BLOG STARTUPS, VENTURE AND THE TECH BUSINESS
What The Financial Crisis Means For Entrepreneurs, Part 2: Course of Action
Part 1 painted a grim picture of the current state of entrepreneurial finance: reduced revenue for most companies, longer exit horizons, lower exit values, less venture money available from fewer funds, tough to raise follow-on rounds, and general uncertainty as the venture industry restructures.
While revenues and exits should improve over the next several years with the economy (at an uncertain pace), reduced funds availability is likely to persist. Most institutional investors in venture capital (“limited partners”) have not made a decent return for a decade, and they are under stress from shrunken portfolios and reduced liquidity. Most likely their venture allocations will not return until the performance of venture capital improves dramatically, which will take five or ten years, given the long time horizons inherent to the industry.
Until recently companies could always raise another round if there was a good product and team and a believable upside. With money much scarcer, the ability to get the new investor, and the ability to tap large amounts of capital, is very uncertain.
How will entrepreneurs survive and prosper? I suggest six principles.
1) Focus on lean business models. In a market where $100 million is a very good exit, companies have to be built for $10-$20 million to pay for the failures and earn a return that brings the limited partners back. Venture capital is not for everyone anymore. Inherently capital intensive businesses will need to be funded other ways. It is going to be rare to see a venture backed company build a fab or other serious manufacturing facility, build a large enterprise sales force, or develop a large system with investor dollars pre-revenue.
The positive news here is the emergence of new ways to be lean. Most infrastructure can be outsourced. Labor can be off-shored. There are new ways to sell like the Apple app store. Partnerships are a way of life.
2) Develop support from major customers and government. The federal government has a swelling budget and is trying to stimulate selected areas of the economy. Corporations are on the defensive right now, but the strongest still have money for key, strategic technologies, and in better times corporate partners can be a key source of resources. Young companies are quite different in their ability to tap this money. Those that do can cut their net burn rate by 50%, which allows them to stretch the scarce investor dollars much further and dramatically reduce financial risk.
3) Pursue staged markets: A staged market is a place to start, followed by a place to grow. An early niche market provides validation, learning, and cash flow. A further out, upside market supports scaling and brings sizzle for the exit. Finding both and staging them dramatically reduces risk and financing requirement. The N. California IC business was largely nurtured by US government missile programs until the mid-60s (before 1965 the government was most of the market for ICs). Then the computer companies adopted ICs, and the prune groves south of San Francisco became “Silicon Valley”.
4) Couple unique value add with strong commercial skill. This is motherhood, of course, but good to keep in mind. Two great success stories I have heard recently are Assurion, which insures cell phones, and Aptara, which helps publishers repurpose content for digital media. Both of these companies are riding a technology wave, both brought unique value to their market, and both have strong commercial prowess: they are very focused on understanding and serving customer needs with solid processes. They were both able to develop major client relationships early on, and use that income to build the business and become a key supplier to a large industry. The entrepreneurs and managers have done very well.
5) Be really, really cheap. More motherhood (sigh). But, with the advent of really big financing rounds, venture often became corporate. $300k+ salaries, executive assistants, business class travel, $2 million web development contracts, and 401(k) matches crept into the picture. These are all fine things, for companies that have positive cash flow. Start-ups need to find cheaper ways to do it until the revenue is really flowing.
6) Plan to survive with the cash that is at the table. You can no longer write a plan that assumes, “then we will raise a $XX million B round from unspecified new investors” (and implicitly assumes: if that money does not get us there, we’ll raise rounds C, D, and E). The money may not be available, or the price and terms may be so harsh that existing investors say no. This year many companies that went that route will fail to be funded, and have to make emergency cost cuts or face an early sale.
Woody Allen famously quipped “80% of success is merely showing up”. In today’s start-up world a large part of success is surviving until the market develops. The companies that are on their feet when that happens will be winners, even big winners when the equity markets recover.
None of this is new; in fact all of it is old. We need to reinvent the venture funding process along the lines of its original success in the 70s and 80s. Venture capitalists will need to take their share of the pain here: the shake-out, smaller funds, lower management fee, and likely higher taxes, too.
There are big problems to solve and innovation has only accelerated. If we get our business model back in balance, there is a world to change and lots of money to be made.
