How not to start a startup

Xconomy San Diego offers a provocative post by Joe Chung about how not to start a startup. Below are his five bullet points and my interpretation of each:

1. Don’t start a company in an ebbing tide. (Find an unmet need rather than one that's being met)
2. Don’t do something you know 20 other startups are already doing. (Most of these 20 will be losers.)
3. Don’t think too small. (You’re more likely than not to fail, so if you’re taking a big risk, shoot for a big reward.)
4. Don’t think too big. (Focus on something close enough in that you can see the path from here to there.)
5. Don’t build a product without a distribution plan. (When you pick from among multiple ideas, try to target something that has a ready-made channel.)

Of course, read the original posting for the full arguments.

As Chung notes, rules are made to be broken, but these rules will keep you away from common sources of startup failure.

Entrepreneurship means not having to own everything

We had our first entrepreneur of the academic year speak today at KGI in Claremont. Eric McAfee is a chronic serial tech entrepreneur, having started two biofuels company, a solar company and a software company (among others).

I’ve met a lot of tech entrepreneurs and heard a few Silicon Valley entrepreneurs speak. Even so, I felt he made an important point about leverage and open innovation for startup companies.

For McAfee, the distinction between an entrepreneur and a manager is that an entrepreneur is someone “who allocates resources that they do not currently control,” while the manager allocates resources they control.

To me, this is the flip side of the oft-quoted Teece 1986 formulation. Teece focused on what entrepreneurs should do if they can’t control resources. McAfee’s point is that entrepreneurs often shouldn’t even try — that it’s usually better to buy or license the missing piece of the puzzle.

He explained two examples from his current biofuels company, Cupertino-based Aemetis. First, to get key bioprocessing technology he bought another company — U. Maryland spinoff Zymetis — rather than develop the technology in-house.

His reasons were completely in consonance with the open innovation paradigm. From a technology standpoint, “most companies are stuck with the not-invented syndrome,” McAfee said. “We’ve got to be the best technology company which sometimes means we have to buy other companies or license technology.”

The other approach is that they’re taking that technology and using it to improve the cost-effectiveness of existing ethanol plants — which are often stuck in a commodity business. So instead of buying and owning those plants, Aemetis partners with the existing owners and shares in the proceeds.

So if in Teece’s world of 25 years ago, the goal was to control as many resources as possible and make do when you cannot, in McAfee’s world, the goal is to control the resources that are important and partner for the rest. I think there are clearly cases when the latter approach is superior — particularly in a fast-moving industry where capital is scarce and the window of opportunity may close.

IPOs dying again

I got an email from one of my former students this week who works with startup companies trying to IPO:

It's a brutal market out there! … Many companies were looking to go public in late Q3/early Q4, however, the continued demise of the stock market has many folks running from the idea of an IPO.

Her remarks brought home a nasty side-effect of this month’s stock collapse. And sure enough, MarketWatch and USA Today later reported that at least 8 announced IPOs have been deferred due to “current market conditions.”

PWC (as reported by Business Insider) notes that 2011 was shaping up to be a much better year for IPOs than 2010. Now that trend is in doubt.

As I’ve been saying for years, I think entrepreneurs should look at it the other way: the normal exit will be by acquisition, because only during certain rare (and frothy or bubble-y) periods will an IPO be available. Perhaps the IPO window will open again, but (as has been true since the dot-com crash) the opening will only be temporary.

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.