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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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.

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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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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