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.

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).

Teach your children well

America has been a more entrepreneurial country than most, and California a more entrepreneurial state than most. It’s not in the water, perhaps some of it has to do with institutions, but certainly culture (and traditions and norms and values) have a lot to do with it.

Entrepreneurship is normally a subject taught in college, but various data points suggest that a lot happens at the K-12 level before entrepreneurs get to college. Below are some random thoughts about how such values can be inculcated, from my own experience as both an entrepreneurial scholar and the parent of a teenager.

Traditionally, Junior Achievement was the way to get kids to think past the lemonade stand into the opportunities provided by free enterprise. My wife taught several years at the elementary school level until she shifted to become a substitute teacher. Personally I think reaching everyone at a young age opens their eyes to the possibilities, even if their actualization is much later.

This week, the WSJ “Small Business Report” (advertising section) offered advice about how to raise an entrepreneur. After interviewing experts, pundits and actual entrepreneurs, writer Barbara Haislip suggested a list of six attributes:

1. Adventurous: to explore and indulge their curiosity
2. Dependable and Stable: have high standards
3. Observant: have them see unmet needs
4. Team Player, particularly through sports
5. Lead by Example, from entrepreneurial parents

I have not been trying to raise an entrepreneur, but it matches pretty well what we are doing as parents. However, I think those that have done Junior Achievement will be more inquisitive and observant.

What does seem to be getting through to our daughter is the TV show “Shark Tank.” The staged confrontations don’t teach much — any more than the silliness of Idol or DWTS — but the issues that are salient certainly will stick with a young viewer. But personally, the value I see is in the ideation — some of the ideas are truly awful, but they show everyday people trying to build a better mousetrap, a few of which might actually cause the world to stand up and take notice.

Personally, I think it could be fun to combine all three. Take the WSJ checklist, do a brief lecture, watch an episode of Shark Tank and then debrief. Do this early in the year, before the JA program starts, so students are sensitized to the realworld implications of entrepreneurship (and perhaps watch other episodes, past their bedtime, to the consternation of their parents.)

The problem of being acquired

(Cross posted to the Bio Business blog.)

At #IndustryStudies2011 this week in Pittsburgh, I heard an interesting talk about what happens to biotech startups after they are acquired. Panos Desyllas of the University of Manchester presented his study (with two Manchester co-authors) of UK biotech firms acquired 2006-2010 by non-UK companies.

The team studied in depth six acquisitions, interviewing executives from both sides of each transaction and also analyzing five years of trailing patent data. They also traced what happened to the key scientists after the merger by noting their affiliations in subsequent patents.

From this data, they came up with a simple (but useful) 2x2 typology: are the two firms similar in technology and are they similar in capabilities?

The firms might be exploring different technological frontiers. Or the acquired firm might have something that the acquirer does not — or vice versa — whether it be UK marketing by the acquired firm or global marketing by the acquirer. The (plausible) intuition is that complementary acquisition is more likely to create ongoing value than a more directly competing one.

The typology worked as predicted. In the case of acquisitions where both the technology and capabilities overlapped, the buyer closed the acquired company, keeping only an IP expert or two as a temporary consultant to transfer the tacit knowledge.

In discussion during and after the session, we discussed the case where the buyer bought a rival with the sole purpose of killing it. This happens all the time, and in some ways it seems like a special case with an utterly predictable outcome.

The other case I brought up was when the acquisition starts out as being complementary — but the acquired firm gets killed anyway.

In April, Cisco killed the Flip camera line that it bought for $590 million in 2009. Pure Digital founder Jonathan Kaplan was sorry to see Cisco knife his baby rather than put it up for adoption, particularly when it remained profitable.

The other example (from the life sciences industry) was Biogen Idec, billed in 2003 as a merger of equals between two biotech startups, Boston-based Biogen and San Diego-based Idec Pharmaceuticals. However, the failed merger brought the closure of the former Idec operations in San Diego last November, and the layoff of some 300 employees (including a close personal friend).

During Desyllas’ session, we discussed whether the closure was a good thing or a bad thing for the local economy. In true Schumpeterian fashion, the creative destruction makes available skilled talent to the local economy for other ventures. On the other hand, some off the displaced workers may never have a similar opportunity again.

But in the end, we agreed that the pattern proved a familiar point: companies get sold when the owners want to sell — usually when they want liquidity for an illiquid investment. Whether the founder (such as Kaplan) or the venture investors, once the company is sold all bets are off.

Death of the IPO

We all know the IPO has been dying a slow death since the dot-com crash. While the liquidity that IPOs provide startups was seen as providing a major advantage to US startups, all signs point to the 1980s and 1990s as being an aberration in the long-term economy.

Earlier this month, Barry Silbert of SecondMarket spoke at the Stanford Technology Ventures Program on his new vision for capital markets.

A key 5 minute segment of that was about the “long, slow death of the IPO.” During that segment, Silbert asserted that "I don’t think a lot of people realize that over the last 10 years, the IPO market has been dying a slow death”.

(Actually, most of us who study entrepreneurship are at least dimly aware of this, as are entrepreneurs. A year ago I asked if we had seen the “end of the IPO anomaly.”)

Silbert provided specific evidence of this death. He showed a chart with the IPO rate down by 75% during this century, and almost complete disappearance of small IPOs (under $50m).
He attributes the end of the IPO to:

• end of research on small cap companies due to
• end of full-service brokerages (at the hands of Charles Schwab, eTrade etc.)
• shift from fractional to decimal pricing and thus the end of the bid/offer spread
• successful litigation against big 10 brokerages by then-NY AG Elliot Spitzer to end incentive compensation for stock researchers
• Sarbanes-Oxley increase in regulation and costs
• an explosion strike price class action litigation

The net result is increasing the time to IPO from 5 years to 10 years, which (as he notes) doesn’t work for angels, VCs or employees.

Of course, as the CEO of a secondary financial market Silbert has a stake in all this. The IPO traditionally achieved four goals for young companies.

1. raise capital
2. provide liquidity to investors (an exit event)
3. allow the stock to be used as a currency for acquisitions and employee compensation
4. and as a branding event

Silbert argues that the secondary markets are providing the first three. Certainly the success of Facebook suggests that this is a route available to highly visible consumer-focused companies.
The rest of the talk is, naturally, why the audience should believe in SecondMarket.

Hat tip: VentureBeat

Building a $50m lifestyle business

One of the more irritating habits of the academic view of entrepreneurship is when people disparage anything other than the next Google as a mere “lifestyle business.” In this view, unless the founders are maximizing their desired exit market cap, they’re just tyros doing it for fun.

I had lunch with a friend today talking about his next startup. He’s going to bootstrap and keep it small, both so he can do tasks that he enjoys and also not spend his whole life chasing after external funding.

For the average entrepreneur, a successful IPO is a fluke in good times and nowadays like being struck twice by lightning. Still, my friend’s plan would be disparaged in many classrooms as a “lifestyle” business, because he’s planning something that he wants to do rather than purely utility maximizing.

One argument is that job creation and wealth creation comes only from these IPO-bound high growth companies. So society — whether it be academic researchers, MBA teachers or government bureaucrats — ought to focus on these IPO-bound companies.

But what if my friend grows his new firm to a $50 million/year business? Is that still a lifestyle business? Over three decades, John Beyster built SAIC into a $7 billion/year Fortune 500 company with 42,000 employees before he finally decided to IPO.

Of course, many of the “lifestyle” businesses stay small. But the majority of the venture-funded rockets crash and burn. The chances of creating the next Google are even less than achieving an IPO that allows the VCs to sell their loser to an unsuspecting public.

And is market cap the only measure of venture success? About a year ago, I got to hear fellow MIT alumnus Sal Khan talk about his nonprofit startup, the Khan Academy. Sal is going to change how we think about education — either at the margins, or perhaps the standard K-16 modality for all of North America. Is this just a “lifestyle” business?

Finally, there are the inherent efficiency and effectiveness advantages of the owner-manager business. Investors, banks, the government, even academic theoreticians go to great lengths to solve the inherent principal-agent problem of having one party provide the capital and another manage that capital. As Enron and Worldcom and Government Motors demonstrate, sometimes these controls fail miserably.

If the owners are the managers, then all that effort is no longer necessary, because there are no abuses to prevent. Who has the most incentive to run a business for its long term success? The “lifestyle” business owner. Of course, success may not be as defined by some external economist or finance professor — but does that make it any less successful?

I hope to play a role in my friend’s new business. Perhaps he (or we) will grow it to a $10m/year business, or even a $50m/year one. I feel better about recommending this model of entrepreneurial development to my entrepreneurship students than gambling on VC and a successful exit.

Experiential entrepreneurial education

I am now just recovering from the weekend I spent with the three SJSU teams at the 47th Annual International Collegiate Business Strategy Competition. Our teams did very well — two firsts and a second — surpassing the total (if not the batting average) of our two 2008 teams.

The experience of coaching the ICBSC teams for the past six years has made me a true believer in the value of simulation in business education. In fact, I among several strategy faculty this month discussing how to include simulation in SJSU’s planned revision of the undergraduate B.S.B.A. curriculum.

I believe that the ICBSC experience is also a great one for prospective entrepreneurs. It’s hard for me to separate out the intercollegiate competition from the underlying software (the Business Policy Game), but from my own startup days I recognize degrees of realism in the simulation that we don’t otherwise have in the undergraduate or graduate curriculum.

The BPG backstory is not particularly entrepreneurial. The student team (typically 4-6 people) is taking over as the new executive leadership of a 2-year-old publicly traded (!) company, and you have five years (20 quarter) to growth the business and do a better job than your competitors in terms of stock price, net income. profitability ratios and other elements of what looks a lot like the “Balanced Scorecard.”

However, the way the simulation plays out is very entrepreneurial. Despite having revenues of $10 to $30 million a year, the “executives” have no staff: if anything is going to get done, it gets done by the team members.

There are also immovable deadlines: whether a decision is optimal or not, the game follows the maxim of one of my former entrepreneurial mentors: “any decision is better than no decision.” (Would that I’d followed that more often).

On Saturday, members of one of my MBA teams said that their ICBSC final presentation reminded them of working in a startup — editing the slides for their presentation literally as they walked into the room to give their required talk to the judges. (Alas, this approach was not as effective as the other SJSU team that had started their talk earlier).

However, the most important point is one that generalizes to any simulation for entrepreneurship students. I ask my students to write business plans, and I give them feedback on what parts of their plans are good and bad. But they see this as just my opinion, and sometimes they’re right.

In a simulated business competition, the computer is telling them what’s working and not working, at many different levels. Perhaps their new product is selling well, but their margins are too low due to high input costs or limited pricing power.

The simulation comes as close as we can to providing feedback of the market in terms of meeting a payroll and getting to positive cash flow. Believe me, all of the teams have etched into their heads that “cash is king” and the importance of keeping cash inflows ahead of outflows. (One rival did so badly that they had to sell both factories to cover their bills, leaving them only one quarter away from closing operations.)

Some people say that the way to educate prospective entrepreneurs is to have them run actual businesses. There’s a value to that, but I think that’s more something they should do in high school in Junior Achievement than necessarily in college.

The problem is that these student businesses are just that. Yes, you learn how to get customers and cover costs, but unless you’re Michael Dell, they’re just a student business. (Even Ralph Rubio waited five years after graduating to start his fish taco stand.)

For would-be tech entrepreneurs, the challenge is more daunting. yes you can start an iPhone app business or a software consulting business, but most tech business require more capital (and typically some seasoned management) to pull off.

After years of coaching these teams, I think there’s an event more fundamental difference: we learn more from failure than we do from success. Our teams this year made mistakes — a few huge ones — and I suspect those mistakes will stick with them a long time.

I still remember spending $250k of our retained earnings on a product that failed, taking with it the company’s retail software operations. (Fortunately, we refocused the business and got lucky when customers jumped in our lap five years later.)

Are we ready to have lots of student businesses fail, and fail big? Or will we give them so little resources that they fizzle out quietly before they can lose to much money?

In that regard, the simulation competition may distort the lessons that could be gained in a classroom setting. In the ICBSC competition, if two teams grow their company from $10m to $30m/year (with 10% net margins) only one can be a winner. In the real world, both management teams get nice houses, nice vacations and happy investors.

More seriously, the 5th place teams give up because they have no chance of winning, rather than trying to do the best by the employees, managers and investors. So in the classroom setting, I would give a bonus for winning, but in the end grade the students on how well they ran their business rather than how well they did versus competitors.