Seven Plus One Paradoxes of High-Tech Startups
Source: Time To Cash, The Seven Keys To Successful High Tech Startups (ISBN 978-1-4092-6367-8) available from www.timetocash.biz
The world of startups is an absurd world. Here are some of the paradoxes you should be aware of.
Paradox 1: The Illusive First Mover Advantage
Many startups are in a hurry to be first to market. They believe that there is a big pot of gold waiting for them, as long as they get to market first. But the first-mover advantage is illusive. How did the first-mover advantage become the myth that it is? The answer is relatively simple. Many entrepreneurs and investors fail to do their historical homework. They assume that market leaders today developed their product's category because the dominant firms themselves now claim to be the pioneers and because the first-mover failures have been lost to history that is all too rarely studied with the care that Gerard J. Tellis and Peter N. Golder have done in their excellent study “Will and Vision” [Tellis, 2002].
The case against the first-mover advantage that Tellis and Golder make goes beyond evidence from the highly interesting cases they vividly describe (the Gillette case will stick with me forever. Their central conclusion is that the first-mover advantage has never been the advantage it has been cracked up to be in any but six of the 66 industry groups they studied. Moreover, the failure rates of pioneers is quite high - 64% for all industries studied; for high-tech industries still a massive 50%. What is the secret of market leadership if first-mover is not it? Tellis and Golder draw the following lesson:
We find that at the root of enduring market leaders is a unique vision of the mass market. Coupled with this vision is an indomitable will to realize the vision. Will manifests itself in four important components: persistence, relentless innovation, financial commitment and asset leverage. (…) Firms endured as market leaders because they had most or all of these attributes. On the other hand, many market pioneers failed because they lacked one or more of these factors.
[Tellis, pages 54 – 55]
Paradox 2: The Vision – Execution Gap
OK, so the ideal founder is a man (or woman) of vision. A very clever, technology-savvy entrepreneur who has the foresight to see and articulate why her “thing” is going to be a multi-billion dollar market and who, during her years as a scientist at a university has created the core technology which will drive a wave of disruptive innovations.
It turns out, however, that many of these ideal founders do not succeed! They get stuck in the Vision – Execution gap. A person who has a vision he firmly believes in, will usually execute towards the fulfillment of that vision. An important assumption for realization of the vision is that the market will adopt your visionary “thing”, typically a disruptive technology, product or service. Geoffrey Moore identified this problem already in 1991 with his excellent book titled “Crossing The Chasm” [Moore 1991]. The time lag between the launch of an innovative product and the adoption of it by the mass market is called the chasm. Moore states:
Most companies fail to cross the chasm because, confronted with the immensity of opportunity represented by a mainstream market, they lose their focus, chasing every opportunity that presents itself, but finding themselves unable to deliver a salable proposition.
[Moore, page 67]
The vision may be correct, but it takes small steps and disciplined execution to win niche markets, which populate the chasm, before mass market adoption becomes a fact.
Paradox 3: The Paul Principle
One of the most common paradoxes in the world of startups is the Paul Principle. You may be familiar with the Peter principle – in a hierarchy every employee tends to rise to his level of incompetence. The Paul principle is the transposed version of this axiom – competent people who have moved up the career ladder at large organizations sink to their level of incompetence at small no-frills startups.
Take the case of two very clever guys who started a software company. Both were committed to a vision that they could contribute to a safer world, and worked hard to win initial customers. When applying for venture capital, the participating VCs believed that one of the two founders was too much of a researcher and that the other lacked leadership qualities. The founders met with an acquaintance of one of the general partners. He was a very successful executive at IBM The VCs had made the appointment of an “accomplished” CEO a condition for closing the deal and under pressure from time the founders matched his salary, his bonus, his pension plan and his company car. To top it of, they gave him five percent of the company in stock options. The day the new CEO started, he initiated a search for an assistant. Next, he hired a marketing director, with whom he spent a week in New York to gauge the strategy of the company. Their first act was to create a new corporate visual identity. After that, a new office building was rented. When the founders objected to the amount of money being spent on the decoration of the meeting room (which was aptly renamed into Board Room), the former IBM executive explained that customers only purchase from successful and trustworthy suppliers, and that this investment was part of creating a favorable perception. In the months after that, many executives from the likes of IBM, Cisco and HP visited the new CEO. After that investment bankers came to visit. Then there were two late night meetings with the same VCs which had advised the founders to hire the former IBM executive. A few days later the company applied for bankruptcy and shut down.
Paradox 4: The Inverted Risk-Reward Curve
Investors are well aware of the trade off between risk and reward. Investing in government bonds was (at least up to mid 2008) considered to be a lower risk investment than buying shares in a company. Therefore, government bonds are priced at a lower expected yield. Similarly, venture capital companies, who invest in high-risk assets such as startups, need to show much higher returns than other fund managers, who for example manage investments in bonds or commodities. This phenomenon is called the risk - reward curve. The higher the perceived risk, the higher the required expected returns an investor will demand. But when it comes to startups, the curve is inverted. The higher the assumed risk, the lower the reward!
What is going on here? When you start a venture, you need to make sure that there is money to pay bills. What do you do? You convince friends and family to donate cash in exchange for shares, contending that wouldn’t they have liked to purchase a percentage of the shares in Microsoft in the early 70s for $ 25,000?. So these “angels” put some money into your venture in return for which they get a few shares. Let’s assume that you convince 10 people to do this, so after a day of extracting money from friends and family, you have issued 10% of the shares in exchange for $ 250,000 in cash. Now you can pay some bills.
A few months later you need more money. The good news is that your prototype performs according to expectations. Everybody is enthusiastic, but there is still a long way to go. Nevertheless, a VC decides to fund your venture. It offers $ 2,500,000 in exchange for 63% ownership. You need the money and there are no other avenues to get this amount, so you agree. Lo and behold, a few months later the venture gets an all share offer and is acquired for $ 10 million.
The following table summarizes the capitalization of the venture (and is therefore called a cap-table):
The founders seem to have done well, they get over $ 3 million. The Round A investors, your friends and family!, have done pretty good too, with a return of 50%. But the VC-investor has done best of all, with a return of 150% (and that is not counting liquidation preferred shares (“liqprefs”) and other protections VCs typically put into their conditions for investment). When comparing Round A investors with Round B investors, it turns out that the latter ran the lower risk but got the higher return.
Most ventures need several investment rounds – and often more rounds than the business plan predicts. So by the time your venture starts to gain traction (and assuming your investors are still willing to invest!) you and your family are diluted to a few percent of ordinary shares with four classes of liqprefs hanging over it. Sweat equity has evaporated and friend and family should be happy to get their pay-ins back.
Paradox 5: Small is Complex
Running a startup requires you to be fast and creative. Decisions must be taken swift and implementation often starts immediately because communication lines are short and the team is geared up for rapid execution. So, the impact of your decision is as direct as it can be, but an error will have dire consequences, because there is no backup for failure. To be successful as an entrepreneur, you need to possess many skills, talents and capabilities. You need to have the ability to focus on visionary, long-term goals and reach them through small, focused steps. You need to have the ability to muster sufficient resources and apply them as productive as possible. Furthermore, you need to win the confidence of financial backers, such that money comes available to your venture. And you need to assemble a team who can pull it off. Hiring the right people is probably the most difficult task of every manager.
Another, often overlooked skill is that you need to have the creativity to use third party resources to achieve your goals. Resellers, suppliers, landlords, bankers – without their support from day one, you won’t be able to get traction.
Possibly the most difficult part of the job is convincing customers to do business with you. Startups typically lack name recognition and there is little awareness of the product you are selling, let alone interest, desire and action. This makes running a small startup one of the most demanding jobs in business. Contrary to generally held opinions, small is complex.
Paradox 6: The Resource Paradox
The digital era brought us the vision of a paperless office and the reality of information overflow printed on stacks of paper. This not merely meant a boon for paper, printer and ink suppliers, also IKEA made tons of money selling filing cabinets, as offices continued to increase their paper storage capacity. The irony was that in those offices where more closets were put up, more paper was stored and vice versa. This is the law of perpetual scarcity of resources: any activity can always use more resources, hence there is always a shortage of resources. But the fact that more resources are needed, does not mean that resources are applied in a productive manner. People who had access to fewer filing cabinets became keener to select which papers to file and which not. With fewer documents filed, they increased file retrieval speed and were therefore more productive. Similarly, small startups can be much more productive, through strict focus and a non-convoluted, straightforward strategy.
Paradox 7: The Cashflow – Profit Paradox
The seventh paradox is well known, yet often ignored. There is a difference between profit and cashflow. Being profitable doesn’t mean you have positive cashflow. Since cashflow is your biggest constraint, you should manage for cashflow. Even so, most startups focus on profitability. When profitability is your top objective, you are likely to buy equipment, rather than renting or leasing it. When profitability rules, you are likely to focus on margins, rather than, for example, encouraging customers to pay early (like real early, as in advance payments).
Yet, despite the fact that “cash is king”, up to fifty percent of available cash is wasted. This is probably the biggest paradox regarding high-tech startups. The biggest source of waste is the time it takes to rake in revenues. Entrepreneurs can shorten time to cash by following a few simple and proven principles. Focus on pain. Design for sales. Use existing infrastructure. Avoid the lure of traditional marketing tools, which are detrimental to startups. These and other principles are described in the book TIME TO CASH – SEVEN KEYS TO SUCCESSFUL HIGH TECH STARTUPS
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