Monthly Archives: November 2012

Startups and status symbols don’t go together

In a recent discussion with a fellow VC, he bravely compared what we do to astronomy. For those of you who, like me, don’t immediately see the analogy, here is his explanation. Just like an astronomer looks for patterns among stars and connects them to form constellations, he argues that VC’s look to connect disparate pieces of information about founders to decide whether they want to back them. I think the analogy is a bit extreme, as I certainly hope that there’s more method to our madness than the search for patterns among stars. However, it accurately highlights a key VC skill. Since there’s a lot of uncertainty around the future of startups, there’s no magic ball to tell which ones will succeed. As a result, VC’s invest in those startups where they feel sufficiently comfortable with the red flags, or sources of future risk, that they see.

There are too many examples of red flags to list them all here. Some common ones which I look for include part-time members of a founding team, the absence of conviction for the idea that a team is pitching, and founders who talk about their exit strategy at the first meeting. A somewhat less common but equally troublesome red flag is when a team uses status symbols to pitch their startup. Since I’ve encountered this three times within the last week, it deserves to be the topic of this post.

The first example was a founder who began his pitch by saying that he had already spoken to prominent investors A, B, and C at top tier VC firms X, Y, and Z, and that they were all very supportive. There are many things wrong with this pitch. First, if X, Y, and Z were all very supportive, how come you’re still looking for funding? Second, if you really want to work with X, Y, and Z, why are you speaking with me? Third, VC’s talk to each other. When I reach out to A, B, and C and discover that you’ve significantly embellished your story, you not only lose the opportunity to receive funding from me but may also lose the trust of A, B, and C.

The second case involved an email with a meeting request. Even before describing what the startup does, the email emphasized that the founding team consisted of graduates of prominent schools A, B, and C. That may be a good strategy to receive a job interview at an investment bank or consulting firm, but it won’t work as well for a startup pitch. I’m interested in hearing about what you’re doing, how it’s different, and why you’re the best people to do this. There are thousands of students graduating from top schools A, B, and C each year, so knowing that you’re one of them doesn’t help answer any of these questions. In addition, you likely won’t be competing against people from your university but thousands of others who may have gone to less prestigious colleges, or not gone to college at all. Chances are that these people are going to want it a lot more than you do.

The final example was of a startup founder who pointed to their most recent press coverage to justify the potential of their business. Once again, there are many things wrong with this approach so I’ll name just a few. First, getting press coverage for a tech startup isn’t that difficult these days. This tells me that you’re as good as pretty much every other startup out there. Second, if a particular journalist has the ability to pick winning startups, please let me know. I want to hire them. Third, if the same journalist knows the potential of your business better than you do, you should also consider hiring them.

As these three examples illustrate, startups and status symbols don’t go together. By definition, a startup is a young company with no status. A startup is not part of the establishment. For it to succeed, it needs to work harder and smarter than its competitors, which often include the establishment. So what I want to hear from you is not status symbols but creative ideas, metrics if you have them, and the ambition to execute. If you’re someone who cares about status, do yourself and VC’s a favor and join a Fortune 500 company, not a startup.

It pays to be patient, even in startup land

One of the most common recommendations which entrepreneurs receive is to execute fast. In the uncertain environment of startups, you’re told to try something, see how it works out, and iterate until you find something that sticks. Since ideas are a dime a dozen, superior execution is required to succeed. While it’s true that you can’t do without superior execution, superior doesn’t always mean fast. At times it pays to be patient, even in startup land.

There are two common cases where patience is a virtue for startups. The first is when you want to obtain more information to make a better decision. For example, if you’re looking to land a customer, it’s often wise to delay your pitch to the biggest account. Instead of going after the biggest fish in the ocean on day one, you should test your pitch with smaller accounts. This patient approach will help you capture more information about the requirements of your customers and their most common objections to your pitch. This will allow you to refine your offer to better meet customer needs while also improving your pitch to preempt their most common concerns. By the time you present to the big fish, the information you’ve gained by being patient will ensure that you’re better prepared and more likely to win the account.
The second big advantage of patience lies in its signaling value. Whether you’re interacting with a potential customer, supplier, employee, or investor, keep in mind that you’re dealing with people. We haven’t changed much since our high school days. If you show too much interest in someone in too short a time, they’re more likely to run off than to reciprocate your approaches. You’re essentially sending them the signal that you’re desperate, and they’re drawing the natural conclusion. If this guy is desperate, chances are that he’s not the cream of the crop. It’s exactly at the moment when you back off that they start reaching out to you. 
The same is true for startups. If you received a term sheet offer from an investor and made a counteroffer, but the investor hasn’t responded to your calls or emails since, chances are that they’re no longer interested. I don’t buy the argument that they might be very busy, because even if they were, they would create the time to reach out to you. You’re simply not a priority for them right now. And continuing to reach out to them won’t help your cause. On the other hand, if you take a patient approach, you’ll be signaling to them that you don’t need the funding right now or that you may have secured it from another source. Just like in high school, that may be just what’s necessary to trigger the investor’s attention.
Each of the languages I speak has a saying which expresses the virtue of patience. Our ancestors clearly recognized the informational and signaling advantages of a patient approach. If they could see how we treat patience in startup land today, I imagine that they would be scolding us from their graves. Rather than repeating the same mistakes that produced sayings like “patience is a virtue”, I recommend that entrepreneurs learn from those that have gone before us. Be fast in your execution, but only if this is what makes sense. If being patient can give you an edge, don’t hesitate to slow down. Our ancestors will thank you for it. 

Perseverance breeds success

I recently received a call from an entrepreneur who I first met two months ago. At the time, I had been very impressed by his team’s enthusiasm. However, as they were an unproven team coming together for the first time, I was uncertain about their ability to execute. I left them with the recommendation to develop their prototype product and build the partnerships necessary for their startup to attract its first customers. 

This is my preferred approach for teams who are pursuing an attractive idea and have a can-do attitude but whose entrepreneurial abilities I can’t accurately judge in a meeting. There’s no better judge of entrepreneurial ability than actual execution, so I recommend that the team take its first steps outside the safety of the sandbox and return to me with their progress if they’re still looking for funding. Unfortunately, I don’t hear back from most teams. Some of these teams don’t return because, as I discover later on, they raise funds from another source. However, most of them simply don’t take the steps necessary to prove their ability to execute.

I was therefore pleasantly surprised to hear back from this founder. And my surprise grew larger as he began to present what his team had achieved in the last two months. They had established over 20 partnerships with key industry players. This was more than enough to measure the initial customer traction of their product. They had also built their prototype and were about to begin testing it. He was inviting me to take part in the initial tests and provide feedback so that they could improve their product by their December launch date. I hadn’t expected this much progress in this short a time period. I thanked the entrepreneur for acting on our discussion and am now looking forward to testing the prototype.
So what’s the moral of the story? You might think that it’s something along the lines of “perseverance wins investors”. This would be both inaccurate and limiting. Inaccurate because I have yet to try the prototype and see the initial reactions of other customers. We’re still far from reaching a funding agreement. However, I strongly believe that if this founder keeps executing as he has done so far, he’s very likely to secure funding from one source or another. More important, drawing the conclusion that “perseverance wins investors” is limiting. Fundraising isn’t the ultimate destination. It’s only part of the journey, and actually a fairly early stage of the journey. Ultimately, the startup’s success will be determined by customers, not investors. However, by persevering to win investors, the entrepreneur has signaled that he will also persevere to win customers. Perseverance wins not only customers and investors, but also employees, suppliers, and partners, to name just a few. Perseverance wins people, and people determine your success. So a more accurate and comprehensive takeaway would be that “perseverance breeds success”. 

The most important clauses of the VC term sheet, explained

The VC term sheet is daunting for most entrepreneurs. The variety of different clauses and the legal jargon in which they’re presented can confuse even the smartest and most experienced entrepreneurs. Each VC has a different style, preferred deal structure, and set of specific terms that are important to them. In addition, each interaction between an entrepreneur and VC is governed by a different set of dynamics, which depend largely on the relative negotiating positions of each party. What are the entrepreneur’s other funding options, and if they have other options, how much do they really want to work with a particular VC because of the value add that they bring to the table? How much does the VC really believe in this specific entrepreneur, and how willing would they be to back another entrepreneur building a similar business if the terms were better?

These are just some of the questions whose answers influence the progress of term sheet discussions. However, despite the uncertainty surrounding the final form of each clause in the ultimate term sheet, certain terms carry much greater weight than others. More specifically, most VC’s agree that the most critical terms are those of valuation, right of first refusal, and liquidation preference. The composition of the board is also important, but much more so for later stage startups that have an established business and management team than seed startups where the management team is the business. Let me now explain each of these terms in greater detail.
The most critical term, that of valuation, is also the simplest. It essentially comes down to how much of the startup the VC’s investment acquires. For example, if the startup is valued at $4M prior to a $1M investment, we say that the pre-money (before investment) valuation is $4M, and the post-money (after investment) valuation is $4M + $1M = $5M. The VC therefore acquires $1M / $5M = 20% of the business in exchange for their investment. Just make sure to think about valuation and the resulting ownership in terms of the percentage of the startup’s shares that each party owns, rather than the absolute number of shares that a party has. Owning 1M shares is meaningless if you don’t specify whether the startup has 10M shares outstanding, in which case you have 10% ownership, or 100M shares outstanding, in which case you only have 1% ownership. There are also other financial instruments outside of equity, like convertible debt and options, which are commonly seen in VC term sheets. As an entrepreneur, your goal should be to determine the ownership stake of each party in the event that all of the financial instruments become equity. We call this your fully-diluted ownership. For example, this would include converting debt into equity and exercising options in the case of convertible debt and options respectively. Since your fully-diluted ownership stake depends on assumptions about the future conditions at which the conversions occur, it’s useful to build a few scenarios with a probability attached to each.
Another key term is the right of first refusal, which I covered in detail in an earlier post: Entrepreneurs and investors win when existing investors participate in future rounds. This term gives existing investors the right to participate in follow-on rounds, to the extent necessary to maintain their original ownership stake, at the same terms as new investors. It’s very important for investors, and especially early stage investors, because it gives them the opportunity to share in the future upside of a startup which they supported in an earlier round when other investors were not comfortable with its associated risks. The clause supports the economics of VC investments in general and early stage investments in particular. The right of first refusal is also beneficial for entrepreneurs as it signals to new investors that existing investors still believe in the startup. Existing investors have an informational advantage about the past history and hence future prospects of a startup, so their participation in the next round helps attract new investors.

The next key term is the liquidation preference. This essentially determines how a startup’s proceeds are split among the equity owners in the event of a cash distribution. For example, a 1X liquidation preference is designed so that, when a cash distribution occurs, the investor recoups their original investment before other equity owners, including the founders, start receiving cash. A 1X liquidation preference is necessary because, in its absence, a startup could simply take the cash from an investment, distribute it among the owners according to their percentage stake, and leave the business. As an example, consider a $1M investment at a $5M post-money valuation in which case the VC has 20% of the business. Since the startup now has $1M in cash, in the absence of a 1X liquidation preference, the entrepreneur could distribute 20% of the cash, or $200K, to the VC, take the remaining $800K, and leave. While the 1X liquidation preference is necessary to prevent such an outcome, a higher liquidation preference can be dangerous. For example, in the case of a 2X liquidation preference, the investor recoups twice their original investment before other equity owners start being compensated. This can encourage the entrepreneur to take unnecessary risks and swing for the fences in the attempt to create an outcome where there is sufficient money left on the table after the investor has been handsomely rewarded. The bottom line is that a 1X liquidation preference is necessary but a higher figure does more harm than good.

The final important term is regarding board composition. The board’s only decision making responsibility is to determine whether or not to continue with the existing CEO. Beyond hiring and firing the CEO, each of the board’s other roles are supportive, not executive, in nature. For example, the board offers advice for the startup’s strategy, but the CEO is ultimately responsible for deciding which course of action to take and executing in that direction. Since the board’s only executive role is to hire and fire the CEO, seed startups don’t need a formal board structure. The entrepreneur is the business at the seed stage so if a seed investor wants to fire the CEO, they shouldn’t invest in the startup in the first place. Board membership becomes more important for VC’s investing in later stage startups where replacing the CEO and other members of the management team may be necessary to support the startup’s transition from the early stages of creative growth to the later stages of operational growth.

This is by no means an exhaustive list of the terms that you’ll face in a VC term sheet. Although you should prioritize valuation, the right of first refusal, and liquidation preference for all startups, and also consider board composition for later stage startups, I recommend that you understand each term in detail before agreeing to a term sheet. Most important, don’t be afraid to ask a question if you don’t know what something means or why a particular clause has been included. Once you boil them down to their core, each of the terms should have a simple explanation and specific set of future outcomes which justify their inclusion. If, after digging in, a term is still too complex to understand, it’s probably not because you’re stupid but because it shouldn’t be on the term sheet. 

Pricing for enterprise IT startups

After an enterprise IT startup has established product-market fit, one of the most important issues it faces is pricing. Pricing is not a simple technicality as, together with volume, it is the core driver of your revenues. The difference between optimizing and overlooking pricing may be the difference between success and failure.

Most IT startups that deliver a differentiated product which creates large value for their customers choose to charge their customers based on their ability to pay rather than a measure of the value that is being delivered. This allows them to extract maximum value from each customer. However, despite the logical sense of this opaque pricing approach, few startups have the negotiating power and relationships with key IT purchasing managers necessary to adopt it. Especially in their initial stages, the majority of startups need to rely on a transparent tiered pricing model to win customers.

The traditional tiered pricing model offers different levels of service at different price points. The different levels of service commonly vary along dimensions such as product features, the number of user licenses granted, and customer support. The final shapes of most pricing models are similar in that there are a number of tiers with each successive tier offering a higher level of service at a higher price point. However, this is where the similarity ends, as startups take very different journeys to determine the specific attributes of their packages.

At one extreme are those startups which arbitrarily assign different service levels and price points to different packages. Although higher service levels are more expensive, there is no method to the madness, or reasoning behind the pricing. An exaggerated example of a common mistake is for the basic package to already offer each of the product features that all of your customers want. The difference between the basic and premium packages may be a product feature which no customer wants. As a result, you won’t sell any premium packages, and will leave money on the table by not further segmenting the service levels of the basic package according to customer needs.

This leads to the right way to determine your pricing strategy. In particular, startups that excel at pricing start by segmenting their customers according to their needs. This can be done by surveying prospective customers or looking at the actual usage of existing customers when available. The goal is to determine the product features, number of user licenses, customer support levels, and other attributes demanded by each customer. The next step is to group these customers into segments based on the similarity of their needs. Since few customers are likely to have identical needs, this grouping is as much an art as a science. A good rule of thumb is to create between three to five customer segments. Any less and you’ll likely be missing out on the opportunity to discriminate between the specific needs of different customer types. Any more and your pricing strategy will confuse your customers.

Once you’ve grouped your customers according to their needs, you need to determine what price to charge different groups. Once again, this is more art than science. However, a good approach is to estimate the value in terms of greater revenue and cost savings which your product generates for different customer segments. You should then charge a price which allows you to capture a chunk of that value. The more differentiated your product relative to that of competition, the greater the share of the value you should try to capture. Some of your customers will be performing the same calculation on their side so this approach will help you keep your customers happy while also generating as much revenue as possible from your product. And when in doubt, err on the side of charging more, not less. You can always lower your price to attract more customers, but an increase in price is much harder to justify. What’s more, a higher fraction of your customers than you’d expect won’t even bother calculating the value delivered by your product!

Coming unprepared to first meetings with entrepreneurs

This one’s going to be short and sweet. I’ve recently been experimenting with a new approach to first meetings with entrepreneurs. I used to prepare by reading up on the startup, including reviewing its business plan and any other documents made available by the team as well as searching the web for relevant information. Roughly two months ago, I started entering first meetings unprepared. And trust me, it’s not because I’m lazy.

The downside of conducting a first meeting without any preparation is that I have not researched and thought through important elements like the team, idea, market, and competition in advance. As a result there’s likely to be a large gap in my knowledge of the subject matter and that of the entrepreneur. Most of my comments in the first meeting are instinctive reactions rather than well-constructed arguments which reflect a deep understanding of the topic at hand. This unstructured approach also makes it unlikely that we comprehensively address each of the factors necessary to make a fully informed investment decision in sufficient detail.

However, the same factors which make it risky to conduct a first meeting without any preparation also contribute to the success of the approach. By bringing an outsider’s perspective to the discussion, I’m able to ask those obvious questions which the entrepreneur should have already thought about from many different angles. In a surprisingly high fraction of first meetings, I discover that the entrepreneur has yet to properly reflect on and address one or more of these obvious points. This sends a strong signal about the natural inclination and ability of the entrepreneur to focus on what matters most rather than getting lost in the details. This unstructured approach essentially helps us focus our discussion on the most important 20% of the factors which will explain 80% of the startup’s future success.

The second big advantage of an unprepared approach is that it makes the entrepreneur responsible for guiding the discussion. If I was prepared, I would already have a predetermined agenda and a set of questions which I’d like to ask of the entrepreneur. I would essentially be leading the discussion, even though the entrepreneur, not me, will be leading the business. This sets the wrong expectations on day one. The vast majority of startups need a strong leader to be successful, and a strong leader should be able to convey a clear vision and convince their team, investors, and customers about the value of what they’re doing. If they can’t lead me in the direction they seek, this is a strong signal that they’re either not convinced of the direction themselves or are incapable of attracting followers.

The jury is still out on whether this unprepared approach will produce better investment outcomes. As outlined above, I have strong reasons to believe that this will be the case. However, the results won’t be clear until several years later, when I’m able to compare the investment outcomes of those startups whose first meeting I prepared for with those whose first meeting I entered with no prior research. Even then, the difference in the timing of the two sets of investments will make a direct comparison incomplete. I’ll need to benchmark the investment outcomes against an index representing the average outcome for comparable investments during the relevant time period. Please remind me to perform this exercise before 2020. Until then, try this approach at your own risk!

Yemeksepeti’s opportunities for geographic and adjacent business expansion

I’ve been meaning to share my thoughts on General Atlantic’s investment in Yemeksepeti for quite some time. General Atlantic is a growth equity investor managing $17B, including investments in popular internet names like Facebook, Box, and Gilt. Yemeksepeti is the leading online food ordering service in Turkey, with smaller operations in the UAE and Russia. General Atlantic’s $44M investment in exchange for a minority stake in Yemeksepeti makes this the largest venture capital investment of the year in Turkey.

Since the investment took place as recently as September, we have yet to see where Yemeksepeti will be applying its newly acquired resources. However, there are two significant opportunities for expansion. The first is geographic, and the second is into adjacent businesses. Geographic expansion is the safer bet with a clear path to short-term monetization. However, the entry into adjacent businesses with at times unproven business models is necessary for Yemeksepeti to develop beyond its origins as an online food ordering service. By taking the right steps now, the firm has the long-term potential to become the first name which comes to mind in the restaurant industry.
Let’s start with geographic expansion. In order to understand Yemeksepeti’s geographic growth opportunities, we first need to understand the nature of the online food ordering business. Yemeksepeti is the first and pretty much only name which comes to mind when someone in Turkey wants to order food online. This is because it is the single location that houses the largest number of restaurants in the country. This makes it attractive for users who have access to an incredibly wide range of dining options under a single platform. In turn, the large number of users makes the site more attractive for restaurants who want to increase their sales volume through a cost-effective channel. This is the classic case of a virtuous circle where restaurant relationships drive user acquisition which attracts yet more restaurants, ad infinitum. Being the first player to launch this virtuous circle has tremendous benefits. You certainly still need to invest in maintaing and developing restaurant relationships, presenting a simple user interface, and offering great customer service both pre and post-order. However, being the first mover to capture the significant network effects inherent in the online food ordering space is the key to succeeding in this business.
This is exactly the role that Yemeksepeti fills in Turkey. This has made it very difficult for upstarts like Istelezzet to take off. The switching costs for users, specifically in terms of foregone dining options, are simply too great. Although working with another online food ordering service doesn’t represent an additional cost for restaurants, they simply don’t have an incentive to be present on a platform without users. However, as Yemeksepeti now looks to expand into other geographies, the same factor which facilitated its success in Turkey will make it more challenging to succeed in other markets. Yemeksepeti’s main competitors Just-Eat and Delivery Hero are also well funded, having raised $64M and $50M respectively in the last 6 months. Just-Eat has a strong presence in the UK, Spain, and several other smaller Western European countries, as well as Brazil and India. Delivery Hero is present in some of the same Western European countries as Just-Eat, as well as Germany and Austria. The company’s emerging market presence includes Russia, China, and Mexico. The solution for Yemeksepeti is not to forego geographic expansion, but to focus on growing in those countries where its competitors have not captured a market leading position. These include populous markets in the Middle East like Egypt and Saudi Arabia, as well as Eastern European countries like Ukraine, Poland, and Romania. By prioritizing these untapped markets, Yemeksepeti can capture the same pole position which paved the way for its huge success in Turkey.
The second expansion opportunity for Yemeksepeti is in adjacent businesses. At this stage it’s helpful to think about an individual’s dining journey. Take yourself as an example. You first decide whether to eat at home or to eat out. If you decide to eat in, you can either prepare your own food or place an order for delivery. Yemeksepeti currently only serves you in the second case. It therefore has the opportunity to build a business which delivers the ingredients required for specific dishes to you when you want to prepare your own meal.
What if you decide to eat out? Your first step is to decide where to eat. A source like Yelp in the US, or Mekanist in Turkey, which presents users with reviews of specific dining options based on filters like cuisine, location, and price, is a great starting point. 
After you decide where to eat, you may want to make a reservation. OpenTable in the US is successful in this space. Rezztoran has attempted to offer the same service in Turkey with limited traction so far. 
Once at the restaurant, instead of relying on a traditional menu and lengthy waiter interactions, there’s an opportunity to enhance the dining experience through technology. E la Carte, a Romulus portfolio company, addresses exactly this need through its Presto tablet. The Presto lets diners browse a restaurant’s menu, place their order, play games, pay the bill, earn loyalty rewards, and provide feedback to the restaurant. The result is a 10% increase in sales per table and a near 10 minute reduction in table turnover times. A win for the restaurant and a win for the customer. While many competitors offer smartphone and tablet applications which customers must download to access similar functionality at specific restaurants, this approach has met with limited customer adoption. E la Carte is successfully driving customer growth by incurring the upfront hardware costs and offering the Presto directly in restaurants.
A good starting point for Yemeksepeti to prioritize these adjacent businesses is to look not only at which services are being implemented in other countries but also the success of monetizing each service. This approach would suggest that entering the restaurant reservation and in-restaurant dining technology spaces are most attractive and should be a first priority. These services have not only gained widespread adoption in the US but also have clear revenue models based on a combination of subscriptions and commissions. Among the other adjacencies, the restaurant review space is likely to be a second priority as it has yet to establish a clear path to profitability. The advertising revenues of restaurant review platforms are currently insufficient to cover the operational costs of the business. The delivery of specific ingredients for at-home cooking is likely to be a third priority as customer demand for this model has yet to be proven in other countries. 
After deciding which adjacent businesses to enter, Yemeksepeti needs to determine the most effective way to grow in each. This could be organically, through the acquisition of a capable local player as in the case of restaurant review platform Mekanist, or by serving as the local partner of a foreign player. Whichever path it ultimately takes, expansion into adjacent businesses has tremendous potential to complement Yemeksepeti’s geographic expansion. If Yemeksepeti were to grow in these adjacent businesses, it would gain much more than the contribution of each individual business. A customer’s actions and revealed preferences across different stages of the customer journey can provide Yemeksepeti with a treasure trove of data. By properly mining this unique data set, Yemeksepeti has the potential to offer its customers increasingly personalized journeys, while also giving restaurants and advertisers the opportunity to deliver Yemeksepeti users highly targeted promotions.