and mindset that is more akin to the fox than the hedgehog. It’s all about broad experimentation, trial-and-error, pattern recognition and connecting dots. It is a gut instinct driven process. Act, evaluate, re-calibrate, repeat…

Growth Equity Investors are Hedgehogs

By contrast, growth stage investing is about backing companies that are developing a successful, growth-generating formula and consistently and maniacally pursuing execution of that formula. Growth stage businesses need to do a few things and do them at a world class level. For the sake of capital efficiently, it is equally important for growth stage businesses to know what they are not going to do in order to maintain a narrow focus on the few things that will move the needle. Execute, execute, execute is the mantra. As a result, growth equity investors have to be hedgehogs. Growth equity investing is all about data driven decision-making and focusing management teams on a narrow set of objectives that generate profitable growth. This isn’t to say that growth stage businesses don’t experiment, they do. Their experimentation is just more data driven and graft onto a growth formula that is already working. The experimentation can’t distract from the core execution focus.

Are you a Hedgehog or a Fox?

I’m not suggesting VC and growth equity investors are in an epic battle as in Berlin’s parable. I’m also not suggesting that one is superior to the other. Hedgehogs are not better or worse than foxes, just like growth equity investors are no better or worse than venture capitalists. But, hedgehogs and foxes are different as are growth equity investors and VCs. As with most things in life, it’s all about fit between skills and scenario. Growth stage businesses benefit from hedgehog leaders and hedgehog investors. They are focused, data driven, execution minded and consistent in their pursuit of a growth formula. Venture stage businesses benefit from having fox leaders and fox investors. They are instinctive, opportunistic, and willing to change tactics quickly, frequently and sometimes with little to no data.

None of us are 100% hedgehog or fox; we all have attributes of both. I tend to lean toward the hedgehog mentality in a business context. In part, and over time, this has led me to prefer growth stage investments. Growth stage investing is a better fit with how I frame the world.

Unfortunately, none of this helps answer the timeless and timely question: What does the fox say?

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After the honeymoon

Earlier this week, I participated in a panel discussion organized by Holland & Hart, a Denver-based law firm that has a strong practice area working with entrepreneurial growth-stage businesses. The topic of the panel was “After the Honeymoon”, focusing on investor/entrepreneur relationship dynamics in the critical period following the closing of an investment or acquisition transaction. Also on the panel with me were Matt Hicks of Excellere Partners and Flint Seaton, CFO of Accellos, an Accel-KKR backed business.

The discussion was principally focused on investor/entrepreneur relationships in the context of growth equity style investments. We had a wide-ranging discussion hitting on topics that included financial forecasting, strategic planning, executive team recruiting, and many others. Each of those specific areas matters a great deal. But no matter which element of the work that goes on between investors and entrepreneurs during the post-investment period the panel discussed, the conversation returned to two key concepts – alignment and trust. Alignment and trust set the tone for how investors and entrepreneurs work together. Investor/entrepreneur coordination works great when both are in place and poorly when either is not.

Alignment is a straightforward concept, the goal being to harmonize expectations between the investor and the entrepreneurs. But it doesn’t just happen. You don’t stick and investor and an entrepreneur in a room expecting that they are automatically “aligned”. Creating alignment takes work. Trust is a more nebulous concept. But suffice to say that once trust between an investor and an entrepreneur is violated, it is hard to recapture. There are more ways than you can count to violate trust.

So how does are investors and entrepreneurial management team’s supposed to derive alignment and trust? It is my strong opinion that if an entrepreneur is working to drive alignment and build trust with an investor (and vice-versa) after a transaction has closed, it is already too late. The time to begin working on the fundamental building blocks of a successful entrepreneur/investor relationship is before the transaction gets closed. The benefit… everyone knows what is expected of them day 1, day 30, day 100, … and there is no lag between the Company taking capital and management’s execution of an agreed to plan of attack.

We like to perform a strategic planning session with management teams we want to back before the investment closes. We expect that our management teams to use the results of the strategic planning to derive operating plans. We do this annually with each of our portfolio companies, but in the case of a new investment, we expect that the strategic plan be crystallized into a 30-60-90 day post investment execution plan before the investment closes. The benefit of going through this exercise (which is a lot of work for everyone) is that management and the investors know exactly what to expect of each other during the critical months following the investment. There is also a built-in trust builder baked into the pre-investment strategic planning process. It takes a lot of trust on the part of management to bring a prospective investor into the intimate thoughts of a management team, particularly when that planning is likely happening simultaneous with a diligence process. Teams that are willing/able to go into a strategic planning session with a prospective investor are saying, through their behavior… “I have nothing to hide. I’m comfortable expressing the good, bad and ugly about my business and you are going to want to invest despite having heard it all.” An investor that goes through that process with a management team and follows-through with the investment is saying… “I know about all of your imperfections; I acknowledge them and I love you despite them.”

Pre-investment strategic planning isn’t the only way to build alignment and trust between an investor and an entrepreneurial management team, but its a pretty darn good starting point. Investors and entrepreneurs need to lay the groundwork for alignment and trust before the closing of a new investment. Everything becomes easier with alignment and trust in place… If the right alignment and trust aren’t there, don’t proceed with the investment; that goes for both entrepreneurs and investors.

Thanks to Holland & Hart for hosting the event and to Matt and Flint for being great co-panelists. I had fun participating.

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