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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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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The fallacy of averages

A discussion with a portfolio company CFO yesterday reminded me that statistics are a dangerous thing and averages are misleading.

“There are three types of lies — lies, damn lies, and statistics.”

Skewed distribution

Most businesses analyze their performance using overly simplistic tools. For an extreme example, imagine a scenario where the average customer produces monthly recurring revenue of $10,000. Well, it is one thing if the MRR of each of the individual customers is scattered tightly in a normal type of distribution around the $10k MRR level. It is another thing entirely if the distribution is skewed like in the image here. For example, what if a small handful of customers are significantly larger than all of the others and are skewing the mean (or average) upward. In such a scenario it is possible that the company is losing money on every one of the smaller customers and making a boatload of money on the larger ones. Unfortunately, there would be many more small customers than large ones (ie the median is lower/smaller than the mean).

If management’s understanding of the business is limited to the average, they might be inclined to pursue a strategy of getting more customers regardless of customer size and profitability, which could result in the company recruiting many more small, unprofitable customers. Rather than looking exclusively at averages, I suggest it is important to look at the distribution in the form of a histogram. More often than not, looking at the histogram leads to conclusions that are obfuscated by the average.

Don’t make decisions based on averages unless you know the distribution around the average is normal. If you suspect the distribution is skewed, put a histogram together and make decisions based on the histogram.

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You missed your numbers. Now what?

By now, you should know where you stand relative to your 2013 budget. Hopefully, you made it or beat it. For some, the finally tally will show a “miss to the downside”. When i say miss, I’m referring to performance against the original budget – the one you put together in December 2012. Performance against the 2013 re-forecast you prepared mid-year (hopefully not multiple times throughout the year), isa separate matter. The fact that you had to re-forecast because of  downside miss is a signal in and of itself.

So, you missed; now what? The first thing you should do is ask yourself: Why?

There are too many reasons companies miss plan to list in one blog post. Some are legit; many err on the side of “excuses”. I think it is important to attribute misses to reasons over which management had some measure of control. If you can’t control it, you can’t make a change in your execution strategy that adjusts for it. All the other “reasons” are interesting, but aren’t particularly useful, with the exception of black-swan style macroeconomic shocks, which aren’t excuses but are facts of life.  To simplify, I break down reasons for missing plan into two categories – forecasting error and execution error.

Forecasting error

A budget is a forecast with a lot of moving parts. Sales productivity, unit prices, churn, cost of goods, sales and marketing expenses, headcount, compensation levels, the list goes on. I think it is a good discipline review your budget and determine which specific assumptions (if any) are at variance with actual performance. Forecasting error will show itself when there is an assumption in the budget that is at variance with actual performance, management could not have know that the forecast was wrong and the error can’t be attributed to execution error. For example, the fact that your sales reps produced 50% of the bookings per rep that you budgeted is more likely execution error than forecast error, particularly if you had good reason for setting the forecast at the chosen level. Some might argue that forecasting error isn’t within a management team’s control, to which I’d respond:

If management didn’t prepare the budget, who did?

Forecasts are entirely within management’s control. No-one knows more about the assumptions that go into building a budget than the management team that is steeped in the business. That said, a company’s performance against a budget may be affected by factors beyond management’s control, however, that type of miss is probably a different type of error. Forecasting error will happen at a higher rate in earlier stage businesses or businesses where a new management team has been brought in. In both cases, the process of developing the drivers for a forecast/budget may not have the benefit of significant historical data. In the absence of historical data, forecasting is a process of making informed guesses, many of which may turn out to be wrong.

Forecasting error also occurs when a management team “misses” a plan to the upside. This type of forecasting error is forgivable, but is equally important to correct over time.

Execution error

The alternative to forecasting error is execution error. By default, no matter the stage of your business, you should suspect execution error before forecasting error for any miss, unless you can prove to yourself beyond a shadow of a doubt that you executed well. Execution error takes many forms, all of which require corrective action. Where execution error is present, it is critical for a management team to be honest with themselves and to take corrective action. 

Differentiating between forecasting error and execution error?

You know it is forecasting error if:

  • There was little to no historical data to back up an assumption in the forecast;
  • You made efforts during the year to improve performance against the assumption, but without success; and
  • The miss can’t be attributed to execution error.

You know it is execution error if:

  • There was good historical data or sound reasoning to back up the assumption in the forecast, but you missed anyway;
  • Efforts to improve performance against the assumption had a positive impact during the year, execution improvements made an impact; and
  • Team members responsible for performance against the assumption are viewed as under-performing.

Is one worse than the other?

For me the answer is yes. I’m much more forgiving of forecasting error than I am execution error. The caveat being that, over time, management teams should be able to increase their forecasting accuracy (reduce forecasting error) with the accumulation of experience, knowledge and data about the dynamics of their company. Management teams that are unable to close the gap between forecast performance and actual performance over time aren’t learning and forecasting error and execution error become indistinguishable.

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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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