How Startups Work
Before diving into the details of how to design a product for startups, it is important that I cover the fundamental concepts and terminologies used in the blog. This blog aims to introduce some of these concepts and terms, as well as the unique roles startups have played in the course of human history.
It will also cover the basic realities of startups as businesses in the 21st century and introduce the concept of a product team—a team responsible for creating the products driving the successes and failures of startups.
How Do Startups Fit into This?
In part, the Industrial Revolution has led to today’s economic systems. Most of the world’s societies have embraced market economies. Despite the differences in state-sanctioned policies among countries, individuals by and large have the freedom and means to participate in buying and selling goods and services. Startup companies operate within this global reality.
The dictionary definition of a startup is simply a newly established business. The motivations to start a business can be incredibly nuanced, but three basic categories exist wealth accumulation, personal achievement, and helping others.
Before starting businesses, individuals often assess economic factors around them, as well as their own abilities to estimate the possibilities of success. Then they go about registering the business with the local government.
Starting up could be as simple as that. In fact, every single company in the world, from a mom-and-pop shop to a global business conglomerate, began with an idea and an assessment of factors.
What makes startups interesting in today’s world is the combination of the freedom and ease to establish new businesses and the breakneck advancements in technologies related to computing and the Internet. This combination has allowed some companies to grow very rapidly.
How Does Design Fit into This?
Quite simply put, the design is the conception and planning of the tools humans use and interact with. From the moment prehistoric humans first picked up a wedge-shaped stone and used it as a chopper, the design has become a part of our experience.
The early humans who planned and conceived of using that stone were the first designers. Over time, tools diversified and became much more complex.
Now tools are ubiquitous in everyday life, in every corner of human existence. They affect the clothes we wear, the buildings we live in, the roads we walk on. In fact, every single human-made object is the result of design.
Tools have become systems, platforms, networks, and nonphysical things. Beyond utility and function, aesthetics have also become a big part of the design.
The technological sea change in the last three decades has led to the need for a new type of designer. Products today are no longer just physical; they are made of bits as well as atoms.
Soon, most of the world’s communication will occur digitally. Business will be conducted almost exclusively on the Internet. In this reality, the new type of designer needs not only to work within this digital realm but also manage a high level of complexity in these systems.
Designers must also be well versed in the high-level knowledge of computing and the Internet, as well as the specific industry context in which their businesses operate.
The Modern Startup
The term startup has been co-opted by the media, entrepreneurs, and technology investors to mean a newly formed business in industries related to technology and the Internet that is intended to grow very quickly.
They aim to do so by developing innovative products and/or services that often replace, reinvent (“disrupt”), or improve upon traditional ways of life and commerce as they existed before the explosion of personal computing and the Internet.
Paul Graham, a renowned computer programmer, entrepreneur, and venture capitalist transcribed his thoughts on startups. To him, the most important characteristic of a startup is growth, in that the startup is designed specifically to grow rapidly.
His point is that out of the millions of new companies created every year, most are traditional service-based businesses, such as barber shops or restaurants. These are not startups, in that they are not intended to grow fast—in revenue, profits, number of customers, etc.
The fundamental difference between a startup and traditional business, according to Graham, is that not only do startups “make something lots of people want,” which traditional businesses do as well, they also “reach and serve all those people” in ways traditional services-based businesses (e.g., a barbershop) cannot. This new reach is mostly owing to the Internet, which did not exist 30 years ago.
The trait of innovative reach can be seen in most startup companies. Unlike your local community center, for example, Facebook is a hub that connects all of the worlds.
Unlike your local radio station, Spotify is a music-streaming service for the entire globe. Unlike your local public storage, Dropbox is a storage service accessible from anywhere with wi-fi.
Startups Are Fickle
The upside of startups is that this new reach allows for the potential to grow and scale up a business quickly if the product or service is done right. The downside of this reach is that it now has to compete with the entire Internet, which potentially has hundreds of thousands of businesses potentially doing the same thing.
In fact, by their nature, startups are fickle. Most of them fail—an overwhelming majority of them within the first few years.
The unique advantage a startup has is that the rapid progression of technology has yet to show signs of a significant slowdown. This constant progress allows doors to be opened that were unimaginable a few years previous.
Steve Jobs and Steve Wozniak wanted to assemble a personal computer in 1975, back when no one wanted one. Larry Page and Sergey Brin wanted to create a search engine when most people didn’t know what a search engine was.
The key to really hitting it big is to be able to peer beyond the horizon and anticipate something big that’s about to happen.
However, peering into the future is almost akin to trying to predict the future— most people get it wrong. This is why initiating a startup can be incredibly difficult. If you’re joining the industry because you think it will guarantee you wealth, you couldn’t be more wrong.
For every Google or Facebook, there are tens of thousands of failed companies that were often started by people just as smart and driven as the Google and Facebook founders.
The journey of starting a technology company can be fraught with hardships, surprises, and failures. However, the companies that battle through these challenges and continue to grow over time are the ones that change the world.
Following are the terms that people working in startups are quite familiar with. They will be referred to later in this blog.
Agile: A method of developing software that emphasizes adaptability, collaboration, and cross-functional teams
Angel investor: An individual who provides the initial capital for a business to start, in exchange for equity/ shares in the company
B2B: A business model in which the target customers are other businesses, rather than individual persons. The opposite of a B2B company is a consumer company.
Bootstrap: To bootstrap is to start and grow a company without outside investment.
Equity: Ownership shares in a company, often used to exchange for capital
Growth hacking: A buzzword for marketing with data-driven methodologies
Incubator: Organizations that help to develop early-stage startups by providing initial funding, industry insights, connections with investors, and access to a network of entrepreneurs, usually for a small amount of equity in the company
IPO: An initial public offering. This allows a company to be listed on a public stock exchange. Typically, after an IPO, a company is no longer considered a startup. Investors often hope to make a profit through an IPO of a startup.
MVP: Minimum viable product. This refers to the simplest version of the product, in terms of features, that could satisfy customer needs, built with the goal of soliciting feedback, which enables quick and iterative product development.
Pivot: A change in business strategy, often done to promote better profitability and a more sustainable business model
Product: A term that refers to the product and service that a company sells
SaaS: Software as a service. This is a business model in which software is provided as an on-demand service via the Internet. Most SaaS companies are also B2B companies.
Scope: The information that is explicitly expressed before working on a new project. Specifically, project scope refers to the work that must be completed in order to finish the project. Product scope refers to the planned features and functionalities of a new product.
Unit economics: The net revenue and cost number, expressed on a per-unit basis (per sale, per usage, etc.). It is usually used to measure the business viability and sustainability of a startup.
Valuation: A company’s worth in monetary terms. This is usually determined by assessing the company’s current capital structure, revenue, and future potential.
Venture capital: The money provided to startups that allows them to grow. Capitalization is usually done in series, typically after the initial capital provided by the angel investor or the incubator and after the startup has demonstrated growth traction.
The Product Team
The nucleus group of a startup is its product team. While there are many functions of a business, the product team is key to the success of the startup, because it directly impacts whether and how people will use the product.
The size of a product team can vary between three to fifteen people. This number greatly depends on the size of the startup, the industry it’s in, and its specific stage of growth. At a minimum, the product team should consist of a product manager, a product designer, and a few engineers.
If possible, data scientists, user researchers, and product marketers also should be included. Depending on the nature of the business, a project manager, an operational manager, and client success managers could also be embedded with the product team.
The tasks of the product team are simple: (a) figure out what to build and how to build it; (b) build an MVP and validate it by testing, then learn from the tests; (c) improve upon the MVP, based on what’s learned, then test again.
Unlike the executive decisions made by the company leadership, the product team is responsible for decisions that actually execute the roadmap, by figuring out what details and features should be included, so that the customers’ problems can be solved, and the company’s vision can become a reality.
Of course, if the company is a small five-person team, this separation between company and product team won’t exist. However, what is constant in startups large and small is the iterative product development cycle of researching, hypothesizing, building, testing, and iterating.
A product manager (PM) has two key responsibilities. First, the product manager should work with the company leadership team to figure out what should be included in the roadmap of a product.
In essence, the product manager should capture opportunities where the company mission can be realized in the form of a product. Ideas are cheap. They can come from anyone and anywhere. It is up to the product manager to come up with a framework to score, filter, and rank problems worth solving.
Second, the product manager is responsible for determining what goes into a product and what stays out, in other words, defining the product features and functionalities, by embodying the customer’s pain points and the company’s unique advantages.
It is his/her job to work with customers directly, to figure out what the goals are, or with researchers and salespeople, who are proxies for the customer’s voice.
Product management entails a considerable amount of collaboration with other teams, conducting primary and secondary research, then coming up with a set of heuristics to evaluate customer problems that are worth solving.
After this, the product manager works with designers and engineers to hypothesize product details. These two tasks of figuring out what problems to solve for and what solutions to hypothesize are central to the product manager’s job.
Product designers are responsible for the core need of the customer being addressed by the products they design. They work with product managers to figure out a product’s features and functionalities. Product designers are also responsible for the experience of a product.
Unlike user-experience designers, a product designer cannot be blind to aspects of the product outside of the user experience. In other words, if a product doesn’t address the users’ needs, their experience doesn’t matter. The product designer should address the fundamentals first.
After the features and functionalities of the product have been scoped out, it is the designer’s job to turn these into concrete plans and artifacts that engineers can refer to build out the features.
Specifically, the designer is responsible for creating a vision of how a product could be used successfully in real life, architecting the experience in broad strokes first, then filling in the details of how the interface would work and what specific interactions models should exist.
The goal should be to make something people want. Much of this blog will cover the product designer’s process and goals and how to achieve those goals within a startup product team.
Project Manager and Engineering
The project manager is the one who keeps track of the schedules of engineering tasks and deliverables. Engineering leads or managers sometimes take on this role. Large projects often have a dedicated project manager.
Engineers are the ones building the product. Unlike a physical product, digital ones don’t require a manufacturing process, thus the engineers are the ones making the products.
It is important to note that engineering’s role could vary greatly for each product, depending on the industry and its scope. However, in almost every case, engineers should be involved early in the problem definition phase of the project, to ensure the proper capture of the technological constraints and landscape.
Data Science, User Research, and Product Marketing
Data scientists are often embedded in a product team, to conduct quantitative research and to gain insights into how the product is performing. These insights are internalized by the team and used to make better product decisions. This role is especially important for products with large-scale user-base or usage patterns.
User research tackles the qualitative side of insight gathering. It works with real users in a small sample size, to gather information on their perceptions, beliefs, and underlying behaviors.
Product marketing is responsible for telling the story of the product to an external audience. It also involves collaborating with sales and marketing for the startup as a whole. The product marketing role is often overlooked, but it is very important to a product’s success, especially for those for which good public perception is key.
Product designers must be keenly aware of the world that their businesses operate within. They must be able to speak the startup language and understand the impact their decisions have on the business. Furthermore, they must closely collaborate with other team members, in order to create successful products.
Sell the Company
You successfully built a solid company. You have customers, you have good business processes to deliver great services, and after 2 or 20 years you are ready for something new.
Maybe that something new is to find investors so you can reach a new growth point that requires an influx of cash (even if only to maintain cash flow). Or maybe you actually want to straight-up sell the company and let someone else deal with it.
In this blog, we’ll look at how to set a price on the company by ascertaining the value. We’ll look at the types of agreements you make when you exit a company, and we’ll look at what it looks like if you’re staying on with the company.
But before we get started, let’s talk about feelings. No matter what you do or how you do it, selling part or all of the company is a very emotional time. And the longer you’ve owned the company, the more emotional it should be. Many are likely to tell you to leave the emotions at the door.
Keep in mind that the loyalty of your customers beyond the contracts they may have signed with you cannot be assigned a price. Nor can the community, no matter how wonderful, of employees that you have. Instead, a valuation is about assets and liabilities.
The contracts you have with customers are assets. The time that you owe customers who prepaid, and your bills, are liabilities. It’s that simple. Or usually, it is.
Who Is Going to Buy the Company?
Consulting firms are typically acquired by other consulting firms who want to fill various gaps in their business or as a means for non-organic growth.
Skills acquisitions: Some acquisitions are about buying the skills you have on your team. This is often the case when a very large company is buying a much smaller organization that makes a product that will be discontinued.
For example, let’s say you have a consulting firm and a very large customer wants to go enterprise-wide with Apple devices. They might just acquire your firm to become their new support team so they can get the project done much quicker.
Customer acquisitions: Other acquisitions are all about the customers. The purchaser might not want any of the databases or staff. This is common when getting gobbled up by a seemingly similar company, especially if they’re in the same geography and have been a long-time competitor.
Inorganic Growth: A traditionally Windows-centric MSP might want to add an Apple practice to their portfolio rather than build one from the ground up. Or another Apple practice might want to get into your geography, and instead of slowly starting to sell into that geography, they might want to buy an existing leader in the market.
Product: Another organization might be interested in acquiring yours because they want a product that you have developed. The services products are typically a pre-packaged bundle of services that provide a deliverable.
Along with acquiring name recognition of the product, the purchaser is also often looking for know-how around how to develop the product.
Keep in mind that the value of the product to the purchaser is about domain knowledge and customer acquisition. Anything beyond that could be developed internally at the purchaser without having to buy another company.
Software: Software product might be something customer-facing that customers pay you for or might be an internal software product that is used to allow your organization to be more efficient and therefore more cost-competitive.
If done properly (and packaged properly), the software can be a huge selling point; however, keep in mind that integrations between internal systems are usually going to already be established at an organization that might be purchasing your company and so might not increase the value of your company.
Another SKU: Some organizations already sell software, printer services, or something else to customers, and your team might just provide the best possible new SKU that can be cross-sold to customers.
When that happens, you may become an attractive target acquisition because the acquirer can sell the crap out of what you do. This is great when you have excess capacity and good business processes but don’t have a strong sales team.
When is the community you built considered an asset to the company? Usually, when there’s a greater impact that the purchasing organization can take above and beyond the standard value of your assets.
For example, let’s say another services provider purchases your company and wants to tap into tools that you’ve built to manage tickets or integrate with common services management tools.
Or this can occur when the purchaser can expand their platform support and, in doing so, not only takes on your Apple customers but also sells Apple services to their other traditional customers.
Hopefully, you’ve become an expert with all things Apple at this point. And doing so is trendy. Many a large company wants to know what their “Apple strategy” is these days.
Even if the organization looking to acquire your firm doesn’t say it, this is likely on their mind and should factor into the negotiations when you’re trying to justify a higher value of the organization.
A valuation is an estimation of your company’s worth. A mature organization will hire a professional appraiser to determine the valuation. These are often compiled by large accounting firms like Mackenzie, Accenture, or Deloitte—and they’re not exactly cheap. But they’re worth it!
Preparing the company for a valuation is a task that can take multiple years, according to how large the firm is and how it’s being sold. So the earlier you start, the better. Some steps to prepare the company for a valuation are provided here.
Make a list of all liabilities. Liabilities are what you owe. This includes traditional debt, such as credit cards, but also any contracts where you’ve received money from a customer and not yet delivered services, such as annual retainers. Also look at any outstanding contracts for property, internet access, insurance, legal, etc.
Make a list of all assets. Assets are what you own. This includes traditional fixed assets such as property, as well as depreciating assets (or assets that go down in value over time), such as computers. Assets include contracts as well as a percentage of the value of customer business that is not contractually bound.
The length of the relationship with the customer and a steady rise in the business done with the customer makes that percentage higher.
Subtract the liabilities from the assets. Once you’ve put together a list of what you have minus what you owe, this is a simple calculation. Practice Generally Acceptable Accounting Practices (GAAP) and make sure to have an accountant help you so as not to have any surprises later in the process.
Document the margin for the last 3 years. A healthy margin can make a valuation higher. How much do you bring in, and how much does it cost to run the business? The more you can document the better, such as per-customer, per quarter, etc. Plotting things out on a spreadsheet and having a solid trendline will help with the process.
Project future growth. I like trend lines. Microsoft Excel is excellent at producing trend lines (as is Keynote and Numbers).
Put a price on your intellectual property. Consider a company blog and the related SEO you get from that, your sales pipeline, your contacts (including the customers), various Standard Operating Procedures (SOPs), databases used to automate the business, and anything else you built a company intellectual property.
In the event of a sale, it stays with the company. If you want to keep any of this when you leave (or re-use it to start a new business), negotiate that during the sale.
Focus on MRR. Monthly Recurring Revenue is the most predictable way to establish the value of a company. Preferably when contractually bound. The rise of MRR can be plotted on a trend line to prove that the company is moving in the right direction.
MRR can include the sale of your products but also the resale of subscription services, such as Internet Service Providers (ISPs), Google Apps subscriptions, Office 365 Subscriptions, leases, and other commissions.
Ultimately, what is the company worth? The answer, no matter the valuation, is whatever someone is actually willing to pay for the company.
To the right purchaser, the company may be worth far more than it is on paper, as they may have a plan to cross-sell services, they may have a system they can put your customers into where they can amplify margin, etc.
But in most cases, I’ve seen companies worth far less than what the owner thinks they’re worth, especially in organizations that have primarily relied on hourly consulting efforts, with no long-term contracts.
Mergers and acquisitions can take on a number of different forms. Rather than pay cash for a company, I have seen a number of acquisitions where the purchaser is basically buying staff and customer lists/contracts in exchange for a percentage of the business that is done with the clients.
Consultancies struggling with apathy, growth, or margin make great targets for such an acquisition. Should you be evaluating an offer, or structuring an offer of this sort, keep in mind that the principals in an organization rarely stay around following an acquisition.
So, what makes the multiplier? What someone is willing to pay for a company. That’s all. But things that help are even, ascending numbers for profits. This means moving much of your business to MRR as we covered previously.
Non-Compete Agreements and Covenants
The sale of your company will likely come with an agreement that you will not compete with the purchaser. Your non-compete agreement or covenant (which is similar to a non-compete but even more binding) is an asset that the purchaser paid for.
Non-compete agreements are more binding in some states than others, but in general, whatever the law says can pale in comparison to the legal fees to prove what the law says. If you will be working with a former customer in any capacity, I would try to get a waiver to do so.
I’ve heard many consultants say, “But the client called me first,” or, “They’re not being treated right by the new management.” One of the things that likely made your company successful is the fact that you were good to your customers.
You probably formed personal relationships with many outsides of work, and it will be hard to see them potentially not taken care of in the way that you would have taken care of them.
But you are legally bound not to interfere. And violating that agreement may come with serious repercussions, so be cognizant of your risk, and the risk to your former customers, if you do so.
Are You Going to Stay with the Company?
This is one of the most important questions. The company will likely do better if you’re still there, at least for a time. And any mature purchaser will understand this and likely want you to stay, at a minimum, for the transition period.
After years of owning a company and making all of the decisions, it can be awkward to suddenly be asking others what they would do, or for permission. If you will be staying on for any duration of time, make sure to work out some details with the new owners of your company.
What authority do you still have in regards to hiring and human resources?
What spending authority do you have?
If working in sales as well, what discount authority do you have?
How are you going to be phased out, including a final date of employment?
If you are planning on leaving, make sure to work out an acceptable exit strategy with the new owners. This should include milestones with fixed dates attached to them. I’ve found that being transparent to staff is important, so letting everyone on the team know the schedule is best, when possible.
Wielding Political Capital
Going from owning a business to working in a business can be challenging. When you own the business you can chart the course for the team. When you don’t, you can’t. Instead, you have to wield political capital sometimes. For example, you do a favor for someone. Because then they owe you. That’s how it works, right? No.
You do a favor for someone because it’s the right thing to do. You should expect nothing in return. It’s called being a mensch.
Maybe you get something in return; maybe you don’t. But it always works out in the end. I see a lot of different people who try to manipulate situations in order to get a specific outcome. Don’t.
These days I try hard not to manipulate anyone. But I have. In the end, when people realize that you are manipulating them, they will never trust you again. That is bad. But that is not the only reason to avoid such behavior. Avoid it because it’s just plain wrong. If you can’t win a heart and mind with the truth, don’t bother.
Suddenly then it seems like there might not be such a thing as political capital. But there is. It’s called karma. And there’s no reason you should think about it. Instead, just be a good person. Practice honesty.
Be virtuous. Help others. Avoid judging others. Help those less fortunate than yourself. Then, you won’t need to wield that political capital because your actions will guide you and you will prosper in the ways you are meant to.
This does not mean you shouldn’t have an opinion. Nor that you should try to convince others that your opinion is the correct outlook on a given situation. Nor does this mean that you should be weak.
You can be strong and have an opinion that isn’t shared with everyone in a given organization. And you can gain political capital by not always having to be right (even when you aren’t).
And if you are a decision maker, you can be the gatekeeper to make sure your part of an organization contributes to the mission of the organization. When others make requests of you, do what’s right—not just for your budget or team but for the mission of the entire organization.
And when you have needs from others, trust they will do the same—hopefully without setting the expectation that you will need to repay them. You may build trust with others, but neither party should walk away with an expectation of repayment unless negotiated at the time a favor is given. But then it isn’t a favor, is it?
But humans are human. And so power struggles occur. Stay clear of too many. Heed those old adages our parents taught us, like “take the high road.” Ultimately, we’ve then defined political capital as trust, rather than what you can do for others. Trust is built on merit and cannot be rushed.
Your capacity to help your part of an organization (and long-term, all parts) is then based on the political capital you and your team can build, which takes time, success, and patience. Remember that, and avoid the mistakes we were taught to avoid in kindergarten, and I think you’ll do great!
You have control of the company to someone else. Don’t go second- guessing them all the time to say things like, “That’s not how I would have done it.” This will not do anyone any good.
This doesn’t mean that you need to be inauthentic and just agree with everything the new ownership says. Instead, give the benefit of the doubt, and address concerns privately in order to give the new ownership the best possible chance of succeeding.
I heard a great analogy once: “The old mayor shouldn’t be second- guessing the new mayor all the time.” Wise words from a wise person. There’s a reason that the change occurred; respect boundaries, but try to be as helpful as possible—even if you don’t always agree with new perspectives.
Ultimately, you have options! You might choose not to sell your company after all and instead go an entirely different direction. Or you might choose to hang onto the company and move into being a part-time owner, which we cover in the next blog. No matter what you do, throw a party.
Acquiring a company can infuse your company with new blood. Your employees can be energized by a new flock of customers and your customers can find more value in the additional services you can then offer. Now, let’s talk about growing your own company inorganically via an acquisition.
There are as many ways to go about acquisitions as there are companies that have been purchased. And there are many ways to find a company to purchase. One way is to look for companies that are on the market.
Another is to look at companies that might not be on the market yet. Don’t limit yourself to opening discussions with companies that are for sale.
Make a List
Look for possible organizations that might align with yours. These may be companies you’ve done business with before or companies you’ve competed with locally. Make a list of the ones you could imagine yourself operating.
And think about what they add to yours. Maybe you’re a solo practitioner and you would like to buy out a larger shop with the nickels you’ve squirreled away. Maybe you’re the larger shop who would like to buy out the solo practitioner.
I don’t always tell people to make lists. Some are list-makers, some aren’t. But you really should make a list this time. Once you’ve got your list, move it into a Google sheet or Excel and add some columns. Now, let’s think about what attributes you might get from an acquisition.
What Are You Actually Trying to Buy (or Roll Up)?
When most companies purchase another company, they’re usually looking to acquire something specific. When consulting firms look to acquire other consulting firms, it’s usually about existing customers, talent, technology, brand identity, and/or vendor contracts (and in my experience, it’s in that order). Let’s unpack each.
Customers are only as good as the contracts. Why? Customers can leave with staff who defect during the transition (including principals who came as a part of the acquisition). Rather than buy a company just for their customers, you might choose to just hire more salespeople, the staff of a competitor, and/or aggressively pursues their customers yourself.
Talent on the Apple platform can be harder to find for other platforms. Apple consulting expertise is a growing market, but hiring a team or finding good staff can be a challenge.
You could attempt to hire talent away from an incumbent, take on talent from new customers, train new employees, or go hire people from recruiting and headhunting sites.
But the ability to bring on two, three, or more engineers who can hit the ground running (especially if you’re getting customers as part of a deal) is priceless, especially since they can be used to onboard net-new employees while providing a seamless transition to customers who might be acquired with a deal.
Technology is usually easy to recreate in some way unless it’s patented, or you don’t yet fully understand the business logic. However, the time to market can be critical with new ventures.
If a competitor has the ability to immediately deliver something that you’ve only begun to think about, then consider the cost of going to market and the lost business from being latent to market.
This might be customer-facing technology (such as products that are cross-sold into customers with services, as well as implemented ticketing systems, client automation, integrations, middleware, etc.
Brand Identity is something I’ve always struggled with. Being first certainly doesn’t mean being best. You will frequently roll identities into one another anyway.
You can also launch a new product or service and, with a media blitz about being new and fresh, often build a competing identity on your own. But if there’s technology or a service that’s already in the market, then it’s easy to merge brands or bring another brand underneath your own.
My challenge here is that I usually see people getting caught up in wanting to own the brand, not in wanting to provide value. One of my favorite consulting acquisitions was Geek Squad, who was acquired for the most part because they had a good brand.
However you might feel about the talent level in Best Buy stores or their brand since neither you nor I make more than Best Buy does, it’s worth giving them props for expanding that brand into all of their stores and making money off space that had previously been considered an exclusive warranty replacement department.
Vendor Contracts can take a long time to get processed. Large computer companies like Cisco, Apple, Microsoft, and others might require certifications (both with regard to your staff and your company or location).
You also need to be in business or established with a vendor to get a good line of credit for purchasing (let’s not forget that for hardware and software you’ll often pay up front and then take payment in 30 to 90 days).
But more importantly than acquiring the contracts is acquiring talented people that know their way around these systems, know how to unlock the various SPIFs, and have contacts at those companies. Sure, you can figure it out, but in the process, you might end up losing far more than the cost of a rollup or acquisition.
When it’s possible you want to get a little bit of each of these when you are navigating a good acquisition or rollup. Each has its own value. Just don’t forget that you want to bring in everything you can.
So rather than just tell people to get on board with how you’re doing things, listen thoughtfully to what new people have to say and accept any process changes that might make sense, or table and you aren’t ready to deal with.
Approaching Acquisition Targets
Many a relationship takes the tone with how that relationship begins.
I guess some things come down to first impressions. Perhaps you already know the principals of an organization you want to acquire. Or maybe you are looking to meet them for the first time. Either way, approaching someone about acquiring their company is a delicate process.
Imagine if someone wanted to buy your company. You probably aren’t going to go out for Happy Hour, have a few too many drinks, and wake up in the morning having signed away your company.
I’ve heard stories that include things like hiring private investigators to follow people, having background checks performed without their consent, and going through the garbage at someone’s home. Having said that, I’ve heard of large companies doing at least two of those as well, just to hire talent (or hiring headhunters to do it).
So let’s not go that far. Let’s say that maybe you do a little bit of due diligence (nothing creepy) and then look for any contacts you have in common. The warm introduction is, by far, always the best. And I wouldn’t look for an introduction on LinkedIn or through e-mail (although you take what you can get in this world).
I want to push for an in-person introduction—just lunch, like the dating service, says. This gives you the chance to meet someone face to face. You don’t have to say you want to acquire their company. Instead, you can say you just want to meet someone else who you’ve heard so much about!
Once you’ve met in person, if you get to that point where you want to start discussing an acquisition or merger, then I like transparent, direct, and early communications.
“There’s a chance our two companies might better serve customers as one company. How do you think we might make that happen?” Be direct, but not aggressive. After all, you didn’t hire someone to go through this person’s garbage, right?
The Finer Points of Acquisitions
The criteria for any acquisition absolutely begins with the P&L. If there’s profit, then why would someone want to sell? If there’s no profit and no plan to profit, then why would someone want to buy?
But if you have a plan to find more revenue or cut costs by combining operations to become more efficient, then that obviously makes an acquisition more attractive, provided there aren’t too many hurdles (which can crush you if you aren’t careful).
Some questions that might limit liabilities:
Can you get out of contracts for overlapping services?
ISPs, leases for office space, the costs of RMM/MSA/ CRM solutions, licensing for cloud services, E&O insurance, retainers for lawyers, etc.
Can you liquidate unnecessary assets? The most substantial of these is property. If both companies have real estate holdings then it’s likely that both are unnecessary (if they’re within a short distance of one another). I’ve never seen real estate come as part of a deal in a roll-up, but it would be an asset that might come with a purchase.
Are there overlapping teams to do the same things?
No one ever wants to think about letting staff go.
Throughout this blog, I’ve been a proponent of repositioning staff where needed. When it comes to core services you can likely use one operations team rather than two, which might give you the ability to repurpose someone into a net-new role that provides more value to your customers.
Overlapping customer-facing talent is a great problem to have! If you end up in this scenario, then either bring on more sales personnel faster or if you’re a smaller shop, then grab your sales bag and hit the pavement, because those are the moments that you want to seize.
We had previously discussed what you want out of an acquisition or rollup. This section hopefully allows you to polish your business plan by finding a more efficient single organization than two separate organizations operating independently.
The faster you can achieve operational efficiency, the more quickly your teams can learn to work together. Don’t be afraid of delegating as much of the operations as you can so you can get in front of customers to maximize your chances to retain them and to understand their needs.
Culture is one of the most underrated aspects of running an organization. Having a great culture is at the heart of what motivates the best people to want to work for you.
Lasting culture is founded on strong values that unite and inspire. An acquisition represents a single event that could destroy your culture if not done properly. So you have some difficult questions you’re going to want to ask first.
Can you work with these people? We didn’t really address this question when we covered selling your company, although through the blog we have touched on culture. But you don’t want a combative situation being set up inside the company you’re acquiring.
If you hired your team, then you know you can work with them and I sincerely hope you enjoy doing so. But you didn’t hire these people. Ask the seller about the people.
Are the clients a good cultural fit? We frequently bring on similarly sized and/or minded customers. That’s one reason why you might be looking to purchase another organization, to expand out of the beachhead you’re in.
But if your staff can’t work with the new customers, then you might have to make different plans. And it’s best to know that before you’ve passed the threshold from which you can’t return (signed on the dotted line). I don’t think there’s a silver bullet here. Talk to the employees and be transparent. You’ll figure it out.
Based on the size of the organizations being merged, the new organization will likely not need people or vendors in certain roles. The most obvious, among smaller Apple consultancies that merge, is likely accounting.
If the new entity needs double the capacity for accounting then you’ll be happy to have the added resources. But if not, you will have some hard choices to make. We discussed some operational aspects you need to decide on before you acquire an organization.
RMM, MSA, and ticketing systems
Customer Relationship Management (CRM)
Patch and server management systems
Managed service components, including backup, cloud services, messaging, and groupware services, etc.
Contract management systems
Messaging, groupware, and internal productivity systems
Outside accounting services
Custodial and facilities services
Financial and real estate services
Human resources and outsourced HRIS systems
401k and profit-sharing services
The most important thing to keep in mind with all of these is to pick the best solution. At first, you might think that the tools you were using are all the best.
However, if you ask to be taken through how they’re used by the old team, then you may find that you like the business processes and the technology that drives them better than your own. And when the new team sees you embracing what is best, they are more likely to trust you concerning what is best for them as well.
Many business owners are going to find this the really crappy part. You find these great companies, you meet the employees, you merge operations, but in the process of building out a final product, you run into a problem with comp packages.
Maybe the employees who come to you as a part of the acquisition have salaries that are too high compared to your existing team. Maybe it’s the opposite problem.
Salaries should fit in a similar range, per position. If you haven’t yet created position contracts and done salary leveling, then I would recommend doing so at this time.
While you don’t want to make drastic changes in the comp, you want to be ahead of this before the merging of entities. If you are inheriting staff that is paid less than yours, then I recommend providing some kind of profit sharing or goals to get teams up to speed.
Note Leveling seems silly at smaller companies, but if you plan on growing, it provides guidance so staff can grow with the company.
If you inherit staff that makes more than what you currently pay, then check the levels. If the staff you obtain as part of the acquisition make above what the levels say they should, then find out why. They might be doing more than what you think. If not, then you have an issue that needs to be addressed.
If addressing that situation causes people to make less money, then assume they will leave as soon as they can. If they don’t, then assume they will not be in a positive place and could damage the morale of other team members.
Salaries aren’t the only numbers employees will need to know about. Stock is easy if both companies have similar stock option programs.
If the one you are acquiring doesn’t have a program, then it’s easy to roll the staff into yours. But if they do and you don’t, then you either need to create one or provide commensurate compensation, such as profit sharing.
And you need to zero out the money from stocks that the employees should have received as part of a vesting event if that’s not handled by the seller.
This can be really challenging math, so seek professional help to figure out what’s appropriate. And when you figure out what’s appropriate, if possible, do a little better than that.
Benefits are one more thing to look at. As with stock, if people will have fewer benefits, then they should receive additional compensation commensurate with replacing those benefits. If not, then assume a situation similar to salaries.
If you see a general theme with all of the numbers in this section, take care of the employees. Remember that in a services business, they are the most valuable asset and likely the largest cost in the company.
You need to be profitable and have a multiplier to make an acquisition and to make that happen, you need to first make sure that all of the numbers for the staff make sense. As with everything in this blog, be deliberate.
Rather than Acquire
You might come to a place where you choose not to acquire another company, but in the process of trying to work out a deal, you really came to like the principals and/or staff at the other organization.
That’s awesome! In this case, there are still other options. Probably about as many options as there have been mergers or missed chances at mergers in the history of organizations merging or not merging.
The easiest thing to do is pass business back and forth to one another. You can’t completely overlap or you wouldn’t have started discussing acquisitions. If you will be passing business back and forth, I recommend an agreement where you can bilaterally refer business to one another and receive long-term compensation for doing so.
You started the deal for a reason. Just because you realize at some point that you can’t merge the organizations doesn’t mean that you also have to walk away from the relationship you’ve formed with the principals, provided everyone acts ethically.
If you have the margin, start at 10% and work forward or backward from there. Why do I recommend there absolutely be compensation bilaterally?
Because if there’s no compensation and one party provides far more referrals than the other, then one party is likely to feel taken advantage of. Check the performance over time. Keep in touch, and honestly, be glad to have more friends.
Are Assets Transferrable?
Contracts are a funny thing. Some are locked to a given company or person. Some require various dependencies be met. When acquiring a company, it’s critical to do due diligence and make sure that any assets are transferable to the new entity. Hire a lawyer to do so.
Re-evaluate any deals you’ve made once your attorney reviews them. If you have to make a deal before you have a chance to have all contracts legally reviewed, make contracts contingent on assets being transferable.
In fact, that goes for anything—all deals are contingent on any and every unknown in order to provide maximum liability coverage in case the deal falls through. As such, treat the following as assets:
Partnerships, including reseller agreements, existing support contracts, and alliance agreements
Contracts with customers, especially managed services contracts, but also including subcontracting agreements
Contracts with vendors, making sure that prices aren’t going to go up, and that all agreements will be enforceable once the name of the organization has changed and business based on vendors isn’t negatively impacted
Once you have verified that all of the I’s are dotted and t’s are crossed, you can start completing plans to actually merge the companies.
Don’t Make a Bad Deal Just Because You Can’t Let Go
Ever bought something on eBay and spent way more on it than you really meant to, just because you got competitive? Now imagine that you spent thousands of dollars on legal fees and a deal is falling through.
Sometimes that’s a good thing. If, in the midst of due diligence, you find that the deal keeps getting a little less awesome at every turn, make sure to check that the investment is still worth it.
It can be hard to walk away from a deal at the last minute. Sometimes, you’re unable because your pride gets in the way. And sometimes, it’s because you have invested too much. Not to overuse analogies in this section, but something similar can happen when buying a house.
You get an inspection done and you find the house needs a new floor in the bathroom, then a new furnace, then a new roof. At some point, the contingencies pile up too far and the risk becomes too high to proceed.
Similarly, between debts that are uncovered, assets that cannot be migrated, team members that defect, and potential customer attrition, there may come a time when you have to end the deal.
Otherwise, you’re upside-down. But if everything works out and you can make a better experience for your customers and employees by merging the organizations, then it’s time to execute the deal!
Once a deal is in place, it’s time to start executing your plan to merge the companies. Start by finalizing your plans. As soon as possible, communicate the merger with customers, vendors, partners, and other stakeholders. Communication should be as thorough and transparent as possible.
Make sure to include the following:
You’re taking care of the employees
You’re taking care of the customers
Why you’re doing this
Specifics about how the customers will be better off
The plan and timelines for merging services
How communications with the company might change over time (e.g., how customers file tickets, etc.)
If you will be doing any press around the merger or acquisition (and you probably should), make sure anyone who is contacted about the merger is told that there’s an “embargo” on the press. An embargo is an industry-standard term that refers to media not releasing content until a specific date.
In fact, if the press goes early, you might cause concern among customers and employees, so consider doing PR after the merger and having a press release go out after the announcement. Don’t do anything that could cause your team or customers to feel betrayed. Remember, this should be a good thing for everyone involved.
Be careful with acquisitions. You can easily get into a place where there’s a cultural disparity or a deal isn’t right. You need to make sure you have a vision of how to integrate the organization you’re acquiring into your own.
You also need to make sure you have a handle on costs, understand what you can do to control costs, and understand the impact doing so has on the bottom line. But if you can make more ROI per dollar spent on acquiring rather than building, then jump on that.
Just make sure to remember why you’re doing all of this. It’s never quite as simple as you seem to think at first. Usually, inorganic growth will come with some inefficiencies (the laws of thermodynamics it seems are true in business as well).
Try to retain as much value as possible in the merger, and provided you’ve been careful and done sufficient due diligence, the two organizations should be stronger as a single entity!
Running a Consulting
Many companies have services departments. In the Apple space, these are primarily software vendors. Some hardware providers do so as well, such as large tape library manufacturers.
Most companies that sell hardware and software that appeals to the enterprise will have products that their customers need to bring on services for. Some smaller software vendors will have services teams as well.
Some of the reasons customers might want to purchase services from a hardware or software company include the following:
Services are required. This is often the case when a lot of customization is required.
The customer doesn’t have time to implement the hardware or software.
The customer needs the training to get up-to-speed on implementing the hardware, software, or updates.
Customers need to bring on services for part of a project and would prefer to keep them on a single
The reason I mention these is that you can build packages or bundles around meeting these customer needs. But first, let’s look at what the company you work for wants you to be doing (which can often be quite different from what the customers want you to be doing).
What Does the Company Want You Doing?
Many of us will take the approach that we want to sell services and grow a services business. Then we can hire more people and help more customers. But is that what our company actually wants us to be doing? Sure, money is money. But many companies will look for you to drive sales of the core product more than sales of services. Kinda’.
This is a hard balance, and the most important part of finding that balance is to actually talk (yes, use your human words) to your boss and their boss.
I’ll tell you up front, most smaller organizations will say something like “go make all the monies,” but larger organizations might come back with talk of things like building ecosystems of vendors.
The important thing is to find the right mix of growth, margin, and community enablement. And for everyone to be on the same page.
Getting the Right Mix
As I said earlier, someone is eventually going to ask about margin and profit. And if you don’t have a good story to tell (and in writing) then you’re probably going to be looking for a new job. So what is the right mix?
The remainder of this blog will focus on unpacking some of this, but before you start pushing an agenda and possibly are doing the opposite of what’s being asked of you, consider the following (which you should review with your management):
What profit margin is needed from the services organization?
How many services are going to be given away for free in order to drive software and hardware sales?
Will free services be credited back to the services team in the form of a chargeback?
How should sales enablement for services be handled?
Should you plan on staff augmentation as part of your services packages?
Will the services team be involved in getting the community (resellers, consultants, MSPs, integrators, etc.) enabled to deliver services, or will the two be competitors?
Note These aren’t that many questions and even a CEO will be happy to answer them, given the potential impact to profits. These should be reviewed with your manager quarterly and probably up a tier annually as well, given that your manager might not always be in lock-step with their manager or any time there’s turnover in the management chain above you.
Once you understand the margin goal and sales goal, set a rate. I would approach pricing the same that we’ve done in previous blogs. After all, a business is a business. The difference here is that you’d set aside whatever time has been allocated for free services.
A warning though: don’t get too synthetic with the numbers. If you’re supposed to make 15 percent or 40 percent margin, that’s your key metric. And when you know how much you need to make, you can build bundles and prepare your services to be sold.
Building Service Packages
Bundles are a great way to amplify the sale of services within a larger organization. They also reduce friction during the sales process because they’re easy to explain.
Once you know your necessary margin, look at your costs, look at the percent that you can bill versus the percent of the time that the organization will be giving away to close sales, subtract out the reseller margin, and figure out a necessary daily number. Easy, right? Let’s extract margin from a daily average price versus cost structure:
((Number of days billed in a year * MSRP) * Average Reseller Margin) / Annual Departmental Cost
If you pull a report of the total goods sold, you start to get a pretty good picture of costs associated with running a team and the complexities that can arise. The above formula quickly goes into a spreadsheet or a database. And it only gets more and more complicated.
Once you know your daily cost, the necessary margin, and the actual goals, now let’s build a bundle. Wonder why I said to figure out pricing in the previous section (before you did this exercise)? As a sanity check.
Tip When at all possible, I prefer working in daily increments with services teams inside larger organizations. If you’re sitting in a meeting or need to make a snap decision, knowing the daily cost and the daily profit gives you a great baseline.
Even if you deal in fixed-cost Statements of Work, you’re going to do the math to build the bundle based on an amount of time it will take to achieve your deliverables.
The bundle is meant to make it simpler to buy services. This makes it easier for teams to communicate what a customer is getting. There are two ways to approach bundling: days or deliverables. And then you need to decide if you will bundle services with other products in the portfolio of an organization.
For example, let’s say your organization sells training classes. You might bundle 5 days’ worth of training and 5 days’ worth of custom services, apply a 10 percent or 20 percent discount to that and then a customer is more likely to buy the bundle, thus potentially getting you additional sales that you might not have had otherwise.
Bundles of days mean fewer Statements of Work need to be written (less is very different than saying none). This impacts your costs, and customers always have an expectation that they will get a discount when buying in bulk. Just make sure that when stacked with a reseller margin that you will still be meeting your target margin.
Now that you’ve built out your services packages and the appropriate discounts that can be applied to them, it’s time to put the processes in place that support the services component of the business or refine them to meet the new services packages.
Once you’ve built the products and services you plan on taking to market, they should undergo scrutiny and then be put into a form of change control. The scrutiny will look different in each organization, but be thankful for it and not defensive in the least.
If no one feels comfortable providing scrutiny, go to the product management team. All product management teams are happy to give feedback on anything you might ask them of, including the product, everything around the product, the best way to make a peanut butter and jelly sandwich, and endless debates about whether Led Zeppelin or Pink Floyd was more impactful to rock and roll music.
Every company is going to have different areas that need to be checked off before you can consider your new services packages and operations as being on autopilot, which is really the goal of any business function.
According to the size of the company, there are teams you need to meet with to explain what you’ll be doing and why. A few of these will even give you homework.
Here are some questions you should ask, and if there are teams at your organization who deal with these, schedule meetings to confirm your assumptions.
Legal: One of the most important aspects of delivering services is to make sure your contracts with customers cover all of the goods and services provided to customers. Any time you change or add an SKU, make an appointment with your legal/contracts team and verify that these cover what you’re doing.
If your legal team manages corporate insurance policies, then review these as well; otherwise, work with both the insurance/risk team and the legal team to make sure that insurance policies cover the scope of the services you’ll be providing.
Sales operations: Most sales teams need an SKU. We’ll talk about sales enablement later, but you need to equip sales operations teams with a list of product names and costs.
Schedule this meeting early, as many organizations have specific change windows where SKUs can be changed due to similar windows with distributors and resellers.
Typically, a change you make will not take effect with resellers for at least 60 days. Additionally, iron out any details with how communications and sales enablement are handled with partners.
Finance: You have coordinated SKUs, but now it’s time to figure out what happens when they’re sold. Some details that need to get worked out include the following:
\ When is revenue recognized (e.g., upon delivery of the service or spread equally across the duration of a services contract)? How will finance report on that?
What kind of impacts do costs in finance have on the revenue that gets recognized, including commissions, costs, unallocated expenses, facilities costs, subcontracting costs, etc?
How is the income derived from those SKUs actually allocated once the revenue is recognized, and how will you report on this?
Ticketing: This is an important component. You need to ticket in such a way that you don’t make supporting customers even harder than it is otherwise. Therefore, your tickets need to use the same system as that of your support teams.
But the ticketing system also needs to probably track travel and support reporting on the utilization of time-based consultants. Additionally, if you recognize revenue based on ticket closures, then make sure to work out how finance will get those reports.
Once you’ve sorted out all of these details, write them down. If your company has an intranet or wiki, put the information there. Be as complete as you can be and then have the teams you meet with confirm the notes you took, which then became articles. These also act as an FAQ for when people ask about how the services operations work in the future.
Now that you’ve got a bunch of details sorted out, expect more that I can’t begin to prepare you for. Once those are sorted out, you can move on to getting marketing and sales enablement efforts underway. Before you start working with sales teams, first make sure your marketing team has provided some good air cover to support their efforts.
Once you have a product, it’s time to develop a marketing plan. This is similar to how you’d market your own consultancy, covered previously in the blog, except rather than spending your own money, you’re probably going to try to convince someone in a marketing department to spend their budget.
Getting allocated budget is the easiest at the end of a year. If you start at a company in July, and they’ve already planned all of their advertising and marketing expenditures for the year, then chances are, you won’t be able to get much done. But that’s when it’s time to start talking about the next year and what you want to accomplish them.
In the meantime, you’ll want to build as many assets as you can. And you’ll need to keep those assets up-to-date. This includes internal sales and marketing enablement assets, as well as external assets that teams can give out via e-mail campaigns, at conferences, etc. These assets include:
Customer success stories: Customers bought services and got to market so much faster. And it was awesome. You see the draw there, right?
One-pagers: Ideally, this would be one per product SKU, which could be handed out at conferences.
Stock imagery: If you can’t buy advertising yet, you might as well pick up some assets to start building advertisements in the meantime.
Contribute to other marketing assets: Yes, it just so happens that the better you get at working with people, the more likely they are to be willing to help you.
Once you have some good lift on the marketing front, it’s time to start working with sales teams on enablement.
Sales, Sales, Sales
Sales teams are your best friends and your worst enemies. They sell your services and so in a way are the reason you’re at the organization. But they also want to provide discounts quite often.
And discounting services and other ancillary SKUs is often much easier than discounting the core product. And honestly, the company is in business to sell the core product, so it should be.
But you have a margin target. And comping services to win sales is causing your blood pressure to go through the roof. If there are a lot of free services going out, eventually someone is going to ask why the margin of the services business sucks. Even if they say they won’t ask, they will. And when that happens, it’s important to be able to tell a compelling story.
The easiest way to do this is to show on the actual P&L that you’re making a profit (and let’s face it, how can you not make a profit in services?!?!). How do you do so with free services? Charge-backs.
The simplest way to describe a charge-back is it’s taking the discounted service days and charging it to another team. If a sales team is “dinged” for discounting your SKUs or giving them away, they’re far less likely to do so, even if a charge-back is performed using a soft cost rather than the opportunity cost that you aren’t billing.
But as mentioned, sales can be your best friend. They are the life- blood of the organization, bringing in new business and closing sales of the services you’re charged with delivering.
And the more attention you give them, the more services are front of mind and the more they sell. So here are some of the levers used to drive desired sales behavior in your organization.
Always make sure sales and account teams have all of the assets they need. If they need something, make it. And before they ask, you might as well build the following:
A one-pager that can be distributed externally, describing each SKU.
E-mail templates describing the service or bundle.
Talk tracks around services and bundles.
Statements of Work per SKU to provide to customers.
FAQs or Wikis outlining common questions and answers about the service.
This is removing any barrier to the seller feeling comfortable selling your services products and therefore making them more confident. And quite frequently, confidence is the most important aspect of selling.
If you want to increase the sales of services, focus on making those sales teams confident and staying in front of them doing brown bag lunches, enablement meetings, dropping off donuts, and, of course, asking them for feedback.
Once services are selling, it’s time to build a team to deliver services.
Unless you’ve already built a team. Then it’s time to manage that team.
Careers of employees in a consulting firm are pretty straightforward and we dedicated an entire blog on them in this blog. But careers of service employees in a larger company are a bit different. Keep in mind that your best possible outcome for one of your staff is to leave you. Or replace you. The best feeling is when those who deserve to do so, replace you.
All that training, all that work, and suddenly they’re better off when they leave the services team. Why’s this? Well, let’s start with why employees would be leaving in the first place.
To get in front of the product: How many people have been in front of as many customers in real-world scenarios as those who go to customers and do work? Those are often the best situations to then build product roadmaps.
At some point, many in services will get tired of complaining about priorities and will instead want to get more active about the future of the hardware or software that your organization makes.
To get closer to the product: Services engineers often make great Quality Assurance (QA) testers (after all, they’ve been testing the product with customers after it’s been released) or can easily end up moving into development teams provided they’ve acquired those types of skills.
To move into sales: Few in services will want to admit this, but in a hardware or software company, they make some of the best possible system engineers you can ask for. Those who actually try to move into sales can not only talk the talk, but they can walk the walk as well.
Travel is too much: The previous reasons were other roles that services engineers might move into. This is a reason someone might choose to leave the company outright if you can’t find a solution. Many team members begin the job loving the travel, but then as we grow up, we want to have relationships and children and settle down.
There are certainly going to be other reasons. But those are by far the main ones that I’ve seen thus far. Some organizations choose to build very small teams or not build a team at all and instead rely on subcontractors, which we’ll cover in the next section.
Professional Services as a Service:
Focus. Software companies often need to focus on what they’re good at: making software. But here you are, working on building a services team, potentially competing with your own customers.
Outsource everything, right?!?! First, we outsourced our ownership of hardware with leases. Then we outsourced the support of hardware to managed services providers. Then we outsourced our servers to hardware as service providers. Then we decided we’d rather use the software as a service and moved to websites that are hosted by vendors.
In an age where we take old concepts and rebrand them “as a service” many software companies are choosing to hire other organizations to be their professional services arm, rather than building one themselves. This allows them to stay focused on their core business (e.g., building software, refrigerators, or fields of solar panels).
Most organizations that already have a Professional Services department won’t be interested in something like this. You’ve done the work to build processes, you’ve hired road warriors, and it’s a part of your budget.
But if you’re building a new company, or trying to react to hyper- growth, choosing where you invest your time and resources is important. And if services aren’t part of your core business, then you might be able to accelerate more intelligently if you don’t do services.
Overall, if you have a product that requires services here and there, outsourcing the entire services component is a low-risk way of delivering services while still capturing revenue. But there are a few questions you should ask vendors as you look to outsource services.
Margin: How much money are we talking about here? If you are talking about 3 to 5 points then there’s no great reason to embark on a journey like this unless you want to streamline the sales process for your core product or services.
Scoping: Make sure to work out how scoping will happen if a customer needs something that isn't part of a standard services catalog.
Lateral Support: Customers expect mastery when they pay the vendor directly, so make sure to work out third- party support.
Discounts: When a company runs their own services department, there’s a pretty standard application of discounts to services in order to close sales. After all, on paper, you want to look like you’re selling as much of your core product as possible.
Therefore, make sure you know how much of a discount is allowed (both in terms of percentages and annual revenues), and that all stakeholders understand the impact this will have to the margin of running a services organization.
This is critical when subcontracting as it’s possible to have a net loss on services sales if you aren’t careful.
Visibility: How are projects being handled? You should be able to see the date and time that services are delivered and more importantly integrate that into the accounting system so your finance team can recognize revenue properly.
Customer Satisfaction Problems: Customers are often likely to call their sales team when they have a problem. You want your sales teams selling, not back-peddling to deal with unhappy customers. So, have a standard script for dealing with unhappy customers.
Customer Surveys: Customer Satisfaction isn’t just reacting to angry customers when they call in. Being proactive and reaching out to get surveys is a great way to keep tabs on how customers feel about the services being provided.
Follow-up Support: Can the subcontractor directly engage with the customer? If not, then there should be strict rules around this. If so, then sales and account teams need to understand the potential impact on future services sales.
The word “risk” is the most important aspect of this type of endeavor.
There is always the risk that something goes wrong with services. From travel delays causing resources to missed appointment times, to accidentally shutting down a network for a customer and causing them to stop business on their busiest days of the year, I’ve seen it all.
If you build your own services department, then you are taking on some risk. If you have a large enough team, that risk will be amortized across the staff and likely not impact margins too much.
What are you supposed to be doing? Growing a services organization? Focusing on profit? Squeezing margin out of the organization? Building a stronger sales funnel? Helping to close sales? Improving the product?
All of the above? There are about as many answers to this as there are companies that have services teams. In general, smaller organizations are going to be after service dollars and as organizations grow larger and more mature, these conversations need to be revisited repeatedly.
Having your own company can be pretty sweet. But there’s a lot of risks. If you’ve been running your own consulting shop, and you are ready for a new gig, then running a services team in a larger organization is certainly one of the places you may choose to look for your next position.
Or, if you’ve been in other positions within a company and are moving into services, hopefully, we’ve managed to provide a little insight in this blog into some things to do and ways to look at the business.
Most organizations that sell hardware and software to businesses will have a services team. And most will have a different perspective on what that means. In some cases, like when Gerstner took over IBM, a software company can become much, much more of a services organization. But that was an intentional transition.
Ultimately, job requisition numbers in growing companies are hard to come by. If you require too many services around your product, then perhaps some should be redirected to user experience positions.
Bootstrapping, Debt, and Grants
Bootstrapping is the term for launching a self-financed company. The founders still incorporate, but rather than accepting investments from outsiders, they use their personal savings to fund early development. This is how most people fund their MPVs because it’s pretty tough to raise outside cash for an idea on a napkin.
Bootstrapping a hardware startup can be extremely challenging, due to the capital- and time-intensive nature of building a physical product. It’s difficult to iterate cheaply at any point in the hardware development cycle. Manufacturing problems, design flaws, wasted materials, and the risk of recall is particularly stressful when cash is in short supply.
At the same time, the design or prototype stage is also the period during which funding from an angel or institutional investors is hardest to come by. As a result, many entrepreneurs fund their startup by drawing on their own savings.
Others choose to take on debt, particularly if they believe that there is a clear path to revenue. Since many banks will not write loans for startups, this often takes the form of credit card debt or a personal loan.
Some US-based founders who commit a certain amount of personal capital to their new company might qualify for a Small Business Association (SBA) loan.
The Small Business Administration site offers several different programs, so it’s worth a look to see if you meet the various criteria. The Loan and Grant search tool might help you uncover programs that can help you.
However, investors often view debt on the blogs unfavorably if there’s a need to raise a future equity round, so it’s something to avoid unless you are certain it will bring your company to a point where offsetting revenue can pay it down relatively quickly.
The federally funded Small Business Innovation Research (SBIR) program offers another option: grants for small companies based in the US. The purpose of the program is to support early-stage technological innovation or research and development work. Well-known tech compa-nies such as Symantec, Qualcomm, and iRobot received early SBIR funding.
The SBIR program consists of three stages, which are broken down according to criteria designed to gauge the technological feasibility of an idea and the progress of the company over time (see “How to Navigate the SBIR Process” on page 192 for Todd Huffman’s tips on navigating the process):
Typically a feasibility study, the first phase is designed to verify that an idea or new technology is feasible and has commercial potential and that the team is capable of executing well.
A Phase I grant traditionally provides up to $150,000 over a six-month period, though the exact amount may vary according to the budget of the specific federal agency backing it.
In this phase, the technology and approach vetted in Phase I is further refined and a prototype is developed. A Phase II award is contingent upon meeting success metrics during Phase I. It has a funding cap of $1 million over a period of up to two years.
This phase is the commercialization period. It isn’t funded by further SBIR money, but participants are often eligible for other federal funding programs, and occasionally for direct contracts with the US government. It is possible to go right from Phase I to Phase III.
Friends and Family
If you’re tapped out on bootstrapping and ineligible for any grants, the most friendly faces you can reach out to for money are your friends and family. They know you and trust you, and you’ve presumably already proven to them that you’re reliable and can do the things you put your mind to. They’ve probably heard you talk excitedly about your idea.
However, most people find it difficult to raise more than a small amount of funding this way. Typically, they’re able to round up an amount in the low six figures at the most.
Tapping your personal network has some downsides as well. A small check ($10,000 to $25,000) in the business world might be a large check to the family member who wrote it.
If he’s never invested in a company before, it’s important to make sure he understands how risky an idea-stage investment is, and that he runs a very real chance of losing the money he’s putting into your company.
$100,000 is a drop in the bucket if you’re building something that requires major production work, or specialized warehousing or logistics.
However, if you’re a first-time entrepreneur looking for funds to build a prototype before getting to that next stage, your best bet is likely a combination of self-funding (bootstrapping) and raising money from friends and family.
Angel investors are individuals who invest their own personal capital in early-stage startups. Sometimes a group of individuals invests as part of an angel syndicate, but often they are simply independent investors who have a tech or startup background, have had a successful exit, and/or are independently wealthy.
They typically write checks from $25,000 to $100,000, although some (who are colloquially called super angels) occasionally go up into the $250,000 to $1 million range.
Angels often invest in areas in which they have personal expertise or an extensive network. They can be “just a check,” but many choose to be hands-on investors who actively help their companies grow.
The number of angel investors and angel syndicates has risen quickly over the last 10 years. In 2002, there were approximately 200,000 active angel investors and approximately $15.7 billion in investment dollars.
According to the most recent angel market analysis report, which was in 2013, the number of active angels is 298,800. Capital invested grew to $24.8 billion across 70,730 ventures.
This was an increase of 5.5 percent over 2012. The average size of an angel deal in 2013 was $350,830; average equity received for investment was 12.5 percent, and average deal valuation was $2.8 million.
Many angels invest through networks such as Golden Seeds and Tech Coast Angels. The annual Halo Report tracks which groups are the most active and can be an excellent resource for identifying investors in your sector or regions.
Because startup investments are considered a risky asset class, SEC regulations require that angel investors meet the legal accreditation standards for individuals.
Currently, an individual investor can meet those standards in one of two ways: either by having a net worth exceeding $1 million (not including the value of her primary residence), or by having income exceeding $200,000 (or $300,000 if combined with a spouse) in each of the two most recent years and a “reasonable expectation” of the same income level in the current year.
THE JOBS ACT
A recent piece of legislation, the JOBS (Jumpstart Our Business Startups) Act, aims to change the requirement that investors in nonpublic companies be accredited.
Under this legislation, nonaccredited individuals will be able to invest in new “emerging growth” ventures via government-registered funding portals called equity crowdfunding sites.
These are different from project-specific donation crowdfunding platforms such as Kickstarter because the investments are made in exchange for equity rather than “rewards” or preordered merchandise.
Previously, a private company could have only 500 (accredited) shareholders on its blogs before it was required to meet SEC public reporting and disclosure requirements. The JOBS Act raised that to 2,000, of whom 500 can be non-accredited.
There are caps placed on non-accredited persons investing via crowdfunding sites: the greater of $2,000 or 5 percent of income for people earning up to $100,000 a year, or the lesser of 10 percent or $100,000 for people earning above $100,000/year.
Companies that choose to fundraise in this way will also be responsible for taking “reasonable steps” to verify the status of their investors.
TIP Although the bill was passed in April 2012, at the time of this writing, the SEC is still finalizing the structure of these new rules.
For founders who are new to entrepreneurship, finding and connecting with angel investors can seem daunting. One of the best resources for plugging into the angel community is AngelList.
Started in 2010 by Naval Ravikant and Babak Nivi, the site has grown from an email list (the origin of the name) to a comprehensive platform for enabling entrepreneurs to connect with both angels and early institutional investors.
As AngelList’s popularity has continued to grow, it has become one of the first stops that an investor makes when looking into a potential investment or getting a sense of what’s happening in a given sector or region.
The site is designed as a network, and it enables investors and founders alike to showcase themselves.
Founders can create rich company profiles that feature information such as a product video or slide deck; press coverage; traction information; incubators they’ve participated in; quotes from advisors, investors, and customers; and more.
Investors also create profiles, tagging themselves with the sectors they invest in and the check sizes they write and linking themselves to their portfolio company pages.
AngelList emails the profiles of suggested companies to targeted investors, who can reach out and get an introduction to the founders.
Users can also browse one another’s profiles and follow one another’s activity, discover trending startups, source talent or support staff (e.g., attorneys), and much more. It is a thriving community and a valuable resource.
It’s important to create a polished presence for your company. A top-notch profile can attract the attention of the AngelList team, which may feature you. With enough attention, you may become a trending startup.
In either of these cases, your startup will be emailed out to hundreds of investors and potentially showcased on the site’s front page.
In anticipation of the JOBS Act rules being finalized (see “The JOBS Act” on page 197), AngelList has recently made it possible to raise money directly on its platform. Startups that have a lead angel (someone who has committed a minimum of $100,000) are eligible to close out the rest of their round via a self-syndicate: they post the raise to the platform itself.
Angel investors can form syndicates as well. They commit to investing a certain amount of capital in a specific number of deals per year. Other accredited investors (“backers”) can join a syndicate, committing to invest alongside the lead.
This lets founders potentially receive a much larger investment through a connection with a single angel. For more information about how syndicates work, see AngelList’s Help page.
One of the most daunting things for many new entrepreneurs is the prospect of reaching out to investors and establishing a network ahead of a raise. Since AngelList’s launch in 2010, the team has worked hard to make that process easier. Ash Fontana, product manager, shared a few tips on how best to leverage the platform.
Using AngelList properly means being willing to put yourself out there, in several ways:
Give the market as much information as possible.
Create a detailed profile and think about how to make it the best possible public representation of your startup, almost like a landing page. Use the tagging system to make sure you will show up in searches by industry sector or geographical region. For hardware products, in particular, add lots of images of people using the product to your profile.
If you have units already in production, add some video! Videos help convey a sense that the product is real. AngelList proactively features the best profiles on the site, emailing them out to investors. In order to be considered, an information-rich company page is a must.
Use AngelList like a social network.
That’s how it’s architected. This requires an investment of time on your part. Just as you build up LinkedIn and Twitter contacts and relationships over time, you have to put some effort into building connections on AngelList.
Check in daily, and monitor your feed to see what people are doing or investing in. Add investors and advisors to your company profile as you bring them on. Update with important news, and have friends and followers share the updates so that you appear in their connections’ news feeds.
It’s natural to feel somewhat nervous about reaching out to investors, whether in person or online. It’s important to remember that they’re on AngelList because they are looking to fund companies.
So get out there: request introductions, follow founders and investors, and message all of the people you can message…provided, of course, that you have reason to believe that they’re interested in your space (investors also tag their profiles with their interests).
The time to join AngelList isn’t just before you want to start fundraising; it’s when you’re comfortable announcing yourself as a company. So get on there, build a great profile, and start forming relationships as soon as you’re ready to publicly acknowledge that you’re a company. Then, when you’re ready to fundraise, flip on the Fundraising switch on your profile.
Once you’re actively raising, you might want to update your profile with information specifically geared to investor questions. Add some details about your manufacturing process and relationships if you’re raising more than a small seed round; investors want to know that you’re on top of this. Share pre-sale numbers, signs of traction, and established customer relationships.
The typical process of successfully raising around involves reaching out to many investors. The best way to do that is to be authentic. Keep the first note simple, and be sure to include exactly why you think that a specific investor is a fit for your particular startup.
Once you’ve made a connection with an investor who decides to write you a check, that signal often leads others to follow. One of AngelList’s offerings, Invest Online, helps to facilitate this on the platform itself. Companies that have a demonstrated commitment of $100,000 from an AngelList investor are eligible to fundraise online.
Companies participating in the program are emailed out to the broader AngelList community. It’s a great way to find sources of capital outside of your network, and it generally takes less outreach effort.
AngelList Syndicates are another, relatively new, way to fill out around. Well-known angels and seed investors form syndicates on the platform—mini-funds, in a sense, seeded with their own capital but filled out with money from smaller investors.
This means that an individual angel who ordinarily would have written a $25,000 check has a bigger group behind him and can conceivably now contribute a much bigger amount, in the hundreds of thousands of dollars. Reaching out to these investors is a bit like approaching a fund.
More than a third of the investors on the AngelList platform are institutional investors, from VC and seed funds. It’s more than a place to find your first $100,000.
And as a startup itself, AngelList is constantly launching new features to facilitate connections and access to capital. Be sure to check out the AngelList blog for the latest tools to help you get out there and raise money.
Hardware is a particularly popular category on AngelList, and it attracts a lot of investor interest. “It’s always good to get some pre-sales on Kickstarter or elsewhere, and then go on AngelList to raise an equity round,”
Ash says. “This is a common and successful strategy; investors see it as validated demand. But ultimately, at the angel stage, it’s about the people and the product.”
Venture capitalists are professional investors who provide capital to young, high-growth-potential companies. A majority of the capital comes from outside investors (limited partners, or LPs) and is pooled in an investment vehicle called a fund.
Because the life cycle of a fund is typically 10 years, venture capitalists target investments that will achieve a return for them within this time frame. Generally speaking, they expect to lose or break even on most of the investments in a given fund but earn outsized returns on a few.
Raising a venture capital round is hard work, particularly for a hardware company. Historically, many venture investors have avoided hardware because of the high cost to bring a product to market, the difficulty of rapid iteration, and the challenge of vetting market demand prior to product release.
As discussed earlier in this blog, those concerns have been somewhat mitigated recently, and an increasing number of institutional investors are putting money into hardware startups.
It’s difficult to get exact stats on the flow of money into hardware startups, but data from DJX VentureSource indicates an increasing amount of investment dollars in the sector: in 2012, $442 million was invested into hardware startups. By 2013, that number had nearly doubled, to $848 million.
Even though more checks are being written, fundraising can still be a long slog. Many entrepreneurs on both the hardware and software side will tell you that fundraising becomes their full-time job for several months until they manage to close around.
Since you’d probably like to minimize that phase and get back to product-building, let’s go over some best practices for successfully closing deals with institutional investors.
It’s difficult to overemphasize the need to choose your target investors carefully. It’s important to know what value-add you’d like your ideal investor to provide.
A venture investment is a long-term partnership, so it’s important to find people who will be able to help you grow. A first venture capital raise should be used to help you scale and find product-market fit.
In the short term, you need partners who can help you reach the milestones you’re raising money to hit. If you haven’t yet gotten to market, for example, you might want an investor who’s helped other portfolio companies navigate the manufacturing process.
If you’re selling something into a niche channel (say, a health tech device), you might want to find investors who can help you with connections into hospitals, or who have navigated an FDA approval process. Money is money; the value-add of investors is in the extent to which they can help you grow your company.
The fundraising process is similar to sales: you’re selling a vision. Start by building out a fundraising pipeline. Identify a set of investors you want to target and set up a spreadsheet or customer relationship management (CRM) system to keep track of contact dates, feedback, and requests for follow-ups or additional information.
How do you identify investors and populate the pipeline? Do your research and be selective. To find the investors for you, read news articles, industry publications, and blogs focused on your sector to discover who the active participants are.
Check Angel List’s investor profiles; most VCs on the platform have tagged themselves with relevant sectors or geographic areas that fit their investment theses.
CrunchBase and Quora are also good resources. CrunchBase releases monthly database dumps as Excel files. Get in there and sort by sector and date, and see what funding events are happening in hardware and who’s participating. If you’d like to hear more about an investor’s process or what she is like to work with, reach out to connections in the portfolio.
Not all venture capital funds are the same. Some don’t invest in hardware at all. Some, especially smaller funds, won’t touch certain sectors with large up-front capital requirements or significant risks (e.g., health-care devices requiring FDA approval).
Be aware that most VCs won’t fund companies that are potentially competitive with their existing investments because this can create conflicts of interest. Fortunately, most VC firms’ websites include a portfolio page, so you can get a sense of what the firm looks for.
After you’ve identified the investors who are the best fit for your company, it’s time to reach out for a meeting. The ideal way to do that is to find a mutual connection who can send a warm introduction.
LinkedIn is a great place to discover how specific investors are connected to you through your personal network. Entrepreneur friends who have founded or work at one of the VC’s portfolio companies are another great way in.
If you don’t have a strong network yet, don’t be discouraged. Creating your own warm relationships with investors is much easier than many founders think. If you have a particular reason to want to raise from someone, you probably are interested in his advice just as much as money. So, ask for it. Reach out over email or Twitter.
Ask for a coffee or a quick call, and specify that you’d like to hear his take on a problem or space. It’s important to be specific in your ask. Just saying you’d “like to talk” leaves the investor wondering if you’re beating around the bush about fundraising.
It’s a great idea to do this several month before a raise so that you can solicit feedback and then demonstrate progress over time. Mark Suster has an excellent post about establishing relationships on his blog, Both Sides of the Table, where his advice is to Invest in Lines, not Dots. A “dot” is a single interaction—your company is at a distinct place at that moment.
As a relationship develops, there are more meetings, calls, or email updates—more dots. Eventually, the investor can draw a line connecting these dots, see the path the company has taken to date, and predict where it might go in the future.
The truth is, it’s rare for an investor to write a check to a founding team that she has just met, or that comes with no validation through a personal connection.
Sometimes, it’s easiest to establish a relationship with an institutional investor who isn’t a partner at the fund.
Analysts and associates might not have check-writing power, but it’s their job to meet interesting entrepreneurs, and they are more likely to have time for a coffee and feedback session than a partner might be.
While some Silicon Valley conventional wisdom will tell you not to waste your time with junior investors, their incentives are aligned with yours. They want to bring good companies in to pitch the partnership as much as you want to be in there pitching.
Associates will often help guide a founder through the process and advocate for their favorite startups in the firm’s weekly meeting.
It might mean a few extra meetings before you get to the partners, though, so if you’re truly short on time or about to close around, it isn’t rude to make that clear.
While there are many approaches to establishing a relationship, sending a 30-page deck to the blind-submissions email address (e.g., firstname.lastname@example.org) is not one of them. Those email addresses are rarely checked because investors receive hundreds of emails to their “real” email accounts on any given day.
If you have no connections at all to an investor whom you want to talk to (and no way to make them), try to at least discover his direct contact information. Many institutional investors are also on AngelList, so you can reach out to them via the platform’s Messages service.
TELLING A STORY
Once you’ve landed the meeting, it’s time to tell your story. A good pitch is a story about a problem and a solution. It’s a narrative that weaves together both your existing progress and your future vision.
If you have a prototype or demo, craft the flow of your story around showing it off. Showing is always better than telling.
The best pitches touch on the following things:
What is the customer pain point you’re trying to solve? Be specific. What is it about the problem that has appealed to you on such a deep level that you’re willing to devote years of your life to solve it?
What is your fix for the pain point you’ve just articulated to the investor? The solution doesn’t have to be absolutely innovative; it’s fine to be building a better mousetrap, as long as you’re able to articulate specifically why your mousetrap is better. Are you competing on price, on features, or on something else entirely?
Why is your team the best possible group of people to be solving this problem? Do you have a background or personal experience in the space? The founding team is the most important criterion for many VCs. Ideas often change, so investors back solid people in who inspire confidence.
If you have previously built a company or successfully launched a product, be sure to emphasize that. Even if it’s not relevant to the specific space you’re working in now, VCs like to back founders who have demonstrated an ability to execute. If you’re a first-time founder, focus on professional accomplishments and the milestones you’ve already hit on the product you’re pitching.
The addressable market
Who are the people suffering from the problem that your widget is solving? How many of them are out there? What percentage is likely to pay for your product? Many founders find this difficult to quantify, but it’s important to understand the economics of the space you want to sell into.
You have to be able to make a compelling case for why your market is big enough to be appealing to an investor. Do your homework here, and be honest.
There is a difference between total market (e.g., all of the teachers in the country) and addressable market (e.g., the teachers working in school districts with a budget capable of buying your awesome new ed-tech device).
There are many products out there, hardware or software, that are beautifully designed and in demand by some group of people.
But if there aren’t a lot of potential buyers as well (the SOM is small), VCs are going to be hesitant to back your company. You might hear the term “lifestyle business,” or “not venture-fundable,” in their feedback to you.
This means that your idea is good enough that some people will undoubtedly buy it, and you might earn a nice living from it, but it’s probably not going to grow into a billion-dollar company capable of generating the returns that venture investors are looking for.
You might be asked, “Are you a product or a platform?” This is the investor’s way of asking if he’s going to be backing the one widget you are currently producing, or if there is a vision for a stable of products.
Will you be content making a single connection can opener, or are you striving to be the next Oxo? This is of particular concern for startups that don’t have a software component.
It can be difficult to build community engagement and brand loyalty around a single simple physical product. If that’s all you’re personally interested in making, that’s fine.
But it’s going to be difficult to convince an institutional investor that a product line consisting of one type of mousetrap is going to sell enough units to produce venture-caliber returns. A well-articulated game plan for how you will become the next Oxo is much more compelling.
Your traction and revenue
If you have any existing traction, get it out there, front and center. Investors love traction. If you are a hardware company with a software component, share your engagement numbers and relevant software metrics.
Share preorder or sales data. Mailing list signup counts. The number of Kickstarter or Indiegogo backers you have, and the total dollars raised.
Enterprise company letters of intent (LOI). Any data that you have that can indicate to an investor that there is a demand for your product. Most early-stage investors aren’t looking for some specific magic number of orders or amount of revenue; they care about trends over time.
The funding ask
Why are you asking this investor for $3 million? What does that $3 million get you? Be specific. Is it for hires, or marketing, or manufacturing? While most seed-stage investors ignore the financial projections of early-stage software companies, the hardware is a different beast.
Certain things need to be paid for: salaries, manufacturing, warehousing, shipping, etc. Don’t forget about rent, legal costs, certification costs, and marketing.
It’s important to have a clearly articulated estimate of what your costs will look like, particularly if you’re asking for money to go to market for the first time.
This doesn’t have to be anything fancy, but it should convey how the dollar value that you’re asking for gets you from point A to point B. The investor wants to see you asking for an amount of money that can plausibly give you 18 months of runway.
Every startup has competition. Period. You might argue that your device is the very first of its kind to be conceived, but few problems are new, so your competition is whatever people are currently doing to overcome this difficulty.
If they’re doing nothing, then your competition is people not thinking this problem is important enough to bother spending money on your solution.
Be honest about your competition, because the investor is going to do her own competitive research as well. If you’ve conspicuously neglected to mention your closest competitor, you will seem either dishonest or uninformed about your market.
Many founders like to draw a feature matrix if they’re competing on features, or a quadrant visualization, if they’re competing on multiple factors.
Typically, each of the sections just discussed gets one, maybe two, slides. There are many great blog posts describing how to design an optimal slide deck.
One of our favorites is Guy Kawasaki’s “The 10/20/30 Rule of PowerPoint” (10 slides, 20-minute presentation, no font smaller than 30 points). You can also hit Slideshare, where many startups share their presentations.
TIP Do note that a deck that you send out is different from a deck that you present in person. You don’t want to be reading your slides to the VC in an in-person meeting…and you don’t want to send a minimalist deck with one word per slide to an investor over email.
If you’re building something that is truly new, such as an innovative technology, be prepared for investors who don’t understand what you’re doing. VCs are great generalists, but you might find that few have had professional experience in your area.
Being able to convey why what you’re doing is important to nonexperts is a valuable skill. You’re selling your concept to the VC now, but you will have to sell the product to customers or explain it to the press eventually.
Visuals or nontechnical diagrams in the deck are a great way to make things more comprehensible. An appendix is a great way to ensure that you have all of the information you need to answer the most common questions, while still adhering to the 10/20/30 rule.
If your pitch goes well and the VC partnership is excited, most will begin the process of doing due diligence. This phase takes anywhere from a few days (if the VC already knows the market well) to a few weeks (if the investor wants to do some in-depth research or customer interviews).
The purpose of due diligence is to answer the “Who, What, When, Where, and Why” questions around a particular opportunity. At an early-stage fund, due diligence comprises market research, competitive research, and founder reference checks.
The investor will examine the drivers underlying the market you’re targeting. If you’re working on a health-tech device, this will likely include the regulatory environment.
Competitive research typically takes the form of understanding who the entrenched big players are, and also doing a search for other startups in the space, to see how your offering compares.
Founder reference checks will start with the names that you provide to the VC, but they will likely also include “back door” checks of people you and the investor have in common, or other names that your references provide.
Customer validation phone calls are quite common, particularly if you’re a B2B company. The VC will ask to see your cap table.
Finally, if you already have revenue and are doing a first venture raise later in the game, a thorough examination of financials will also be part of due diligence.
So, what makes a VC say yes or no? VCs most commonly do a deal because they love the team and they are excited by the problem. Building a product that solves a big, meaningful problem typically means that customers will be drawn to your solution organically (or at least that they will be willing to pay you for it).
Investors say no for a variety of reasons. Many health-related hardware companies find that investors are scared off by the 510(k) approval process. For consumer devices, the “product vs. platform” issue might make a startup seem unlikely to grow into a big enough company to tempt a VC.
Sometimes, the pass is about your stage not aligning with where the investor prefers her investments to be (if this is the case, it makes sense to stay in touch occasionally and reach out again for a future round).
“No” is the most common response by far, so don’t be discouraged if your first few investor meetings don’t lead to checks. If you do get passed on, it’s perfectly reasonable to follow up and ask for feedback as to why.
A strategic investor is another type of professional investor worth a separate mention. Strategics typically represent the corporate venture capital or investment arm of a large corporation (e.g., Time Warner Investments or Dell Ventures).
These funds generally invest because of the potential for a mutually beneficial relationship between the big company and the startup.
Sometimes, this takes the form of supporting a potentially complementary product or an experimental technology that might one day help the strategic investor enhance its own product line.
There is often a financial motive: many of these firms specifically focus on areas in which they have deep domain knowledge, so they are likely to have a better-than-average chance at picking a winner. They will often invest alongside traditional VCs.
There are pros and cons to taking money from a corporate venture fund. The strategic partner might add value in the form of technical or business expertise in the industry.
Some will offer access to or advice about marketing channels or management. A big brand publicly signaling interest might also provide a nice PR boost to a young company. Finally, some are simply acting as passive investors, who will provide a source of capital and are likely to follow on in later rounds.
However, on the flip side, there is typically higher personnel turnover in a corporate venture fund, so you might find yourself losing an internal ally and struggling to form a new relationship.
Competitors of your strategic partner might be reluctant to become your customers. Occasionally, the strategic investor might require terms that specifically prevent you from selling your product in their competitors’ distribution channels or retail stores. They might attempt to structure a deal more like a technology license transfer than a real equity investment.
There are also potential concerns about mergers and acquisitions further down the road. You might limit your pool of potential acquirers if one of your investors is a strategic competitor because of the acquiring firm might be hesitant to divulge information about the state of its own business.
A strategic investor with a large ownership stake might have the ability to block a sale. It is important to be sure that long-term strategic partnership intentions and incentives are aligned before accepting corporate venture capital.
Structuring Your Round
There are many excellent blogs and blogs that focus solely on the mechanics and intricacies of round structuring (Venture Deals: Be Smarter Than Your Lawyer And Venture Capitalist (Wiley) by Brad Feld and Jason Mendelson is a great one), so we’ll be brief here.
When you go out to raise around from angel or institutional investors, you have to decide if you’re going to pursue convertible debt or equity financing.
In a convertible note, an investor makes a debt investment (a loan) that converts to equity in the future, generally when a subsequent equity round has been raised. The note is typically structured with a set time period by which you must convert to equity or repay the loan.
A typical convertible note asks looks something like this: “We are raising $750,000 with a $6 million cap and a 20 percent discount.” The first dollar amount is what the startup is looking to raise. There is often a conversion trigger that applies to future fundraises;
for example, once $1 million in total has been raised, the debt will convert to equity. Otherwise, the note converts when a priced equity round is raised. The discount (20 percent in our example) is a reduction in the price of that theoretical next round, and it is designed to incentivize early investors.
If the company goes on to raise a subsequent Series A equity round at a $10 million valuation, the investor holding the convertible note receives her shares at a 20 percent discount.
So if the stock price during that Series A round is on a dollar a share, his earlier $750,000 debt investment converts to 935,700 shares of stock at 80 cents a share—a 20 per-cent discount in price. An investor entering during the Around would get 750,000 shares.
The other piece of the note structure, the cap, is a ceiling that limits the valuation at which the debt can convert to equity, and is designed to align entrepreneur and investor incentives and reward early investors.
Consider the previous example: the cap is $6 million, and the valuation arrived at during the Series A negotiations is $10 million at one dollar a share. The convertible note holder’s $750,000 investment converts as if the company was valued at $6 million: he gets 1,250,000 shares at 60 cents a share ($6 million/$10 million).
Generally, the debt will convert at the lower value of the per-share price as determined by the cap or the discount.
In our example, the best option for investors is the 60-cent price from exercising the cap (not the 80-cent price via the discount). There are many possible intricacies in the terms of convertible notes, including interest rates and liquidation preferences, so make sure you understand what you’re offering.
The main difference between a convertible note and a priced equity round is that no value is set during the former. Priced equity round math is a bit simpler. Rounds are quoted as “$X invested on $Y Pre” (e.g., $750,000 on a $6 million pre-money valuation).
The post-money valuation, which is what the company is worth following the close of the equity raise, is determined by adding up the pre-money valuation and the amount of investment. In our example, post-money is $6.75 million.
Most institutional investors are looking to maximize their ownership percentage relative to the post-money valuation. Typically, they will target between 10 and 20 percent ownership.
Using our example, the VC’s investment of $750,000 is 11.11 percent of the final $6.75 million company. Valuations are generally based on comparable companies. Historically, VCs have had a bit of an edge in negotiation here, because they see deals daily and are familiar with the closing prices of other deals.
However, industry transparency is increasing. Your banker can likely provide you with a list of deals similar to yours, and Angel List recently launched a Valuation tool that lets entrepreneurs check comparables themselves. Law firm Fenwick & West also offers an annual Seed Financing Survey, which can help you understand market trends.
Hardware companies are often more capital-intensive than software companies, so many choose to raise on a convertible note to avoid discussing valuation until there are more data points (e.g., sales).
It is often faster to raise money via convertible note because a rolling close is possible (i.e., not all capital has to come in at once), legal fees are lower, and you can avoid having to formally convene a board.
However, many venture capitalists feel that investor and entrepreneur incentives are misaligned during a convertible note raise, particularly if there is no cap.
Many institutional investors also believe that their investment is more than just a check, and want to take a board seat and an active role in helping their portfolio companies grow. It is always best to approach an investor with an openness to negotiation, particularly if you believe she’ll be a valuable partner in the long term.
If you’re a growth-stage company (i.e., you’ve already raised a Series A, and you have a steady revenue stream), you might be eligible for a form of financing known as venture debt.
Certain banks will offer venture-backed companies the option to take out a loan for working capital or financing a specific project, typically in exchange for interest and warrants.
The bank will occasionally also want the option to invest in a future equity financing round. If you’re interested in using venture debt to fund a production run, there are helpful financial models online that can enable you to get a better sense of how the cash flows work, and whether it’s a suitable option for your company.