The Best Entrepreneurs are Great at Business

Episode Summary

Full Transcript

HEIDI: Welcome to the Startup Solution. I’m Heidi Roizen from Threshold Ventures.  

I often meet early-stage entrepreneurs who are geniuses when it comes to their products and the tech that goes into them. But then I come to find out that some of them don’t know a thing about business.

They seem to believe that the ‘business stuff’ is a necessary evil – a reasonably unimportant thing that you just delegate to someone else. That viewpoint has been reinforced by the media, which glorifies founders for winning the day with their superior tech chops. Those same stories never seem to highlight that mundane business stuff.  

But in reality, Silicon Valley is littered with the carcasses of tech companies that failed even though they had superior technology.

.  .  .

So, you might want to ask yourself, at this point, why do companies fail? And I’ll tell you – they fail because they run out of money! I know, duh, right?

But really, most entrepreneurs tend to burn every penny down to the end, desperately trying to find something that’ll work, and they only stop when they can’t make payroll anymore. So, a pretty important goal, if you’re an entrepreneur, is to not run out of money.  

Now, you might ask, well then, why do companies run out of money? It happens in one of two ways – they either can’t get their business to generate positive cash flow, or they can’t convince investors to invest in them. Or both. And these are not technical problems; they’re business problems.

That’s why the most successful entrepreneurs figure out very early on that they need to devote a good portion of their brain power to the business side of their startups.

This is not to say that you shouldn’t work with specialists and seek the advice of lawyers, accountants, and other business professionals as you navigate the ins and outs of your business. I’m a huge believer in getting knowledgeable, experienced help in these fields because you certainly can’t become an expert at everything, nor do you have the bandwidth or time to do everything by yourself.  

But that doesn’t mean that you don’t have to pay attention to this stuff. Because it often turns out that the business decisions you’ll make will change the trajectory of your company more dramatically than the tech or product decisions will. And what you don’t know or understand can, in fact, hurt or even kill your company.  

Learning about business stuff doesn’t require that you drop everything and head off to business school, but it does mean that you probably have to start studying up on some key components.

.  .  .

You might want to start by becoming knowledgeable about the language of business finance – and by that, I mean accounting. You should learn the basics of both cost accounting and financial accounting – and be able to read income statements and balance sheets. You should understand not only how they were created but also how to make use of the information in them to more successfully navigate the business decisions you’ll need to make.  

And speaking of accounting, you’ll need to learn about cash flow accounting – how it works and how it differs from GAAP or Generally Accepted Accounting Principles. I’ve known more than a few entrepreneurs who’ve put together great business models showing nice healthy profits – and then they’re surprised one day when they can’t make payroll even though they hit their plans. It turns out that when and how revenue is recognized, from a GAAP perspective, can be quite different from when the cash actually comes in the door. And you can’t make payroll without that cold, hard cash.

For those of you who are going to raise venture capital, it’s also a good idea to understand how the venture capital business works. Before you take millions of dollars of someone else’s money, it's quite helpful to understand how their business model works and what their priorities will be once they invest in you. Really, any money you take in to fund your company, whether it’s venture, bank debt, or something else – you ought to understand the details before you sign up for it.   

Another important language of business is law. The most successful entrepreneurs I know become quite knowledgeable about the underpinnings of not only their financings but also their business development contracts, sales contracts, intellectual property, and other areas where getting the legal stuff right may be the difference between survival and not.

And yes, I know this all sounds like a lot of work, and probably not the stuff you fantasized about when you thought about starting a company. But in my decades of experience, this is what separates the winners from the losers. And who knows, you might even find it interesting.

.  .  .

So, when does this education need to start? Well, I’d say, right at the very beginning, when your startup isn’t much more than a PowerPoint deck because it’s never too early to work out your business model. And your cash flow model. And get your foundational legal underpinnings right. And also, because VCs like me are going to ask you about all this stuff when you try to raise money from us.

Sometimes, people raising seed rounds tell me that they think it’s silly that we VCs want a five-year business model and cash flow projections for their startup. I mean, everyone knows those are completely made-up numbers, right?

Well, yeah, that’s kind of true. I mean if there’s one thing I’ve learned about projections over all these years, it's that they’ll almost certainly be wrong.  

But it's the logic, data and assumptions that you used to build those projections that I want to understand. And when they do start to go wrong, as they inevitably will, what you learn and how quickly you adapt as a result will likely be the difference between live and die.

.  .  .

So, let’s talk a bit more about that initial business model. You’ll have to make a lot of assumptions – things like your customer acquisition costs, lifetime value of that customer, and expected churn rates. You’ll also have to estimate your capital costs like factory buildouts and development costs, and usually, the biggest cost, at least for software companies, is the cost of your people. And, of course, we also want to understand what you think you can charge for all of this and why.

Then, we VCs will want to play with that model to understand how sensitive it may be to every one of those assumptions and what happens if those assumptions are wrong. Some may prove to be relatively unimportant – while others might be the proverbial tail wagging the dog. 

For example, if you sell high-margin, value-dense items, like diamond rings, shipping costs probably won’t matter that much. But for low-margin, low-value-dense items, like, say, dog food or bottled water, you get your shipping costs wrong, and that will have a big impact on your business model.

When you’re building out that model, you should not only reflect your own assumptions but also steal from the business models of other companies that have gone before you. Business models tend to come in a few main flavors, and I’ve posted a description of the most common ones in the show notes. Those proven models are a great resource on which to base yours. And just to caution all you incredible optimists out there, thinking that your model will somehow be magically different from similar companies that have gone before you is usually a bad assumption.  

.  .  .

I learned my own lessons about business modeling in my early days as a venture capitalist. I’d spent a dozen years in the software industry, which I’d come to understand pretty well. But I made the mistake of not realizing that a software business model is very different from an advertising-based model that’s also dependent on a hardware product. And boy, did I end up learning the hard way.

That “learning opportunity” happened in the form of an incredible gesture-reactive video platform called Reactrix. This was in the early 2000s, and no one had ever seen technology anything like it, except maybe in science fiction movies. You could, for example, play video whack a mole on the floor by jumping on the moles, or if the display was on the wall, you could paint rainbows by waving your hands in front of it without even touching the surface.   

And as captivating as the demo was, the promise of Reactrix as an advertising platform was even more exciting. An independent study of consumer recall had come out so positive that the study proclaimed Reactrix to be the most exciting new advertising platform since the advent of television. I kid you not.

Reactrix had a stellar technical team and had been supported so far by a few top angel investors that I knew well, so I also had a bit of an in. And when I had my partners experience the demo, they were blown away, too. So, we won the opportunity to invest $12 million in Reactrix, and I joined its board.

.  .  .

After about a year more of development, Reactrix started installing a network of these devices in malls, theater lobbies, a few airports, and even some forward-thinking retailers like Best Buy.  

We put somewhere around a hundred units in place pretty quickly, and we put them all over the country, in the largest metro areas and the highest profile venues. We wanted to go out of the gate with a large and exciting advertising footprint so that we’d be able to sell to top consumer brands like Nike and Sony.   

So now, let’s talk about the Reactrix business model. Each unit cost us about $6,000 to build and install, and in addition, the venues charged us for the space the units occupied – about $2,500 a month per unit. We also had to agree to a 50/50 revenue share with those venue owners for the ad dollars that we would ultimately collect.

But even with all those costs, the model that we developed said we’d only need to sell about half of our ad capacity in order to break even. And at about 80% capacity, we’d be a money-making machine!  

So, we fired up all those units, sent our ad salespeople out into the wild, and waited for the money to roll in. However, as is pretty much always the case, once a startup launches its product into the real world, lots of things don’t work out the way you’d planned.

.  .  .

First of all, the equipment needed to be mounted on much more expensive supports than we had accounted for because of public safety rules we hadn’t known about. Then it turned out that the displays were more delicate than we thought they would be. They became uncalibrated, or the lighting elements failed, or they broke in some other way – which meant expensive engineers flying all over the country to fix them.

Even if they weren’t technically broken, the ones that projected on the floor had an additional unanticipated problem, in that scuff marks or dropped trash would confuse the system’s reactive features, and then they wouldn’t work. So, the surfaces had to be cleaned multiple times a day – and more money had to go out the door to do that.

And regardless of whether they were actually broken or just confused, they weren’t generating any ad revenue when they were just sitting there inoperative.

.  .  .

But wait, it gets worse – because it turned out that even with those outrageous user recall metrics, the Reactrix platform was actually a very hard sell to advertisers.

For one thing, we didn’t fit into anyone’s already-established ad budgets. We weren’t “online ads,” and we weren’t exactly “billboards” either, so a lot of potential customers told us that they just didn’t have the current budget for us. And to come back next year.

It also turned out way harder than we’d anticipated to create the ads since the only way to make the recall numbers so high was to use the reactive features. But those features were unique to our platform, so you couldn’t just repurpose other existing content. Because of that, we then had to develop client-facing authoring tools and had to train the customers how to use them, and that meant more money and more time.

In the end, nothing in that original business model broke in our favor and that led to a catch-22. The cost of keeping the units in operation was going to drain all our cash before we could get to break even. But if we took enough units out of their locations in order to stem the cash bleed, we wouldn’t have enough ad inventory to sell. So there seemed to be no way to make it to break even on the money we had already raised. But in addition, with all the negative breaks in the business model, the resulting revised model was not that attractive to new investors. Even my own partners at the time didn’t want to risk any more money.

.  .  .

And so Reactrix – with its fantastic technology and off-the-charts consumer reaction was crushed under the weight of an unsustainable business model. It was an incredibly painful and expensive lesson for me – and one I think about every time I look at a new investment opportunity.

So, could Reactrix have avoided this disaster if we had been better at business modeling from the very beginning? While I’ll never know for sure, I’d bet the answer is yes. For example, we could have learned more from other hardware companies to understand how their first encounters with the real world led to increased costs and delayed timelines – and incorporated that into our model.  

We could have realized that it was going to take a year or more to fit into the advertiser’s buying cycles and adjusted how much we needed to raise to weather that in advance. We also should have realized that in addition to the whizzy reactive features, we needed the more mundane content development and tracking features to actually be a full-service ad platform. We might have even figured out that being a single-source, soup-to-nuts platform for the Reactrix technology was too big a lift, and maybe we could have partnered with other out-of-home advertising networks or other hardware providers to lighten that load.

If all of this reality had been baked into the Reactrix model from the get-go, we would have had a less exciting investor pitch as a result – but it would have been a more realistic one and one that we would have had a better chance of executing on, surviving through, and then building upon. I think it still could have been attractive enough to get funding, but I guess I’ll never really know. 

.  .  .

Ultimately, as my partner Emily Melton likes to say, “must be present to win.” You have to stay alive, and not running out of money, as simplistic as it sounds, is the number one way to do that. And well-thought-out business modeling, which you then use to continually adjust as real-world data comes in, is a big part of how to do that.

Luckily, there are plenty of great resources for learning about business modeling, and I’ve included a few in the show notes. But I also have a few tips of my own to share, especially for when you’re using those business models to interact with people like me.

First of all, start by doing your homework: know everything about your target market – the usual channels, the typical spend on products like yours, the cost of supporting the customer, the customer churn that others experience, and any other costs you’re likely to have. And it’s a great reality check to benchmark your plan against the actual results of companies that follow a similar model. For example, if ongoing R&D is 10 percent of revenue for other companies in your space, it’s unlikely that your model will work with only 2 percent allocated to R&D.

Next, list out the assumptions that went into the plan: you’ll want it to be easy to trace the numbers back to the assumptions that generated them, and as your model becomes more and more complex, you can’t just go from memory on all these variables.  

I’ve also found it helpful when entrepreneurs build out a spreadsheet that serves as a living model so that we can play with it in real time. Doing this really highlights which assumptions are the most critical and which ones you should spend the most time refining.

.  .  .

My next piece of advice is one that some people find hard to swallow: be open to questions, discussion, and even skepticism about your model. Some entrepreneurs act as if their models are sacred and questions are an affront to their business. But that’s not how the best entrepreneurs think about them. For them, a business plan is a living, breathing thing that has no value unless it learns and adjusts. So, instead of being defensive when someone challenges your model, lean into the discussion. Sometimes, those prospective investors have additional data or insights that you wouldn’t have had access to, so the discussion might actually unlock some great new insights for you.

It’s also good to be willing to say that you don’t know the answers to some of the questions you’ll get. If you’re confronted with a question about an assumption or a number that you don’t actually know, you don’t need to lie or try to wing it. It’s perfectly fine to say, “I don’t know, but I’ll look into it and get back to you.” And in my experience, it’s in those follow-up conversations where the relationship between the entrepreneur and the investor really starts to take form, so it’s actually a good thing.  

.  .  .

The final point I’ll make is that it’s important to be a realist. Sure, you do want to be optimistic, but you should also model your business with a heavy dose of reality – and model out contingency plans to accommodate the misses that might happen. 

You might think a wildly optimistic model will help you raise your first round. And that could even be true. But the problem is: when you can’t actually deliver those results, that might end up being the last round you ever raise.

And that concludes this episode of the Startup Solution. We hope you have enjoyed it, and if you have, please share it with someone who could use it. I’m Heidi Roizen from Threshold Ventures

Further Reading

HBR has a good piece on how to design a business model that pulls from many real-life stories.  

And here’s a great compendium from YC on nine common business models.

I think it makes for interesting reading, and hopefully a few lessons learned, to dig into the failure of other companies. Great material here and here.

I love the early stories about Microsoft that explain how Bill Gates landed some of the earliest deals that put them on the map. Bill has been an extremely adept businessperson from the get-go.

Previous Episode