Posts from management

Profits vs Growth

One of the things I’ve always struggled with as an investor in high growth tech companies is the tension between getting profitable vs growing more quickly. It has become a central tenet of tech growth investing (in both the public and private markets) that growth is more valuable than profitability and you can always focus on profits once you have “captured the market.” This leads to behaviors like investing heavily in sales and marketing to increase the growth rates of a business beyond what it can grow at “organically.”

A few months ago, I blogged about a formula I came across at a board meeting a while back that says your year over year growth rate plus your pre-tax operating margins need to be at least forty percent. Meaning you can grow at 100% per year and have operating margins of -60%. Or you can have flat growth and have 40% operating margins. Or you can grow at 20% per year and have 20% operating margins. There is no magic to the forty percent target, but I do like establishing some relationship between acceptable levels of profitability (or losses) and growth. Too many times I have seen companies invest in growth for growth sake without having any constraints or sanity checks on that investment and the losses that result from that investment.

We have worked with/invested in a few super high quality companies over the past decade that did not make this tradeoff. They got profitable early on in the life of their company and then were able to use their profits to reinvest in the business and continue to grow at very high year over year growth rates without having to burn money and raise capital. Indeed.com is probably the best example of this group but we have had a number of them and they are all special companies that I have enormous respect for.

These experiences lead me to question the orthodoxy in the world of technology that says if you are not investing heavily in growth (and losing money), then you are not maximizing the potential value of your business over the long haul. It doesn’t have to be that way. Now maybe you need to have a very special company that has real structural competitive advantages in the marketplace to avoid this tradeoff. Or maybe you just need to be a really sharp and experienced business person to be able to do this (that’s how I would describe Paul and Rony, the founders of Indeed.com, for example).

I also think the profit motive, generating more revenues each year than the expenses you are spending to do that, is a really valuable constraint on a management team. It forces them to think creatively and logically about the investments they want to make. It roots out bad investments in people, product, sales, marketing, and elsewhere in the business and helps to maintain a lean and mean highly functioning organization. If you don’t need to make money because there is plenty of capital available to fund your losses and you are “investing in growth”, then you can also avoid making the hard decisions that focus an organization and insure a high quality team where everyone is pulling their weight.

I don’t want to come off as a positive cash flow freak. It is our business to invest in companies to allow them to run operating losses in order to get a product in market, grow the business and team, and create value for the founders, management, and shareholders. Most of our portfolio companies lose money and we are used to reading income statements with lots of red on them and staring at runway calculations showing when the money runs out.

But I’m a bit sick and tired of the objective of every operating plan I see is to get the business to a point where it can raise money at a much higher price. That’s nice and it’s how the VC/startup game is played. But at some point I’d prefer to see an operating plan that has the objective of getting to sustainable profitability. And I do mean sustainable.

Because, as I said earlier, some of the very best companies we have worked with at USV got profitable early on in their life and maintained profitability while revenues grew100% year over year for a number of years. It can be done. Maybe the reason that many entrepreneurs don’t think it can be done is nobody is telling them it can. So I’m doing that.

MBA Mondays Illustrated

I’ve encouraged folks to use the MBA Mondays content in whatever ways they want. It is all creative commons licensed and available to be used freely as long as there is proper attribution. This past week Jason Li emailed me about his illustrated version of MBA Mondays. I took a look and was very pleased to see a curated version of the work with fun illustrations on the table of contents and every post. He also included the best of the comments!

This is an example of why creative commons is such a powerful model. He didn’t have to ask my permission to do this. He added value to my work and created a new and possibly better version of it. His work is also creative commons so anyone can take what he did and add to that.

This is how knowledge should work in the digital age. It should be fluid and iterative. The text book is the old model, GitHub is the new model. So thanks Jason for doing exactly what I had hoped would happen with MBA Mondays.

Monday Morning Quarterbacking

Reading the comment thread from yesterday reminded me of something fundamental and true. It is easy to critique but hard to do.

A big part of my job is to sit on boards and when you do that, your primary role is to evaluate the performance of senior management, particularly the CEO.

As someone who has never had an operating job, and never been a CEO, it is easy to sit there and say “she didn’t do this, he should have done that, she didn’t articulate that very well” and I have found myself doing that from time to time. But I try to remind myself that running a company is a hard job and the people who do it well are few and far between.

That doesn’t mean we should be soft on the management team. I believe it is our job to be constructively critical, but also supportive and positive. Everyone can and should work on getting better at their job. When you stop doing that, it surely is time to hang up the cleats and retire. But calling for a CEO’s head is not something I do lightly. You can’t really backtrack from that position once you take it. So I try like hell not to go there unless it is absolutely required and there is no ambiguity about it in my mind.

I was talking to an entrepreneur yesterday and somehow the topic of Netflix came up. I told the entrepreneur that I had enormous respect for Reed Hastings. He said he did as well and bought Netflix when it IPO’d back in the 90s. He told me he would listen into the quarterly earnings calls for the first ten years he owned the stock. And Wall Street was so negative on Reed, his strategy, and the company’s performance. But Reed hung in there, had conviction about the business and where it was going. Twenty years later, Netflix has built one hell of a business and proved most, if not all, of the skeptics on Wall Street wrong.

When Wall Street calls for a CEO’s replacement, they might be right but they might be wrong. A good board will not be pressured by Wall Street. A good board will be attentive to the business, will hear the critiques and try to understand them, will make sure they know what the culture and dynamic is inside the company, and will understand the business model, the financial levers, and the financial performance. A good board will evaluate all of that, provide clear and unambiguous feedback to the CEO so he or she knows exactly where they stand, and will support the board and the management team privately and publicly until they decide it is time to make a change.

I will end with this. Being the CEO of a highly public company (whether it is traded privately or publicly) is particularly hard. You are constantly getting criticized and talked about in the press/blogs/communities. I respect the people who take these jobs. And I root for them to succeed. It’s about the hardest job you can have.

Building A Diverse Culture And Team

Brittany posted today about the first USV portfolio diversity summit. Last year we had forty-two portfolio summits all driven by topics that bubble up from our portfolio. Diversity has been rising as a topic that people want to talk about and we reacted to that by hosting a summit on it. We had 28 attendees from 13 different portfolio companies in attendance.

In Brittany’s post, she cites two important reasons to strive for diversity on your team:

  • Do you want your company to increase your company’s competitive advantage? Extensive research has proven that more diverse perspectives leads to more innovative ideas and better financial returns.
  • Do you want your company to one day serve millions of people? It helps if you know how different people in the population think. If companies want to last, they need to think about this early.

She goes on to outline how the portfolio companies are approaching diversity:

  • Getting Started: having the discussion, language, and online tools
  • Company Culture: embracing diversity, inclusive mission vision values, and performance
  • Recruiting: tactics, expectations, interviews, job postings, resources, and external organizations
  • Constant Evolution: Feedback, measuring success, training, and materials

If you are seeking to build a diverse culture and team in your company, I would encourage you to read Brittany’s post which she will follow with dedicated posts on all four topics in the outline.

MBA Mondays Reblog: Sunk Costs

The Gotham Gal and I made a decision recently where we had a bunch of sunk costs. It reminded me of this post and I am going to reblog it today.

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Sunk Costs are time and money (and other resources) you have already spent on a project, investment, or some other effort. They have been sunk into the effort and most likely you cannot get them back.

The important thing about sunk costs is when it comes time to make a decision about the project or investment, you should NOT factor in the sunk costs in that decision. You should treat them as gone already and make the decision based on what is in front of you in terms of costs and opportunities.

Let’s make this a bit more tangible. Let’s say you have been funding a new product effort at your company. To date, you’ve spent six months of effort, the full-time costs of three software developers, one product manager, and much of your time and your senior team’s time. Let’s say all-in, you’ve spent $300,000 on this new product. Those costs are sunk. You’ve spent them and there is no easy way to get that cash back in your bank account.

Now let’s say this product effort is troubled. You aren’t happy with the product in its current incarnation. You don’t think it will work as currently constructed and envisioned. You think you can fix it, but that will take another six months with the same team and same effort of the senior team. In making the decision about going forward or killing this effort, you should not consider the $300,000 you have already sunk into the project. You should only consider the additional $300,000 you are thinking about spending going forward. The reason is that first $300,000 has been spent whether or not you kill the project. It is immaterial to the going forward decision.

This is a hard thing to do. It is human nature to want to recover the sunk costs. We face this all the time in our business. When we have invested $500,000 or $5mm into a company, it is really easy to get into the mindset that we need to stick with the investment so we can get our money back. If we stop funding, then we write off the investment almost all of the time. If we keep putting money in, there is a chance the investment will work out and we’ll get our money back or even a return on it.

Even though I was taught about sunk costs in business school twenty-five years ago, I have had to learn this lesson the hard way. Most of the time that we make a follow-on investment defensively, to protect the capital we have already invested, that follow-on investment is marginal or outright bad. I have seen this again and again. And so we try really hard to look at every investment based on the return on the new money and not include the capital we have already invested in the decision.

This ties back to the discussion about seed investing and treating seed investments as “options.” Every investor, if they are rational, will look at the follow-on round on its own merits and not based on the capital they already have invested. But the venture capital business is a relatively small world and reputation matters as well. Those investors who make one follow-on for every ten seeds they make will get a reputation and may not see many high quality seed opportunities going forward. Our firm has followed every single seed investment we have made with another round. In most cases, those investments have been good ones. But we have made a few marginal or outright bad follow-ons. We do that for reputation value as much as anything else. We measure that value and understand that is what we are doing and we keep those reputation driven follow-ons small on purpose.

When it is time to commit additional capital to an ongoing project or investment, you need to isolate the incremental investment and assess the return on that capital investment. You should not include the costs you have already sunk into the project in your math. When you do that, you make bad investment decisions.

 

DIY vs Delegate

I am a bad delegator and very much a do it yourselfer (DIY). It’s one of the many reasons I am certain I’d make a terrible CEO.

CEOs must delegate. At scale, they should only do three things; set the vision and strategy and continuously communicate it, recruit and retain the very best people, and keep the company funded. Everything else has to be delegated at scale.

But when you start a company, you (and your cofounders) have to do everything yourself. There is nobody to delegate things to. And hiring a bunch of people to do things like schedule your meetings, answer the phones, keep the books, review contracts, interview candidates, etc is a bad idea because it uses up money which is always in short supply at the early stage of a startup. You can, and should, see if there are service providers who are inexpensive who can help. Bookkeeping is one area where that is certainly true. Reviewing contracts and recruiting is harder to hand off to an inexpensive third party. I wish it were not.

I like it when I see a founder team that is resourceful, has range, and can do a lot of this stuff themselves. I like to see them running lean and mean and spending money on the things that really matter (product!!!!!).

But at some point they need to start delegating this stuff. And first time founders often make the mistake of waiting too long to take things off their plates. For one, they like the control and insights they get from doing things themselves. For another, they are often lean to a fault (penny wise and pound foolish).

Knowing when it is the right time to start handing things off and hiring is an art not a science. It has something to do with the availability of resources. And it has something to do with the scale of the organization. When the CEO is still scheduling her own meetings when there are over fifty employees, something is wrong. Investors can help a lot. We have pattern recognition. We can see two very similar companies (size, stage, etc) and compare how much delegation is happening in one vs the other. We can make suggestions.

One suggestion I frequently make is to find a “utility infielder” for your first business hire. This is someone who can do a lot of things well but nothing spectacularly well. This is often someone who has done this role before in a startup and likes working in companies that are between five and fifty employees. There are people who make a career out of this job. It is lucrative if you value equity over cash compensation. You can build a nice portfolio of early stage equity grants doing the “first business hire” gig for two or three years at a time and then doing it again and again.

Doing a startup is an evolution from DIY to Delegate. And timing the evolution is important. If you haven’t done it before, ask people who have for advice on this. Allocating your time (your most precious resource) is critical to the success of your business.

The Perfect Board

Last month Sam Altman wrote a post about board members and why you should want them. I read it and then tweeted it out:

In Sam’s post, he says:

Personally, I think the ideal board structure for most early-stage companies is a 5-member board with 2 founders, 2 investors, and one outsider.  I think a 4-member board with 2 founders, 1 investor and 1 outsider is also good (in practice, the even number is almost never a problem).

I’ve been serving on boards for 25 years. I’ve been in every conceivable configuration. To my mind, the perfect board is either five or seven and it looks like this:

Founder CEO, Two Independents, Two Investors

Founder CEO, Three Independents, Three Investors

If the Founder is no longer the CEO, then I like this configuration:

CEO, Founder, Two Independents, Three Investors

If you have less than three investors (yay!), then replace investors with independents in each formula and you’ve got a winning configuration.

An entrepreneur the Gotham Gal is invested in asked me this question via email a few weeks ago, and I told him this:

This is a long way of saying that you aren’t done once you put one independent on the board. You are going to need a bunch.
Finally – don’t try to satisfy your VCs. They will want “names” “trophies” and the like. Satisfy yourself. Find people, ideally peer CEOs, you like respect and want to spend time with who you know can and will add value.
A great company deserves a great board. And a great board has bunch of people on it, ideally a bunch of people who are experienced at running a business, growing a business, and dealing with all the stuff that comes with that. Do yourself a favor and build a great board for your company.

Development Is Cheap. Production Is Not.

This is a line from a blog post written by my brother in law Jerry Solomon. He is talking about film production, specifically short form videos. But the point is true of all projects, from designing a building, a home, a film, an art project, a hardware project, a software project, or whatever.

The design process is relatively inexpensive. The build process is not.

In the kinds of companies we invest in the “development” work comes from the product organization. The “production” work comes from the engineering team.

I have seen engineering teams spin their wheels and burn through countless hours of writing code that ends up getting tossed out just because the design process was not right or not specific enough or not thought through enough.

While we might think these issues and challenges are unique to the world of tech, software, internet, and mobile, the truth is these issues pervade everywhere you are making something.

This is not so applicable to a startup trying to find product market fit. But it becomes very relevant once your company starts to scale. A commitment to thinking things through, getting it right at the start, and being efficient in the “production” process is something all great companies figure out how to do. It’s really important.