Posts from Small Business

What do you do when you don't want to sell your company and you don't want to go public either? We've been discussing this issue here at AVC for a long time. I think back to this post from 2008, almost five years ago now, as the kickoff of this long running conversation. This is something I care a lot about because my business model requires getting liquid but I hate the idea that my business model creates problems for the entrepreneurs we back.

Here's a great three minute discussion of this issue between Chad Dickerson, Etsy's CEO, and Sarah Lacy, from last thursday night's PandoMonthly event.

I've been having frequent private conversations about these issues with the CEOs of our portfolio companies and it's great to see some of that become public in venues like the Pando event. This is an important topic, not just for me or for AVC, but for the entire startup ecosystem.

The entire talk between Chad and Sarah is almost two hours and can be seen in its entirety here.

I was talking to a friend who has been displaced because of Sandy. They are struggling to get back to their daily routine and it is hard living out of a suitcase without access to the things they rely on from day to day.

I was talking to the CEO of a company whose business was negatively impacted by Sandy. They are struggling to get the business back to where it was before the hurricane.

One is a personal thing. The other is a work thing. But they are the same thing. Life punches you in the face and you might get knocked out. The question is can you get back up and keep going.

The best entrepreneurs do this well. They can take a hit and keep moving forward. And they can rally their teams to do the same thing. That latter point is so important. If the leader is down for the count, the team doesn't have a chance. But if the leader is up and moving forward, with passion and committment to the goal, then the team will follow.

Sometimes a crisis is a good thing for a company. Recovering from a knockout punch often requires heroic efforts from the team. I have seen engineers get things built in a week that might take a quarter under normal circumstances. I have seen sales teams bring in business that kept the company afloat at the last minute. These heroic efforts can energize an organization and give it new life.

Normal operating conditions can lead to an organization getting fat and happy. A crisis can shake things loose that need to be shaken loose. I would not suggest an entrepreneur manufacture a crisis when one does not exist. But when one comes along, I would suggest seeing it as an opportunity not a problem. Because the best entrepreneurs and the best companies can take a punch and keep going. It is a defining trait of winning teams.

We have five weeks (including today) before we start the sustainability course. It's not enough time to start a new series. So I've decided to rerun five posts on accounting and financial statements that I did early on in MBA Mondays. This is core stuff. If you want to start a business, run a business, and/or operate a business, you need to know the basics of accounting and finance.

So today we will rerun the post on accounting. The next three weeks we will go through the three main financial statements. And we will end with a post on understanding financial statements.

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Accounting is keeping track of the money in a company. It's critical to keep good books and records for a business, no matter how small it is. I'm not going to lay out exactly how to do that, but I am going to discuss a few important principles.

The first important principal is every financial transaction of a company needs to be recorded. This process has been made much easier with the advent of accounting software. For most startups, Quickbooks will do in the beginning. As the company grows, the choice of accounting software will become more complicated, but by then you will have hired a financial team that can make those choices.

The recording of financial transactions is not an art. It is a science and a well understood science. It revolves around the twin concepts of a "chart of accounts" and "double entry accounting." Let's start with the chart of accounts.

The accounting books of a company start with a chart of accounts. There are two kinds of accounts; income/expense accounts and asset/liability accounts. The chart of accounts includes all of them. Income and expense accounts represent money coming into and out of a business. Asset and liability accounts represent money that is contained in the business or owed by the business.

Advertising revenue that you receive from Google Adsense would be an income account. The salary expense of a developer you hire would be an expense account. Your cash in your bank account would be an asset account. The money you owe on your company credit card would be called "accounts payable" and would be a liability.

When you initially set up your chart of accounts, the balance in each and every account is zero. As you start entering financial transactions in your accounting software, the balances of the accounts goes up or possibly down.

The concept of double entry accounting is important to understand. Each financial transaction has two sides to it and you need both of them to record the transaction. Let's go back to that Adsense revenue example. You receive a check in the mail from Google. You deposit the check at the bank. The accounting double entry is you record an increase in the cash asset account on the balance sheet and a corresponding equal increase in the advertising revenue account. When you pay the credit card bill, you would record a decrease in the cash asset account on the balance sheet and a decrease in the "accounts payable" account on the balance sheet.

These accounting entries can get very complicated with many accounts involved in a single recorded transaction, but no matter how complicated the entries get the two sides of the financial transaction always have to add up to the same amount. The entry must balance out. That is the science of accounting.

Since the objective of MBA Mondays is not to turn you all into accountants, I'll stop there, but I hope everyone understands what a chart of accounts and an accounting entry is now.

Once you have a chart of accounts and have recorded financial transactions in it, you can produce reports. These reports are simply the balances in various accounts or alternatively the changes in the balances over a period of time.

The next three posts are going to be about the three most common reports;

    •    the profit and loss statement which is a report of the changes in the income and expense accounts over a certain period of time (month and year being the most common)
    •    the balance sheet which is a report of the balances all all asset and liability accounts at a certain point in time
    •    the cash flow statement which is report of the changes in all of the accounts (income/expense and asset/liability) in order to determine how much cash the business is producing or consuming over a certain period of time (month and year being the most common)

If you have a company, you must have financial records for it. And they must be accurate and up to date. I do not recommend doing this yourself. I recommend hiring a part-time bookkeeper to maintain your financial records at the start. A good one will save you all sorts of headaches. As your company grows, eventually you will need a full time accounting person, then several, and at some point your finance organization could be quite large.

There is always a temptation to skimp on this part of the business. It's not a core part of most startup businesses and is often not valued by tech entrepreneurs. But please don't skimp on this. Do it right and well. And hire good people to do the accounting work for your company. It will pay huge dividends in the long run.

In the comments to last week's Burn Rate post, I was asked to share some burn rates from our portfolio. I can't do that. But an alternative suggestion was to write a post suggesting some reasonable burn rates at different stages. I can do that and so that's the topic of today's post.

The following applies to software based businesses, and most particularly web and mobile software businesses. It does not apply to hardware, life sciences, and energy startups. It is also focused on startups in the US. It costs less to employ teams in many other parts of the world.

Building Product Stage – I would strongly recommend keeping the monthly burn below $50k per month at this stage. Most MVPs can be built by a team of three or four engineers, a product manager, and a designer. That's about $50k/month when you add in rent and other costs. I've seen teams take that number a bit higher, like to $75k/month. But once you get into that range, you are starting to burn cash faster than you should in this stage.

Building Usage Stage – I would recommend keeping the monthly burn below $100k per month at this stage. This is the stage after release, when you are focused in iterating the product, scaling the system for more users, and marketing the product to new users. This can be done by the same team that built the product with a few more engineers, a community manager, and maybe a few more dollars for this and that.

Building The Business Stage – This is when you've determined that your product market fit has been obtained and you now want to build a business around the product or service. You start to hire a management team, a revenue focused team, and some finance people. This is the time when you are investing in the team that will help you bring in revenues and eventually profits. I would recommend keeping the burn below $250k per month at this stage.

A good rule of thumb is multiply the number of people on the team by $10k to get the monthly burn. That is not the number you pay an employee. That is the "fully burdended" cost of a person including rent and other related costs. So if you use that mutiplier, my suggested team sizes are 5, 10, and 25 respectively for the three development stages listed above.

Once you get the business profitable, you can scale the team larger and larger to meet the needs of the business. I don't think of that kind of expense as "burn rate", I think of it as "scaling the team." I believe you want to use a bottoms up budgeting process to determine your headcount needs at this stage of the business.

One final caveat – there are outliers. Twitter had a higher burn rate than I am recommending during the second stage due to the massive scaling costs they encountered. And Facebook had a higher burn rate during the building the business stage due to the size of the revenue team that they assembled and other needs of the business. There are some business opportunities that are large enough that they can justify (and fund) larger burn rates. The mistake we all make is assuming that many of our companies are outliers. There are very few companies that can justify a million dollar/month burn rate or larger. There are many more that thought they could and are no longer around.

We got so many ideas for this Business Arcanery series on MBA Mondays that I'm not going to do it as a series. I am going to do one of these every month. There is enough business arcanery out there that I could do a years worth of weekly posts without running out of material.

We'll start with the term "going concern." What the hell is a going concern?

From InvestorWords.com, "going concern" is:

The idea that a company will continue to operate indefinitely, and will not go out of business and liquidate its assets. For this to happen, the company must be able to generate and/or raise enough resources to stay operational.

Going Concern is an accounting term that makes its way into business jargon because it captures an important concept – "will the business be around for the long term?" A going concern is a business that has the cash and other resources to sustain itself. It can also be a business that has very little cash and assets but has strong and repeatable cash flow.

Accountants are required to assess whether a business is a going concern as part of issuing an opinion in an audit of a company's financial statements. I believe (but may be mistaken about this) that the business must have enough cash on hand to sustain lossses for at least the next twelve months to be considered a "going concern."

Many of our portfolio companies are not going concerns. Most startups are not going concerns. That explains the bags under most entrepreneurs' eyes. Startups are often operating at the edge, with the hope that customers or investors  (or both) will come through and keep them operating.

There is no shame in failing to obtain a going concern opinion, at least in my eyes. We work with such companies all the time. I suspect every great company wasn't one before they became one.

But it is important to understand this concept. And when you are doing business with a company, it is helpful to understand whether they are a going concern or not. If they are not, make sure to get paid quickly because they might not be around much longer. And if your company is not a going concern, you should expect vendors to be more antsy about getting paid because they are doing the same calculus that you are.

The purpose of this series on Business Arcanery is to decode business code words. Going Concern decodes into "are you going to be in business long enough to pay me?"

I wrote in an earlier post in this series that friends and family is the most common form of startup financing. If you are talking explicitly equity investments, then that is probably true. But the most common way that startup businesses get money to get going is they sell something to someone. In this context, someone means customers.

Customers are a great way to finance a business for many reasons. First, customer financing is typically non dilutive. They want something from you other than equity in your business. Customers also help you fit your product to the market. And customers will help debug and improve the quality of the product. An early customer will give you credibility with other customers. And an early customer may spend more with your company down the road.

The most common way customer financing is done is you sell the customer on the product before you've built it or before you've finished it. The customer puts up the money to build the product or finish the product and becomes your first customer. Usually the customer simply wants the product and nothing more. At times an early customer might ask for some exclusivity on the product or even some free equity in the business, but most of the time the early customer simply wants the product from you and nothing more.

So why not take this approach with every startup? Well, it isn't always possible to find a customer who will put up money in advance of the product being complete and ready to use. It takes great salesmanship to convince a customer to buy something from you that isn't built or isn't finished. But even if you can convince a customer to do this, there are some negatives.

First and foremost, building a product explicity for one customer often makes it less applicable to the market as a whole. An early customer who provides funding to build your product will want the product tailored specifically for its needs. And a highly tailored product is often not well suited to a broader market.

Second, you risk building a "fee for services culture" in your company with this approach. Some companies build products for customers for a fee. Other companies build products and sell them "as is" to customers. The latter is the scalable model for building valuable companies. If you use customer financing, you risk being pulled into the former.

And customer financing is much more difficult, if not impossible, in consumer facing services. It is much more applicable in business facing services.

Those are the pros and cons of customer financing. If you can convince a customer to put up significant capital in advance so you can build or finish your product, you should consider it very seriously. Many great companies got their start this way.

Governments will provide capital for startups and I've seen many entrepreneurs over the years take advantage of this form of financing. The grants are usually "free money" in the sense that they do not need to be paid back and they don't cost any equity.

But nothing in life is free. You do pay for this money in ways that may not be in your interest. The application process is usually long, involved, and distracting. And sometimes the grants come with strings attached; you can't move, you have to use it for a specific purpose, you have to hire a certain number of people with it, etc, etc.

I've seen states provide grants to do "economic development." I've seen all sorts of US Federal Government grants. The most common are Small Business Innovation Research (SBIR) Grants. But there are also grants available from various departments related to energy, health, defense, and many more. Internationally, I've seen Canada, Israel, and Slovenia provide "free capital" to startups.

In Canada, startups can get a portion of their headcount funded by the government. In Israel, the government provides grants to startups but they need to keep their IP in country. I am sure that many countries around the world provide funding of this sort. And I suspect we will see more of this sort of thing as technology based economic development becomes more important.

I'm not a fan of this form of financing. First, in principle I think that government ought to stay out of the business of picking winners and let the market do that. But more practically, I've never seen an entrepreneur change the outcome of their startup with government money. It is never enough to really move the needle and the strings that are attached usually make it uninteresting to me.

But if you would like to look into this sort of thing, contact your state and national government and ask about grants for high technology, research, and startups. I suspect you'll find some programs out there that you can tap into.

I went back and looked at all the MBA Mondays post I've written to date and what jumped out at me was a lack of discussion of financing options. Since the audience for MBA Mondays is largely entrepreneurs and the technology industry, I will frame this discussion in the context of what options are available for small tech companies. In this series of posts we will discuss the following financing options:

Common Stock

Convertible Debt

Preferred Stock

Venture Debt

Capital Equipment Loans

Leases

Bridge Loans

Accounts Recievable Financing

These are the options I've seen used most frequently in my time working with small tech companies. If you have suggestions for other financing options to be covered, please leave them in the comments and I will consider adding them to the list.

We will start next week talking about common stock and go from there.

The WSJ says that the SEC is reviewing the rules under which privately held companies raise capital and are subject to securities regulation. They quote the SEC Chair Mary Schapiro as saying:

The staff is taking a fresh look at our rules to develop ideas for the Commission about ways to reduce the regulatory burdens on small business capital formation

Who knows what, if anything, will come out of this review, but I am all for taking a look at rules which were written when I was three years old. Two things I would strongly suggest the commission look at is the 500 shareholder rule and the requirements to be a qualified and/or accredited investor to invest in privately held companies.

Both of these rules directly or indirectly keep small investors, ie the general public, from investing in privately held companies. Most people do not qualify as accredited or qualified investors so their ability to invest in privately held companies is significantly restricted. And because privately held companies cannot have more than 500 shareholders without having to file disclosure statements, most companies prefer institutional investors who can invest large sums of money to small investors who cannot.

Some of the most exciting companies to emerge in the past decade have decided to stay private for longer periods of time. There are many reasons why that is the case, but one of the reasons is that founders, Boards, and senior management realize that being public and having your employee equity go up and down every day has a cultural impact that is not always good for the organization.

The best companies will most likely eventually go public and deal with the issues that being a public company presents, but the value creation that occurs pre-IPO has been and will likely to continue to be very significant. And it would be a fantastic outcome if the SEC decides to allow the general public to be a more active participant in the value creation that happens while companies are still privately held.

UPDATE: A commenter pointed out that a private company can have more than 500 shareholders, but it will be required to file disclosure statements. I fixed the post to reflect that. The same commenter, sdd, suggested that the 500 shareholder limit be amended such that it does not include shares issued to employees. I'd add former employees to that. This is a great suggestion. Most of the companies that I have been involved with that have had 500 shareholder issues have had them as a result of employee equity.