David Cummings on Startups

Category: Entrepreneurship

  • Finding a Startup Idea

    One of the more common refrains I hear is “I want to be an entrepreneur but I don’t have a good idea.” Yes, it’s true that an idea is important, but it’s also true that it isn’t as hard as it seems to start systematically evaluating ideas. Ideas come in all shapes and sizes and most entrepreneurs pivot at least once before hitting on something that works.

    Here are a few thoughts on finding a startup idea:

    • Look at operational challenges or technical inefficiencies at work and ask if a new product or solution could help
    • Ask friends and coworkers what problems they run into on a regular basis
    • Read Sand Hill’s list of recent venture fundings
    • Write down a list of the top five trends in your industry and how they’ll play out over the next 5-10 years
    • Research the top five trends in technology and evaluate how they’ll affect your industry (top 10 tech trends for 2014)

    Now, start collecting ideas your ideas in a Google Spreadsheet and refer back to it on a regular basis. Finding an idea can take time but with effort something strong will emerge. Of course, once an idea is in place, the hard part is customer development and proving there’s a real need in the market.

    What else? What are some other ways to come up with startup ideas?

  • Startups are Messy

    Startups are messy. Very messy. Everything is harder and more convoluted than expected. Stories of success outnumber the stories of difficulty 100:1.

    The timing was wrong.

    The market didn’t care for the product.

    The team member didn’t work out.

    The funding fell through.

    The site went down.

    The mobile app crashed.

    The partner didn’t deliver.

    The passion died.

    The customer didn’t sign the contract.

    And, in the end, things were still successful. Adversity was conquered. Everything worked out.

    Startups are messy, and that’s a big part of the fun.

  • SaaS Company Valuations Will be Cut in Half

    Earlier today Jason Lemkin tweeted that a 50-70% correction is coming to Software-as-a-Service (SaaS) companies:

    I agree.

    Last week Fred Wilson wrote a post The Bubble Question about it where he attributes overvalued tech stocks to interest rates near zero and the desire for growth companies.

    Today, many SaaS companies are trading at 10-12x trailing twelve months revenue, and have no profits. So, why do I think they’re 50% overvalued? Easy. SaaS companies typically spend 40-60% of revenues on sales and marketing to acquire customers (growth is incredibly important). Assuming these sales and marketing costs could be pared back relatively quickly, the theory goes that these companies would quickly achieve 30-40% profit margins.

    The average historical price to earnings (PE) ratio is around 15 for a public company. That is, the company is worth roughly 15x profits (right now the average PE ratio is almost 20).

    If a public company is worth 15x profits, and a SaaS company can quickly achieve 33% profit margins, that results in the same valuation as 5x revenues (15*.33 = 5). 5x revenues is half of the 10x revenues many SaaS companies are trading at now, thus long term, the valuations should be cut in half.

    Of course, this is simplistic in that it isn’t accounting for growth rates, gross margins, renewal rates, total addressable market, premiums for a public company over a private company, etc. But, as an example, if a company is valued based on a function of its future profits, and SaaS companies can become extremely profitable due to the nature of the business model, making a guess as to profit margins results in a straightforward valuation.

    What else? What are your thoughts on SaaS company valuations being cut in half?

  • The 9 Best Startup Blogs for Entrepreneurs

    Five years ago I published a list of a few dozen entrepreneur blogs that I enjoyed reading on a regular basis. Over time, preferences and styles changed. Now, I still read ~10 posts on a daily basis but I no longer read 100+ like I used to do. Here are the nine blogs entrepreneurs should read on a regular basis:

    These blogs, read using Digg Reader (both in my Chrome browser and the native app on my iPhone), make for quality, fresh content on a daily basis that I find invaluable.

    What else? What other blogs would you add to this list of top startup blogs for entrepreneurs?

  • 7 Quick ‘Whys’ for Startups to Consider

    Last week I had some downtime due to Spring Break with the family and I got to thinking about several strategic initiatives. In my mind, I went through a number of current projects and did something of a “five whys” exercise to better evaluate things. After thinking about it more, I believe startups would do well to step back and ponder these 7 quick ‘whys’ on a regular basis:

    1. Why are we doing this?
    2. Why is now the right time to do this?
    3. Why are we going to win?
    4. Why aren’t we doing even better?
    5. Why do employees want to work here?
    6. Why is this the right product?
    7. Why do customers love us?

    It’s easy to get caught in the weeds of working in the business and not spending enough time stepping back and working on it. Asking why more frequently helps frame the thinking in a more strategic manner.

    What else? What are some other good ‘whys’ for startups to consider?

  • Fundraising While Still Building a Business

    Back in summer 2009 we had just cleared $1 million in annual recurring revenue at Pardot after being in business for almost two-and-a-half years. Globally, the macro economy was in the dumps and Software-as-a-Service (SaaS) companies weren’t in favor. Marketing automation as a market appeared to be a huge opportunity and all signs from our customers pointed to the product being a pain killer and not a vitamin. The next logical step was to raise venture capital and build a huge company. Or so we thought.

    Fundraising was a full-time job for four months. After talking to 29 venture firms, doing a half dozen full partner pitches, and getting to verbal term sheet discussions, we decided to call off the process and focus on building the business without institutional capital (see 4 Reasons to Raise Venture Capital). Here are a few thoughts on fundraising while still building a business:

    • Know that fundraising is a full-time job, and plan accordingly
    • Seek help from team members to offload non-essential tasks and free up responsibilities
    • Align potential investors around a desired timeframe and close date, so that there’s a sense of urgency
    • Create a competitive process to bring multiple options to the table in order to maximize strength
    • Always have a backup plan in place in the event fundraising doesn’t work out as planned

    Raising money is incredibly difficult, and, combined with building a business, makes it even harder. Fundraising should be a team effort and everyone needs to be on the same page around responsibilities and continuing to push the startup forward.

    What else? What are some other thoughts on fundraising while still building a business?

  • Requiring a One Page Strategic Plan Prior to Meeting

    Entrepreneurs love seeking feedback and help from other entrepreneurs, it’s human nature. Over time, it’s important to find an appropriate time allocation for helping others while balancing other priorities. With modest entrepreneurial success, it’s easy to be overwhelmed with requests to grab coffee.

    Now, I’m trying a new tactic with referrals to entrepreneurs requesting a meeting: complete a simplified one page strategic plan first and then we’ll coordinate a time (assuming it makes sense). Completing a one page plan in advance provides several benefits:

    • Stage of idea/startup is readily apparent
    • Area of desired help is obvious (sometimes it shows that we don’t need to meet due to inability to help)
    • Goal realism shows whether or not they have experience and/or have done their homework (too often it still says their goal is $50 million in revenue by the third year)

    Much like Jeff’s paying it forward requirement to meet with him, adding some effort and friction to the process of getting together results in higher quality meetings and more productive time. The next time you feel overwhelmed with requests to meet, figure out how to make the meetings more valuable by requiring extra effort from the other party.

    What else? What are your thoughts on requiring a one page strategic plan prior to meeting with an entrepreneur?

  • Internally Sharing the Number of Days of Cash On Hand

    Most startups are burning cash, meaning they are spending more money than they take in. Ideally, the startup will hit meaningful milestones around revenue, customer momentum, and more well in advance of running out of money. By hitting milestones, they can then raise more money from investors or achieve break-even to continue on indefinitely. One debated recommendation I’ve heard numerous times is that a startup should internally socialize the number of days of cash on hand until running out (and thus being out of business).

    Here are a few thoughts on internally sharing the number of days of cash on hand:

    • Share the number of days of cash on hand in the context of the greater mission (e.g. as part of a simplified one page strategic plan)
    • Educate the team members on how the ideal startup process works with milestones, multiple rounds of financing, value in growing faster than revenues allow, etc
    • Develop a rhythm to share the data (e.g. a real-time LED Scoreboard, weekly all-hands meeting, monthly update, etc)

    For many people, the idea of running out of cash in a certain number of days is a scary proposition. Entrepreneurs would do well to socialize it with their key team members and make it something to rally around.

    What else? What are some other thoughts on internally sharing the number of days of cash on hand?

  • Participating Preferred Stock Can Skew Valuations

    Imagine for a second that you make $50,000/year salary as an employee at a startup. Feeling the entrepreneurial itch, you make the plunge and start a company thinking that one of your first financial goals is to grow the company to the point that you can make $50,000/year in profit. Only, once you achieve $50,000/year in profit, you quickly realize that $50,000 in profit doesn’t equal your previous compensation. As a business owner, to pay a $50,000 salary, you also have to pay employer taxes (roughly 10% or $5,000 in the case of this salary) as well as employee benefits (easily $5,000 per year). Thus, to pay yourself the previous $50,000 salary, it’s really closer to $60,000 in expenses. All the taxes and extras are distortionary in that many people don’t think through the costs involved.

    Yesterday’s post titled Example Founder Dilution Over Multiple Financing Rounds didn’t touch on an important topic: participating preferred stock. Much like the example above with salaries, taxes, and benefits, where it isn’t what it seems at first glance, participating preferred stock is also distortionary. The idea behind participating preferred stock is that at time of sale the investors get some multiple of their money back first, typically 1-3x, and then also get their percentage ownership as well. Also known as a double dip, investors with participating preferred equity really own more of the economic interests of the business than their ownership percentage reflects.

    Here’s a participating preferred stock example:

    • Entrepreneur wants to raise $10 million at a $40 million pre-money valuation
    • Investors think it’s worth $30 million pre-money, but want to do a deal, so they offer $10 million with a $40 million pre-money, and a 1x participating preferred liquidity preference
    • Entrepreneur accepts the deal and is happy for the perceived $40 million pre-money valuation and investors are happy that they now get $10 million plus 20% of the business in the event of a sale
    • If the business ultimately sells for $50 million, investors nearly double their money ($10 million as part of the preference and $8 million as part of the 20% of $40 million after the preference is removed)
    • If the business sells for $10 million, investors get all $10 million as the preference are stacked in front of the other equity holders
    • If the business sells for $510 million, investors get $10 million plus 20% of the remaining $500 million, for a total of $110 million

    In the end, it doesn’t matter too much if the business is sold at several times the original valuation, otherwise, participating preferences significantly skew the perceived valuation. When talking valuations, always clarify if there are any participating preferred preferences.

    What else? What are some other thoughts on how participating preferred stock can skew valuations?

  • Example Founder Dilution Over Multiple Financing Rounds

    Continuing with yesterday’s post titled Dilution With Every Round of Financing, it’s instructive to walk through an example as a founder. Before the example, I like to highlight the stories of ultra-successful entrepreneurs that have taken their company public, and the vast majority own less than 20% of the equity at time of IPO (e.g. Marketo’s founder had 6.6% and Cvent’s founder had 16%) . Now, 20% of $500 million is still a massive number, but it’s a far cry from what people might otherwise think the entrepreneur owns.

    Here’s an example walkthrough of dilution over several rounds of raising money:

    • Two entrepreneurs come together and start a company, splitting the equity in half (so, each has 50% of the equity)
    • Angel investors are excited about the working product and early customers, deciding to invest $300,000 for 20% of the business (the entrepreneur now owns 40%)
    • Recruiting great early employees requires equity, so 10% of the shares are set aside for an employee stock option pool (the entrepreneur now owns 36%)
    • Venture capitalists buy into the big vision, value the $1 million in recurring revenue milestone, and purchase 30% of the business for $3 million as part of a Series A round (the entrepreneur now owns 25%)
    • Expansion of the employee base requires a new stock option plan, diluting everyone further by 15% (the entrepreneur now owns 21%)
    • Growth is explosive and investors compete to be part of the $10 million Series B round, buying 25% of the business (the entrepreneur now owns 16%)
    • Sales are skyrocketing and the paradox of more growth consuming more capital sets in requiring a $30 million Series C for 30% of the business (the entrepreneur now owns 11%)

    So, after an angel round, three rounds of venture capital, and a couple employee stock option pools, the entrepreneur owns 11% of the company, and they haven’t gone public yet. Of course, the company is doing great and it’s better to own a slice of a watermelon than the majority of a grape.

    What else? What are some other thoughts on founder dilution over multiple rounds of financing?