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Tuesday, July 26, 2011

When (and whether) to scale?

My friend Tom Eisenmann (@teisenmann) has blogged for his entrepreneurship students on the important question of when (and why) entrepreneurs should ramp up to achieve scale economies. This is an issue that I usually address early when I teach entrepreneurship and also technology strategy.

Of course Tom is a leading scholar of network effects and technological innovation: he knows the material cold. Thus it’s not surprising that his advice is solid — the pros and cons of trying to be a first mover, the benefits of scale, and the obstacles that startups typically face in getting there.

In some ways it’s a more complete explanation than mine would beHe makes the point in a more quantitative way than I have, suggesting that his students are in a program that expects financial analysis throughout the program, not just in a few select classes.

There is only one thing I would add if I were using it in my own course. The posting assumes that the entrepreneur will (or must) scale, and I think it’s a choice that every entrepreneur should consider.

Perhaps it’s Tom’s audience. I can see a scenario where people who plunk down $170K for a Harvard MBA aren’t going to mess around with a mere “lifestyle business” — they’ll take someone else’s money and (ala Babe Ruth) swing for the bleachers rather go for the sure single.

However, in my class I talk to students about what causes scale economies, and how some businesses have them while some don’t — or, more realistically, can achieve minimum efficient scale with fairly modest staff and/or revenues.

Yes, I wanted to create the next HP or Apple, but I didn’t blow my brains out when that didn’t happen — nor did I pull the plug on my business and my customers. (I did cut back to part-time status and get a Ph.D., but that’s another story.)

So what I teach my students is that scale is a choice and a matter of fit to both aspirations and pragmatic realism. If you want to make a rapidly growing business that has a huge exit, 9 times out of 10 you need to attract sizable venture investments and generate the explosive growth those investors demand.

However, if you don’t want to take their money — or don’t have an idea that will generate the growth they expect — you can still start a business. The trick is to find a concept that doesn’t require such scale to create a sustainable competitive advantage.

As with any other aspect of strategy, success is a matter of aligning the goals with the reality, and then executing like hell.

Friday, July 8, 2011

Honesty makes employee incentives work better

Cross posted from Open IT Strategies.

The private equity investors who flipped Skype (from eBay to Microsoft) have decided to screw some of their employees out of their “vested” stock options.

The issue came up when one Skype employee, Yee Lee, found he forfeited his stock appreciation rights when he left Skype before the acquisition. He summarized his problem on a blog post last month.

Corporate lawyer-turned-law-school-professor (and New York Times pundit) Steven Davidoff summarized the controversy in two postings at NYT DealBook. (Not yet behind the paywall).

In the first article, he noted that PE firm (Silver Lake) could have settled the controversy for less than a million bucks. He attributed the decision to a culture clash between NY financiers and SV venture capitalists. The former is not about reputation or honor, but money.
But in Silicon Valley, the community is not only smaller, the people work together again and again, and so trust and reputation are valued more highly. On his LinkedIn page, Mr. Lee alone lists more than 10 companies where he has worked. When you are going to see and work with the same people repeatedly over many years, $1 million is small change to buy their needed loyalty.
Davidoff argues that while VC has a better reputation, both sides add value equally. Of course, he is a former NY lawyer who advised big companies on their acquisitions.

But the reality is that while VCs do is equally greedy and lucrative, what they do is more rare and economically valuable. Restructuring can be (and has been) done by PE firms, managers who lead a MBO, more traditional corporate acquirers, or even in-house executives with the proper incentives. Best practice in operational efficiency disseminates pretty quickly, so very little about the PE business model (or their value add) is protectable over time.

In a second article, Davidoff concludes that employees are just as likely to be screwed by carefully hidden legal mumbo-jumbo by Google or a raft of other recent startups. (What we don’t know is how each company verbally represented this clause — did they call attention to it or did they bury).

Davidoff’s solution to both cases is that the employee should see a lawyer. (In other words, his philosophy is to create a full employment act for his peers and his students).
In a narrow legalistic sense he's right — that is if Lee were lucky enough to find a lawyer with the right kind of experience. As an entrepreneur, I lost $50,000+ on a business deal that was vetted by my lawyer; my lawyer (of many years) didn’t understand my business well enough to anticipate the scenario that played out, I didn’t volunteer it and he didn’t ask.

However, more seriously, this sort of “ask a lawyer before doing anything” causes an unaffordable drag for startups and their employees. Yes,it might only be $500 for the one consultation that spotted the problem, but it’s also $500 for all those other times where it wasn’t necessary but you paid the lawyer just in case.

There is a non-lawyer solution: we acknowledge that there are fundamentally two types of options: those that actually vest, and those that are only exercisable by current employees.

If the ideas of the incentive stock option is to incentivize employee, then the terms and conditions should be clearly articulated in plain English. If necessary, the state or federal government should require employers to spell it out. (Banning misleading practices is the one place where I believe in aggressive government action.)

I once heard ethicist Michael Josephson say on his radio segment: "Integrity means doing the right thing when nobody’s looking.” (The original author is lost, but similar remarks have been made by quarterback-minister J.C. Watts).

In Davidoff’s world, employers and employees are adversaries using lawyers to duke it out even before conflict arises. In a company with integrity — the only sort I’d put my name to — the terms and restrictions for employee compensation are clearly explained in a way that every employee can understand. As an added benefit, doing the right thing makes sure that the employees and employer have their goals fully aligned (at least until after the end of the lockup period).