Sweat Equity as Alternative Funding Model

In an earlier blog post I argued that the funding model for software startups is fundamentally changing. This is hardly an argument and more of an observation of the expense side going down for IT startups and legacy funds largely still caught in their bubble investment models.

There is a LOT of talk in the entrepreneur and VC community about the survivability of this model especially regarding the ability to raise more funds in the coming year. And with that, how many VC's will go into hibernation, change models (i.e. lower raise from largely non-institutional money focusing on companies requiring less capital or switch focus to industries with larger capital requirements), or quietly close their doors.

Seth Levine has an interesting article firing back at the Business Week article on How Venture Capital Lost it's Way. Here's another from Fred Wilson earlier this year on the math of venture capital. And Above the Crowd with his post on Asset Allocation and Venture Capital.

In the face of these facts the early stage software and software as a service (SaaS) early stage ecosystem remains healthy. Companies are figuring out how to generate cash flow earlier, get by with less and raise less, and in increasing numbers are eschewing venture capital paths altogether. Angels have stepped in to fill a larger role in seed stage investment but so too have the entrepreneurs and developer communities.

Contract developers are a lot like angel investors with the exception that they're throwing development skills instead of money in alongside the founders. Their "yes/no" analysis is a mix of knowledge of the founders (friends), attractiveness of the problem/solution (skills), and recognition of the market (money - or Net Present Value - NPV). There's a mix of people who've been through the bubble(s), heavy in skills and slightly jaded on the NPV calc. And there are the people who haven't been through the bubble, are anxious to make their mark and want to believe but are much more pragmatic than similar folks in the heady bubble days.

Both of these groups are willing to work for some amount of equity, and depending on the friendship card and personal cash flow needs, some requirement of cash. After all, food doesn't find its way to the table on it's own. This enables you to get your product built without having to hire someone full time and at a discounted rate. I must admit that I've put in a hell of a lot of time on my recent project to get it off the ground doing a large chunk of the development, but I've also managed to get the entire beta launched in the very low five figure range.

As a side note, I think it's infinitely useful to go back and read 37 Signals Getting Real

I've put together a few of these agreements and they're all fairly similar. Please add a comment if you would like a sample version of one and I'll send it to you. And if your needs are greater, I'll refer you to friend and former Cooley attorney Michael Stack who has helped with some of these agreements in the past.

The mechanism is essentially this:

• Agree upon a discounted rate per hour that will be paid out in cash
• Agree upon a bonus compensation that involves granting a set number of shares per hour that feels fair. You might be able to back into this number by giving a nod to what the company might be worth if someone priced a round. So let's say you think the company could be worth $1M pre-money and there are $1M shares outstanding. After the discounted rate, the developer is willing to take in a bonus of 50 shares per hour worked.
  
• Create an agreement that contains both the discounted rate, bonus stock rate, and expectations, ceilings on hours, IP protection.
  
• 1099 the contractor for the discounted rate plus the bonus stock at the current stock value (which at a very early stage could be as low as .01/share)
• Downside to be aware of is a larger pool of shareholders in your company and some additional dilution.
  

First Things First - Creating the Pitch Deck

At the very beginning stages of a company, even if that company is merely an idea jotted on a coffee stained napkin, the first real step to moving forward is to create a pitch deck. The long and short of company creation, fund raising, and selling is that you need a way to explain what you do in simple straightforward language. This will obviously take various forms depending on the audience. Get started with an investor presentation. Taking the perspective of an investor will force you to answer the hard questions of why someone else would believe in your ingenious world-changing idea enough to give you their money.

Guy Kawasaki broke this exercise out into 10 slides in his book "The Art of the Start" published back in 2001. His 10/20/30 rule holds up.

The people you are pitching to have limited attention spans and have heard 100 business plans in the last 60 days. Guys advice on the 10 slides follow. They don't have to strictly follow this order but the order is good. The biggest one I would consider swapping is "Team." If your team is a very strong component (and it is a primary reason people will invest) then stick it up front, perhaps right after your solution slide.

Ten slides. Ten is the optimal number of slides in a PowerPoint presentation because a normal human being cannot comprehend more than ten concepts in a meeting—and venture capitalists are very normal. (The only difference between you and venture capitalist is that he is getting paid to gamble with someone else’s money). If you must use more than ten slides to explain your business, you probably don’t have a business. The ten topics that a venture capitalist cares about are:

1. Problem
2. Your solution
3. Business model
4. Underlying magic/technology
5. Marketing and sales
6. Competition
7. Team
8. Projections and milestones
9. Status and timeline
10. Summary and call to action

Read more: http://blog.guykawasaki.com/2005/12/the_102030_rule.html#ixzz0XW8WIxS7

After you've collected your ideas, pitch it. Pitch it to your close business mentors and associates, pitch it to your girlfriend, spouse, people in your target market. Pitch, rinse, and repeat.

And when you're ready to take the presentation to the next level to put a finer point on it, check out Presentation Zen. Thanks Catherine for turning me onto it.

The New Deal

I've been out fundraising for my new company, Roundpegg for about five weeks now. I've met with a multitude of venture capitalists, angels, advisors, prospects, customers, and just about anyone with a pulse. A monster meeting schedule is par for the course at this point in the company's life. You constantly walk the line of meeting schedules vs. sufficient productivity to get the product built, demonstrable, deployable. Also par for the course has been VC response. We've done one west coast swing with Roundpegg and although we had a lot of interest, with comments like, "huge market", "it's unique; I haven't seen any other deals come through that are like it", "perfect timing for the market with this kind of company", the week after the VC partner meeting we've gotten the litany of soft no's typical of this stage.

• "You're too early stage. Keep us up to date."
• "If you were in the Bay Area we'd be interested. Have you thought about moving?"
• "Do you have a lead investor in Colorado? Is Foundry investing in you?"

These are radar meetings. Radar meetings are intended to get you onto the radar of the VC community, making them aware of you, and often resulting in a number of offshoot meetings with potential angel investors, partners, prospects, etc. It's always good to have the meetings early and not ask for the money. Ask for advice, ask for contacts, ask what the VC partner thinks about the market you're going into and whether they've seen deal flow recently in this space.

Something has changed in the process though. You can feel it at these meetings and in the attitudes of other entrepreneurs. With the majority of venture funds' portfolio companies still feeling the effects of the recession, venture funds have moved to the right--that is, to later stage investments. Any venture funds still in the early-stage game seem to be speculating on the hyped areas of social media infrastructure and applications, or on clean technology.

There seems to be an increasing gap between the very early friend and family stage of funding, and doing a professional seed round of funding. The Mint.com story illustrated this point further in a post by Christine.net after they were acquired recently by Intuit.

The straight shot: Why should you raise money, and how much?

• Step 1: When you're ready with an Idea: Raise $100K from friends and family, and use it to build a prototype.
• Step 2: Once the prototype is done: Raise < $1M in seed capital, and get into market with an alpha launch.
• Step 3: After that initial launch has traction: Raise $5-10M, and use it to prove/scale the model.

So while the venture fund community has continued to move to the right (from a business stage perspective) the entrepreneur community has moved to the left from a cost perspective. It now takes less than for forever ago to get a software startup off the ground. In roundpegg.com we've spent less than $10K in total over six months to incorporate, build the first fully functioning version of the technology, host the site, and design and build a website for the company. While this is not sustainable and now with customers going live we need a couple of more people the overall cost of getting the company between these early milestones is incredibly low.

So where does this leave us on the investment side? Close to heaven. The groups stepping into the gaping void are angels. Angels typically invest in these early rounds and may even participate in the friends and family stage of the investment. In this environment they are also capable (given two or more with deep pockets) of taking a SaaS (software as a service) oriented company all the way to profitability and skip the venture funding process entirely. There is a huge opportunity for super angels, angel consortiums, or seed stage venture funds to claim this middle ground of professional seed stage investment.

Remember that in a time of disruption opportunities abound.

Ten Tips for Successful Entrepreneurs

Ok, I've become lazy in my posts but this is an excellent bit that was forwarded to me by my new friend Jana Matthews. For those of you who know Jana, you know what a smart, passionate, and caring person she is and I value her input on the startup game. More posts to come on that peculiar rider and vehicle, the entrepreneur and startup. This one offers good insights that you can use immediately to evaluate behavior in your own startup and the threshold to post was so low that it offered a great way to get back in the game.

I just ran across some notes from a session where Guy Kawasaki and I spoke in Cambridge, England on 9/11/2001! Think about them in the context of your own company.

Ten Tips for Successful Entrepreneurs

1. Jump curves or create the next curve. Keep moving.
2. “Don’t worry; be crappy” In other words, ship, test, and keep improving. It’s OK if you’re 10X better than what is. You don’t need to be 100X better, e.g., bad toilet paper is still a lot better than crumpled leaves.
3. “Churn baby churn.” Do versions 1.0, 2.0 3.0, X.0. Do R&D and continual product improvement
4. Break down barriers – enable people to test drive your product or service sooner, rather than later
5. Evangelize – don’t just sell. Show that what you have to offer is in their “best interest “. Show how it will make the world a “better place”. Capture their heart and head. It’s better to legitimize the revolution than to win the battle. Better to legitimize the web than to win market share on the internet.
6. Let 1000 flowers bloom. Think of the many applications of your concept
7. Eat like a bird; poop like an elephant. Birds eat 50% of their weight every day. Be a voracious eater of information
8. Think digital; act analog
9. Never ask people (consumers or customers) to do what you would not do yourself
10. Don’t let the bozos grind you down. Don’t give up. [“ Bozocity” often happens when someone has been successful in one curve, gets stuck, and finds it impossible to move to the next curve (or find value in your new product or idea)].

I hope you find these Ten Tips useful.
Best,
Jana
_______________
Jana B. Matthews
Chief Executive Officer
The Jana Matthews Group
www.JanaMatthewsGroup.com

11+ tips to help survive the downturn from John Doer

Came across this blog entry from Christine.net recording the 11 things John Doer says entrepreneurs should do to survive in an economic downturn. I've copied below and you can get to the full post here. Thanks for blogging this Christine.

1. Don't take a meat cleaver to the core of your business; use a scalpel when making changes.
2. Cut once, and cut deeper than you need to.
3. Keep 18 months of cash flow, being conservative on cash flow from revenue.
4. Defer facilities expansion – don’t spend money on tech or physical expansions.
5. Reevaluate R&D priorities.
6. Renegotiate all contracts that you have, even leases.
7. Remember that everyone in the company needs to be selling the value proposition.
8. Offer people equity instead of cash – e.g., equity bonuses.
9. Secure the cash with things like government-backed securities.
10. Figure out what the leading indicators are for your business so that you can react quickly when things don’t turn out.
11. Communicate honestly with everyone, including all employees, and don’t sugarcoat things.

I really like 11 and think it builds respect and trust. We're all in the boat together after all.

I would say two additions are:

• Truncate deals that are not core to your value proposition. Unless you are still firmly in experimental mode with plenty of cash and small burn SELL WHAT YOU HAVE! Also goes back to the tenets of Focus, Focus, Focus
  
• Pay attention to cost of sales - do you need to travel or can more be squeezed out of inside selling efforts?

Signs you are no longer in a startup

You wake up one day and the company you started is no longer in it's infancy. This didn't really happen overnight but somehow it feels like it. I sat down with another local entrepreneur for a cup of coffee the other day and created this list of signs that you're no longer in startup mode. That doesn't mean you don't still have a sense of urgency or passion, just that you've passed into another phase of company building and all that comes with it.

• You have meetings about meetings
• You have revenues and are less worried about eyeballs or page views than revenue growth
  
• There are people working at the company you haven't yet met
  
• The whiteboards are better than the mylar sheet you can buy at home depot for $20
• More than one conference room
• The board is made up of more investors than entrepreneurs
  
• Sales people
• A second office somewhere else on the planet
• COO
• A formalized vacation policy
• Not sure what other people at the company are doing over the weekend
• Rotten food in the fridge. (also a sign that people are beginning to think that others will take care of things)
  
• Printer is almost always out of paper when I go to print something (see previous point)
  
• Someone you randomly meet at a conference has heard of your company
• Other companies are calling your company seeking partnership
• Expense checks are doled out on schedule
• More than one floor in your office space
• Company events have become more generalized to meet the interests of the larger group
• You've become self conscious of saying "fuck" in the office

I'm certain there are at least 100 others I've left off...

business plan or powerpoint?

Here's the transcript from an IM conversation I had with a friend today regarding business plans.

friend: hey, you have any business plan docs laying around?
friend: that you could share
TimothyJ: you want some sort of template?
friend: no, looking for a real one
friend: that people actually used
friend: and that doesn't suck
friend: i can find templates, but I'd like to see what a real one looks like
TimothyJ: ok. let me see if i can dredge an early copy up. i'm not a huge fan of business plans however. I think there's an internal document you create for brainstorming purposes and then you boil that down into slideware
TimothyJ: you can pretty much use Guy Kawasaki's art of the start as a template for that
friend: ah, interesting
friend: well most of the standard stuff that people put in there is BS
friend: projections of revenue, hiring, etc
friend: but seems like investors want it
friend: even though they know the #s are wrong
friend: way way wrong
friend: vision isn't BS of course
TimothyJ: state your problem, why you are uniquely positioned to solve it, IP, market size, how much it will cost to ramp, a good plan for doing that ramp on a milestone basis
friend: ya, sounds reasonable
TimothyJ: yeah, the investors want to see it's a big market to go after so that's the top down market analysis
TimothyJ: then you do a revenue swag based on percent of market with some sort of ramp the investors can swallow
TimothyJ: first year is to nail down early adopter accounts (and build out product)
TimothyJ: not big revenue expectations
TimothyJ: 2nd year (in your model) would be channel sales relationships and proving out the sales/delivery model are repeatable
TimothyJ: 3rd year is revenue growth, showing scalability
friend: that sounds like a reasonable model
TimothyJ: brainstorm all that, condense it into a deck, and then go practice pitch it to a friendly vc

As you can see, pretty straight forward stuff. I think people get too caught up in creating a comprehensive business plan. In a software startup you need a thesis (the problem), you need to figure out why you have a clear chance of building out what's needed (risk mitigation), and why this grand product will cause people to separate themselves from their money (high value). I think the business plan is a great exercise in force thinking through the business. It just changes so many times over the course of the first 18 months or so it's better to think in terms of slide decks or mind maps.

CTO Series - Out of the Goo

At the outset a company needs a huge amount of energy from a very small set of people to have any sort of chance of making it through the first year. My companies have been fairly complicated software affairs and so much of the energy input has been in the initial product buildout to sufficiently demonstrate the idea. So, in those early heady days of whiteboard brainstorming, myth making, protean moneyless, nothing-else-exists, insomniac haze, everything draws your attention. Servers need to be built. There is no data center so the servers sit half tilted on the desk next to you humming away. Source control needs to be set up. The beginnings of an architecture need to be laid down. You set up the company's email and website. There is no marketing, no sales department, no one booking your flights. You beg and borrow from friend's time to help with various aspects. You push friends and family to the limits of their patience. And you code like crazy, pulling all nighters when you're on a roll and some thorny problem is nearly within your grasp. You're in every aspect of the product, pushing each just far enough along to get that primal system to crawl up out of the digital goo limping into reality.

Key take-aways:

• The early days of startups can get you distracted in a thousand directions so build a plan
• The plan should be optimized to get you into discussions with *real* customers as soon as possible to validate the value
• Don't fall in love with your plan, it will change, perhaps daily some weeks
  
• Build top 10 lists. There's a hell of a lot to accomplish. Figure out what matters most to the plan and create a top 10 list.
  
• In the list take on the hard problems yourself, delegate the easy ones
• Lead by example. Push people but don't expect them to work harder than you do.
• Have someone tend to the business. Incorporation, setting up health insurance, getting office space, chairs, and printers, and a checking account are not where you add value
• Communicate. Constantly elaborate on the vision to any one who will listen and primarily anyone in your startup. This will help you in the evangelism phase later. Things that seem like really great ideas in your head sometimes fail the test when you have to communicate them out loud. This forces you to think through the problem in greater detail.
  
• Don't get distracted. Don't look at your email when you're focusing on the product. If someone has a question that doesn't need to be addressed right away tell them you'll get back to them. Let people know when it's ok or not ok to come ask you questions. Wear a set of headphones when you don't want to be interrupted even if you're not listening to anything. Most people won't bother you if you have headphones on (same as on a flight).
  

Once this is accomplished the road show begins and you spend a lot more time talking to people than writing code. In order for your company to survive you must raise money, either by selling some form of the product, or taking in venture capital. This slows you down to a crawl but gives a lot of perspective on the value of your creation and gives you time to digest the market and what might be important. It also preps you for the next stage in the company's development, R&D growth. Rest here on the bank for a just a moment. There's a lot more evolution coming.

The Idea

I wanted to start writing a little bit about the role of a CTO in a startup company. There's a wide range of behaviors in that role from the more execution oriented engineering manager to inventing a fair amount of the technology to a visionary steward who directs the company towards the optimum market value. I have played many roles in multiple companies across this continuum and wanted to get a few thoughts down that may be of help to others out there trying to make sense of this elusive function.

A CTO is the Chief Technology Officer in the company. In more well established companies this is a contributing role that would typically report up through the Chief Information Officer (CIO). In a technology startup, the CTO role is critical for the successful launch of the company. It all starts with the idea, and in many cases the CTO is not only the founder but the individual who had the idea and the knowledge to determine whether implementing the idea is likely. For the moment though I would like to set aside the notion of solution probability.

Ideas often start with personal pain. Engineers, or rather inventors are inherently lazy. When confronted with a problem, an inventor will ironically go to great lengths, often expending much more energy than giving in to the brute force approach, to try to find a short cut solution. The brainstorming that follows traverses a series of what if's with numerous cerebral dead ends. The beauty of this stage is in the search for the possible and you may have no f*cking clue how likely a solution is but are making probability guesses based upon incomplete knowledge. For instance, in my last company, Dante Software, I had just finished reading the O'Reilly book on Perl for Bionformatics. I was currently the CTO of a Web 1.5 services company where we built Commerce, Content, and Community sites. I'm going to give myself a smallish bit of credit here for incorporating community directly in the site, although I didn't recognize the importance it was going to play in the future. Anyway, we would continually have issues with system performance and outages that impacted the business. The aha moment came after reading the bioinformatics book and realizing that the web business and it's integration to traditional parts of the business had become specialized and the interactions complicated enough that a similar model in bioinformatics to track protein-protein interactions for disease detection was not all that far off from what I was trying to solve. That is, I wanted to detect problem conditions that could impact the business before they became problems for my customers without having to know what alert thresholds to place on every possible metric in the underlaying IT stack.

Now I have a big hairy problem. There's nothing out there solving it (as far as we know). And there's a solution model in a completely different space that looks like it might be adaptable or at least used as a guide for my problem. Aha, idea born. This could work! The next step is to reverse engineer the problem and map to the proposed solution to come up with a reasonable guess as to how it might work. Then researching whether something already exists that may be close enough or could get there faster than you. And SWAG (silly wild ass guess) how long it would take you to prototype. But these are market and time to market questions. I'll address those later. It's a great feeling just to sit with your idea for a bit and relish the brilliance of it before taking that next scary step of analysis. This will be a long road. Right now you need to build up your confidence to herculean levels :)

I remember once telling a VC at this stage about an idea and they said how about company X, haven't they been working on something similar for the last few months. Knowing the people in the other company and having an inflated sense of confidence in my ability to get this idea off the ground, I looked him straight in the eye and said "We'll crush them". ;)

coffee and marketing

I've been helping on the marketing front and as far as I can tell there are five primary components:

1. Evangelism - If the market is not mature you need to create a value proposition that will resonate with buyers and educate the market. Note, this can take a while and is also why it is good to have competition. Didactic distribution.
   
2. Positioning - Know your product vs what other people are selling, accentuate the differentiators using as many keywords as possible. Note, this can be over engineered.
3. Landing - Build a compelling website and landing pages that are informative, appealing, and again, have lots of keywords. Design as a funnel to gravitate people towards certain pages that will result in a trackable lead.
4. Analysis - analyze where people are coming from, how many leads each source generates, and the quality of those leads by how many translate into prospects and customers. Use this analysis to improve lead generation and lead quality.
   
5. Coffee - Purely anecdotal but every good marketing person I talked to likes great coffee :)

Happy Marketing!


Coffee art courtesy of The Cup in Boulder

Quarterly Management Meetings

Meetings, meetings, meetings. They're sort of a necessary evil to running a business. People need to communicate in order to synchronize efforts within and across groups. They can be a huge time suck. At Collective Intellect we were having weekly management meetings. These became laughable at some point due to the overall activity in the company. People were either traveling or knee deep in some project or other with too little time to formally sync every week.

Through the tangible and immediate need to get projects done the team has naturally moved towards more frequent, informal hallway, and highly efficient meetings. So the meeting needs have become more about steering than rowing. We recently decided to solve this gap by instituting quarterly management meetings. This is a technique we borrowed from my last company.

After being purchased by webMethods in 2003 I became part of the management team. We held quarterly meetings that were one quarter strategy and three quarters execution planning. We applauded the accomplishments from the previous quarter, discussed the failures, and talked about what we wanted to accomplish in the next quarter. Each department would present how they planned to support those quarterly goals. We would typically do two days and have dinner together on the night in-between. The dinner was a great opportunity to blow off steam and enjoy each other's company out of the trenches of day to day business.

We've had one of these thus far at Collective Intellect. It wasn't perfect. We've got work to do. But it's a great step forward in the maturation of the company.

Boulder Startup Trivia

A free six-pack of Fat Tire beer to the first person who can tell me the person in the Boulder entrepreneurial community with a copy of Samuel Jackson's character's wallet in Pulp Fiction. You know, the one that says "Bad Mother Fucker" on the outside?

(all people who were at dinner with this person last week are excluded)

add your guess to the comments

appeal to innate laziness in human beings

Was listening to a panel on startups yesterday (I'll highlight these in another post) at Supernova2007. One of the panelists was Paul Kedrosky. When asked what he looked for in a company his answer was "companies with ideas that appeal to my innate laziness"

I think it's an excellent point and I would add to it. If there's a task that occurs everyday in your life, people will always seek ways to either shorten the task or make it more pleasurable. If you can provide a product that does either of these two things you have a shot at success. If you do both well (and have good marketing) you will have great success.