Founder as Shock Absorber for the Startup

Recently I heard an entrepreneur interview and the question of the founder’s role came up. Normally, you hear the typical answers like set the vision, recruit the team, make sure there’s cash in the bank, etc. Only, here I heard one I hadn’t heard before: the founder acts as a shock absorber for the startup.

The more I think about this, the more I like it. A shock absorber is defined as “something that serves to reduce or mitigate the worst effects of an unwelcome occurrence or experience.” In startupland, high highs and low lows are a regular occurrence. While thoughtful transparency of the good and bad is often the right approach, it does need to be modulated and presented with the appropriate commentary.

Right now, things are especially choppy in the world of startups. With so many startups laying off people, it’s easy to just see the doom and gloom. In reality, many startups have strong businesses and will continue to do well, but they also got ahead of themselves raising too much money and burning too much capital. Founders, as shock absorbers, need to get out in front and work with team members and other constituents to help “mitigate the worst effects of an unwelcome experience.” Communication, beyond simply writing an email or blog post, is always the best approach. People naturally get worried and need to be reassured repeatedly. Communicate, communicate, communicate.

The next time you think of a founder’s roles and responsibilities, add shock absorber to the list.

Be Single-Minded Long Enough to Get Lucky

Recently I was sitting outside at a restaurant and my ears perked up when the gentleman at the table behind me started talking about entrepreneurs with his guest. When pressed by his companion as to what makes for a successful entrepreneur he replied, “Be single-minded long enough to get lucky.”

This phrase has been on my mind ever since hearing it.

Single-mindedness is a critical trait of entrepreneurs. Adversity, ups and downs, and continuous challenges are part of the startup experience. Most people, faced with regular setbacks, give up and move on. Irrational persistence is one of the most distinguishing entrepreneur characteristics.

Then, combine single-mindedness with longevity — persistence over a long period of time, makes for an even more remarkable, and rare, combination. The longer the time, the more people are going to give up, especially when core milestones like product/market fit or a repeatable customer acquisition process haven’t been achieved.

As much as we like to think our intelligence and effort determines success, there is a large element of luck. Timing, people, geography, etc. plays a role in the size and scale of success — components outside the control of the entrepreneur. I’ve seen people that are incredibly smart try and fail as entrepreneurs. I’ve seen people that are incredibly hard workers try and fail as entrepreneurs. From being at the right place at the right time, fired from a job and making the leap, hired into a certain industry at an early age, or some life event, luck plays a role.

The next time an entrepreneur asks what it takes to be successful, consider the idea, “be single-minded long enough to get lucky.”

Back to the Rule of 40 for Startups

With the Great Exuberance behind us and more restructuring pain ahead of us, it’s clear that we’re back to the standard Rule of 40 in startup land. For several years, it was growth at all costs. Want to raise exceptional amounts of money? Show strong growth. Now that those days are done, let’s review the Rule of 40.

The Rule of 40 is a score that combines growth rate and profit margin.

Growth rate, as we all know, is typically measured year-over-year. So, if the startup was at $10 million annual recurring revenue (ARR) 12 months ago and is at $15 million ARR today, that’s a 50% growth rate. As always, the higher the better. The big difference now is that it’s in the context of profits/losses, as a percentage of revenue.

Profit margin is talked about a few different ways from EBITDA to free cash flow. For our purposes here, we’re going to focus on free cash flow. Free cash flow is the cash left over after paying all expenses and capital expenditures. As part of the Rule of 40, we’re interested in free cash flow as a percentage of revenue — profit margin. If we receive $10 million in revenue and generate $2 million of free cash flow, that’s 20%. If we receive $10 million in revenue and lose $2 million, that’s -20%.

For our Rule of 40 score, we add growth rate and profit margin together, with a target of 40 or higher. Since we’re adding two unrelated percentages, we call the resulting value a score. Some simple examples to achieve 40:

  • Grow 60% with -20% profit margins (lose money)
  • Grow 40% at break even
  • Grow 20% with 20% profit margins (make money)

The challenge in startup land today is that too many startups have a Rule of 40 score well below 40, with some even having a negative score. To get to a score of 40, or higher, many of these startups are laying off employees to cut expenses to reduce their losses and improve their margins. For all startups, cost cutting is the fastest way to improve the Rule of 40 score.

Beyond being an important overall metric for startups, it’s also an important score to use for educating and aligning employees. As you can see, there’s an indefinite trade-off between growth and profits. Startups, by their very definition, are growth-oriented companies. So, growth is a given, yet it’s constrained by cash — both cash from investors and cash generated/lost from operations. The more team members keep the Rule of 40 as an important driver in their decisions, the more they’ll optimize for capital efficient growth.

Entrepreneurs would do well to make the Rule of 40 score one of the key metrics of their business and ensure all stakeholders understand the importance.

Startup Ecosystem Optimism Post Correction

Our startup ecosystem, like all markets, goes through regular ups and downs. Sometimes we go through a period of unusually high highs, like the back half of 2020 and most of 2021. Sometimes we go through periods of unusually low lows, like the aftermath of the Great Recession post 2008. Now, we’re in the unwinding period of the most recent Great Exuberance and it’ll be painful as we work through the necessary changes.

Only, I don’t believe we’re headed for a long winter. We have too many positive characteristics in our favor. Let’s look at a few:

Depth of Business Model Understanding

Metrics, best practices, and playbooks on how to build SaaS, cloud, and marketplaces abound. We have numerous examples of startups that have scaled past $100M in revenue and a growing number that have scaled past $1B in revenue. While we’re still advancing our understanding of the business model, it’s clear we’re in a good spot with decades of foundational work.

Base of Existing Revenue

While some startups were raising money at astronomical revenue multiples, the vast majority raised at normal-to-high revenue multiples, and therefore have a strong base of revenue. Because these are high margin, capital efficient businesses, almost all revenue goes towards employee salaries plus sales and marketing expenses. If funding were to completely dry up, these startups could dramatically cut costs (layoff employees) and become profitable (cash flow positive) almost immediately. Once profitable, the startup is no longer on the fundraising treadmill and is default alive. While growth is likely to slow, it’s better than the alternative.

Capital to Be Deployed

With a quarter trillion dollars raised to invest in private companies recently (mostly in private equity with a meaningful percentage in venture capital), there’s a tremendous amount of money on the sidelines that has to be put to work. Why? Investors must justify their management fees and therefore need to do deals. Limited partners have a challenge in that they’ve signed contracts to supply capital to these investors, but because of allocation percentages to different types of assets, they’re overweight in venture / alternative assets (denominator effect). Being overweight, these limited partners will often ask that the capital allocator slow down their deployment cycles and minimize capital calls until things are more balanced. While this will slow funding, there’s still an abundance that is going to be invested in startups, especially the ones that have the best metrics and opportunities.

Conclusion

The startup ecosystem is going through a normal course correction and will emerge healthy and strong. Startups that were on shaky ground will get washed out and startups that have the highest potential will get more capital and talent. Much like a forest fire cleaning out underbrush and providing nutrients for the soil, so too does this creative destruction make for a stronger ecosystem going forward.

Context is Critical for Startup Advice

With the continued dark cloud over the economy and public market volatility, there’s been a deluge of startup advice lately. One point that’s been missed is that the advice is often geared towards a certain swing-for-the-fences style startup. Let’s dive in.

When reading TechCrunch and posts from leading venture firms, it’s easy to get sucked in that all startups are the top 10% of venture-backed startups, have raised money at crazy valuations, and are burning inordinate amounts of money. While it’s true that there are more than ever doing that, the reality is that it’s the extreme minority of startups that have done so.

Most startups that wanted to raise money at top-of-market multiples couldn’t. It doesn’t mean these are bad companies. Rather, these are good companies — in the top 1% of all companies just by definition of raising venture capital — building valuable franchises. When a handful of venture firms, crossover funds, and hedge funds paying huge premiums passed on a deal, there were hundreds of additional venture firms that paid more normal-ish multiples. Yes, these firms were stretched higher than their comfort zone, but nowhere near what a tiny number of firms were paying. Put another way, most venture-backed startups raised money at normal-to-high valuations, not exotic outlier valuations.

Whereas a small percentage will have to grow 10 or 20x to have an up round, most startups that raised on a multiple of run-rate will have to grow 2-4x to have an up round — just do the math. If a startup raised at 100x ARR, and multiples are now 10x for the same type of business, they have to grow 10x to get to their last valuation. If a startup raised at 21x ARR, and multiples are now 7x for the same type of business, they have to grow 3x to get to their last valuation. While 3x is massive growth, it’s much less dramatic than 10x.

So, startup advice always need context. Most of the famous firms invest in startups with the biggest markets and fastest growth rates. Most startups have big markets and fast growth rates, and didn’t receive astronomical valuations. Context matters, especially for startup advice.

Think About Systems More than Goals

Last week I was asked about some of my current goals and I replied that I’m more focused on systems and processes to achieve desired outcomes. Goals are important insomuch as you need to decide where you want to go. Only, too often, entrepreneurs spend their valuable time thinking through goals only to have them sit on the side in a dormant state. Once there’s a general direction, effort is much better spent on the systems and processes that will culminate in achieving the goals.

Take for example a common entrepreneur statement: we want to sell 10 new customers this quarter.

How so? We’re going to allocate more time and money to sales and marketing.

Then what? We’re going to track our metrics more closely.

And how does that help? We’ll see where we’re tracking and can optimize our efforts more effectively.

That’s typically the end of it.

Now, instead of focusing on selling 10 customers, and making that the emphasis, the effort should be on the process that produces new customers. Some questions to ask:

  • What sales activities are within our control?
  • How many activities do we need to perform?
  • How frequently do we need to perform those activities?
  • What are the different stages of the sales funnel and conversion ratios?
  • What changes if we fall behind our required output?

Goals represent the outcomes and systems represent the flow of work performed to achieve the output. Especially important is controlling what you can control. You can’t guarantee 10 new customers will sign up this quarter. You can guarantee the activities necessary to have a good chance at the desired outcome are performed. Then, the result is the product of what you can control.

For another perspective, watch The Perfectionist on 60 Minutes about coach Nick Saban. The big takeaway: Saban doesn’t talk about winning and the current score, he talks about how to “challenge the players to play every play in the game like it had a history and life of it’s own” so that the results take care of themselves. Too much time is spent worrying about what’s happened and where things stand — elements that can’t be changed. What can be controlled is focusing on the task at hand and performing it at the highest level.

The next time the topic of goals comes up, focus the efforts on the systems that will achieve those goals.

Startup Success – Good Growth, Gross Margins, CAC Payback, and Burn Multiple

Market gyrations and startup valuations have been the hot topics lately. With so much turmoil across the economy, it’s clear we’re still in for more pain as the world adjusts. On the startup front, a number of entrepreneurs are thinking through what to do and what needs to change in their current plan. While some startups are doing well, many that raised money in the last 18 months did so in a way that their valuation got too far ahead of their performance. What to do?

In the most recent episode of the All-In podcast, David Sacks shares that high growth startups with moderate burn will get funded while ones with moderate growth and high burn won’t. Continuing that thinking, he outlines four metrics startups need to optimize for if they want to raise money:

  1. Growth rate > 100%
    Growth has been one of the biggest drivers of value creation for the last few years. Now, instead of growth at all costs, it’s one of several factors that must be evaluated. So, keep growing fast, but do so in way that’s more measured in relation to other metrics.
  2. Gross margins > 50%
    Gross margins are what’s left over when you subtract the cost of goods sold from the sale price. Some startups have negative gross margins (lose money on every customer) or low gross margins because the business model is either sub-scale or challenged in other ways. The key is to have large, positive gross margins.
  3. Customer acquisition cost (CAC) payback < 1 year
    Sales and marketing costs to acquire a customer can easily get disconnected from what makes for a good business when capital is cheap. Now that capital is more expensive, it’s important to be able to acquire customers at a cost that’s less than the revenue received from the customers in the first year.
  4. Burn multiple < 2
    The old adage that you have to spend money to make money still rings true. Only now, for every $1 dollar of burn, the startup should add one net new dollar of annual recurring revenue. Many startups are burning an excessive amount of capital relative to a new dollar of recurring revenue and will have to adjust.

This isn’t RIP Good Times; it is a return to the basics: build something people want, acquire customers in a way that makes sense financially, and scale as fast as the metrics allow.

Entrepreneurs should focus on their growth rate, gross margins, CAC payback, and burn multiple in a way that’s thoughtful and optimized for their business and market opportunity.

Today’s Our Best Day and Tomorrow’s Even Better

Last week I was catching up with a few startup leaders and we were talking about different styles and personality traits of entrepreneurs. One of the entrepreneurs in the group said something that really resonated with me:

I believe today’s our best day and tomorrow’s even better.

Now, I’ve known this entrepreneur for over a decade and he’s truly sincere when he says that. There’s something to be said about the real belief that today is absolutely the best day and the conviction that tomorrow will be even better. Optimism and positivity is a wishy-washy subject that incredibly subjective. Yet, personally, as someone who feels rather analytical, I believe it makes a difference, even if it isn’t objective.

Why? I’ve met many entrepreneurs that have done amazing things — things that are so far beyond defying the odds — and they are all optimists. Even with a world around them saying “no” or “that can’t be done” these entrepreneurs push on and make things happen. It’s so easy to not take the risk, not put yourself out there, and not get rejected.

The next time you talk to an entrepreneur, ask them about today, and then ask what they think about tomorrow. If there’s optimism and enthusiasm in their voice, know that their chance of success is higher. Today’s our best day and tomorrow’s even better.

Catalytic Mechanism to Drive a Desired Outcome

One of my favorite learnings is the power of the catalytic mechanism to drive a desired outcome. Jim Collins popularized it decades ago writing:

Catalytic mechanisms are the crucial link between objectives and performance; they are a galvanizing, nonbureaucratic means to turn one into the other. Put another way, catalytic mechanisms are to visions what the central elements of the U.S. Constitution are to the Declaration of Independence—devices that translate lofty aspirations into concrete reality.

Turning Goals into Results by Jim Collins

In everyday life, the most common ones we see are things like “The meal is free if you’re not given a receipt” and “Money back guarantee if you’re not 100% satisfied.” In the first example, the desired outcome is that every order is entered into the cash register and rung up so that the payment isn’t stolen. In the second example, it’s an effort to ensure customers are happy such that they are both treated well and more inclined to speak up if something wasn’t right. By doing one thing, you’re increasing the chances that a different, more important thing happens.

Here are a few questions startups should ask:

  • What is the desired outcome?
  • What’s necessary to achieve that outcome?
  • How can I catalyze or incentivize the opposing action or actor to help achieve the desired outcome?
  • What are other ways to align adjacent pieces to help with the desired outcome?

Simply put: what is it that you want to happen and what other behavior can you influence to achieve it?

Catalytic mechanisms are a powerful tool entrepreneurs should incorporate into their startups. While some can seem obvious, take the time to think through how you can use catalytic mechanisms to help achieve your goals.

The Card Game War and One Little Change

As a little kid I loved playing the card game war. War is an incredibly simple, pure luck card game. Two or more people are dealt all the cards in the deck. Then, each turn every player flips over their top card and the person with the highest card wins all the other cards. If two or more of the highest card are the same card, then it’s a “war” where only the players with the highest card then put two cards face down turn a third card face up. Whoever has the highest card wins all the war cards. Finally, whoever wins all the cards in the deck is the ultimate winner.

As a kid, there’s excitement and joyful randomness playing the game. What’s going to flip over next? Is it going to be a war where we have matching cards? Who’s going to win the war? Am I winning?

As an adult, there’s joy in playing with the little ones, but also concern as the game can continue on for hours after one or more players are out. Ideally, three or four of us could play and the downtime between getting out and starting a new game wouldn’t be that long. When I first played with my kids, after decades of not playing the game, I was taught a new rule: every time that a war occurs, each opponent puts one additional card face down. So, instead of always having two cards face down for each war, the first time you have two down, the second time you have three down, and on and on.

One little detail — adding an additional card for each war — changes the game so we can play more often, with more people, and have more consequential wars as the game progresses.

While there are no silver bullets, I’ve found that there are step function improvements that can come with changing one little detail. In the moment, they’re rarely identifiable, but with time, the results can be dramatic. The key is to keep iterating, keep improving, keep working through ideas. All the work is necessary, but some little changes are more valuable than others.

The next time you’re iterating on the product, go to market motion, or any other initiative, remember the war card game and how tweaking one detail can dramatically change the entire experience. Make the small changes knowing that they build on each other and occasionally one little update will turn into a major improvement.