1. How Big Do You Have To Be When You Grow Up? What If Youre Not Going To Be Big Enough?

Frequently at the Startup Clinic, we see companies whose financing plans are completely out of line with investor preferences. Hence this short summary of the rules and possibilities. The first thing to remember is that if you take outside money and give up more than 10-20% of your company, then you will have to sell the company or, much less likely, do an IPO, in 3 to 5 years. People who say, We'll simply buy back the outsiders stock are naive. If you have enough cash to buy out a significant outsider, then you're worth more than you can afford to pay. Second, you need to think about investor expectations. Far too often at the Startup, we see companies that want to raise $5 million to become a $25 million company in five years. Until we figure out a creative way to sell 300% of your company and keep some for yourself, you cant get there from here. Most VCs would like to achieve returns of 50% per annum, which turns a $1 investment into $10 in five years. This means that if you want to raise $5 million and give up half the company for it, then you must achieve a company value of $100 million in five years (their half has to be worth ten times $5 million = $50 million). This is easier said than done -- keep firmly in mind that the late 90s were utterly abnormal and that $100 million companies are few and far between. You probably need an addressable market of $500 million or more -- sometimes much more -- to credibly claim that you're going to be worth $100 million. As a rough rule of thumb, then, think about being able to raise around one percent of your five year addressable market. This isn't very much money, but it's realistic. The big, old line VC firms have more money than people to invest it, so they like to put $5-10 million into each deal. This doesnt mean you have to start with a $5 million round, but it does mean that these firms arent good candidates unless you're going to be a big company. If you think youre going to be a nice, profitable, $25 million dollar company, where do you turn? One possibility is to grow slowly with internal funds. Four out of my seven successes were sold before they had any outside money, all for more than a million dollars nothing spectacular, but nice solid success in each case for a small group of founders. Customer money, sweat, and consulting contracts, are all sources of money on which to grow, albeit slowly. Another is angels. The formal angel groups around town mostly like to see deals that will end up with VC financing, but there are individuals who will come into companies that expect lower growth. Still another is the specialty funds the generally smaller funds that specialize in making smaller investments in an industry or in women or minority owned companies. Whatever you do, match your money raising efforts to your targets expectations if you dont, youll look naive and waste a lot of time. James L. Woodward, Editor jameslwoodward@mediaone.net

2. What I look For

I have recently had an extended discussion with an old friend about his potential investment in a startup. It has led me to think hard about what I look for in deciding whether I think a young company will make a good investment. First, people. Always people. Are they smart, experienced, flexible, and honest? Smart because intelligence always helps and because I enjoy being around smart people. Experienced because I dont want my nickel to be teaching them about business or an industry. This means that the CEO and the chief marketing person (who may be the same person) should have significant experience in the industry. I cant count the number of software gurus who have looked at the hospital market, decided that it needs better software, and plunged in, with no background, no experience, and no hope. It also means that the CEO or the number two should have significant startup experience. Little companies are very different from big different worries, different priorities. Flexible because Moores law says that the world will be different in five years, in sometimes unpredictable ways, and, of course, these are unpredictable times. Honest because I like it that way and because I want to be able to trust them and their numbers. Second, market. Calculating market size is sometimes easy one of my startups sold a $100,000 box that was a peripheral for a special purpose computer, There were 2,000 of these in the world and the payback on our device was so good that everyone would buy one (incredible as it might sound, this turned out to be true). It was easy to see a $200 million total market. (It turned out to be bigger.) Sometimes its not so exact in the case of my friends investment, there appear to be 150,000 potential users worldwide. From that, you ask, how many will share one, how many wont use one, how many will buy a competitors unit, and how often will they replace it? Not an exact science, but something like 30,000 units a year seemed appropriate. Finally, multiply unit volume by expected price in the later years to get the size of the company. Keep in mind that technology prices almost always go down with time. Third, potential return on investment. I dont even try to do a classic ROI calculation there are too many unknowns. A business plan that tells me that Ill make 14.79% per annum on my investment tells me two things that the CEO doesnt understand that startup investors look for returns more like 50% per annum and that startups are uncertain such precision is just plain silly. What I do is to look at the size of the company and the amount of money required. If the size isnt at least twenty times the money, I worry. Exceptionally profitable companies far fewer in reality than in business plans might get away with fifteen times, but twenty is a good number to accommodate a reasonable stake for the management, the various investors need for good returns, and the unexpected glitches that always come along. Note that this does not preclude small companies from getting outside investment Im looking now at a situation that might become only ten million or so in revenue, but it needs only a couple hundred thousand dollars to grow, well within my twenty to one rule. Finally, the technology, intellectual property (IP) protection, and barriers to entry. First mover advantage is rarely enough to prevent an existing player whose lunch is being eaten by a young company from jumping in with a copycat of the new company. I want to see a solid IP position or some

other barrier. This can be anything from a dense patent position to the simple fact that the market is so small that big players simply wont bother. Note that I leave technology to last. This is partly because its the hardest to evaluate, but mostly because the other factors are truly more important. People, market, return, technology. They all have to fit together and to make sense. James L. Woodward, Editor jameslwoodward@attbi.com Summary: What I look for in deciding whether I think a young company will make a good investment. People, market, return, technology. They all have to fit together and to make sense.

3. Rules of Thumb
Last Spring, I wrote two columns about getting the numbers right, with an emphasis on getting the number of employees and the profit percentages right. Heres a little nittygritty to further help your forecasting. The following are figured on a fully-allocated basis each department bears its share of payroll and fringes, occupancy, and similar items. General and Administrative expenses will run around 10% of revenue. This includes the President and the VP-Finance & Administration , their staffs, and the legal and insurance costs. It will start well above 10% while the company is losing money and then gradually drop to high single digits as the company grows past $10 million. Research and Development (including programming in software companies) is typically between 10 and 15% of revenue. You can often get away with spending less for a while, but in the long run, it takes money here to stay ahead in a technical company. The software company might put some extra bucks here, up to maybe 25% of revenue. Sale and Marketing varies all over the lot. In a company that sells only OEM, there may be little or no formal S&M department, deals being done by the President and the Chief Engineer. In a B to C (what used to be called a retailer), the skys the limit. With that said, however, S&M expenses much different from 25% of revenue deserve further thought and some explanation. Of this, more or less half will be spent directly on salespeople their salaries, commissions, and travel expenses (which, by the way, will typically be equal to their pay). Gross margins in a hardware business should be at least 50% and preferably higher. While an OEM with very little Sales & Marketing might be viable at a 40% gross margin, a company that has to spend 25% on selling had better be getting 60-70% if it wants to be profitable. In software, of course, cost of goods sold is low, so the gross margin can support higher operating expenses. Cost of goods sold is not free in a software company, however. Even in a company that delivers product over the Net, tech support and warranty both go into cost of goods sold. It takes 200 square feet per person for a typical high tech company. This is remarkably constant across hardware and software companies; if you go aggressively to cubicles, you need more conference rooms, driving the average back up. While this average is good for hardware and software companies, Id adjust up a bit if you were making a large, cheap product. It will cost around $2,000 to outfit one person with cubicle, desk, desk chair, side chair, work light, bookcase, wastebasket, and computer. Youll buy all but the computer from a used furniture dealer; its crazy to pay new prices for these things. If your engineers require the latest in super workstations and software, forecast them separately at $5,000-

10,000 each. These figures include a little extra for the copier, fax, phone system, network, coffee pot, and conference room furniture. Dont spend a lot of time on occupancy costs unless youre going to have a lot of cheap labor. With Route 128 occupancy costs at $20-25 a square foot including everything (well above the triple-net price quoted by real estate agents), your 200 square feet per person is only $4,000 per year. Youre unlikely to forecast salaries accurately enough to make important errors here. The idea here is to put together a reasonable set of numbers not necessarily to be dead nuts accurate, because 1) thats impossible and 2) even if it were possible, the world will change before it happens anyway -- just reasonable. James L. Woodward Editor jameslwoodward@juno.com

4. A Primer on Gross Margin

Gross margins are often a failure point for startup business plans; most manufacturing startups forecast gross margins that are too low, while most software business plans call for margins that are unreachably high. Then we have that great business advocate, Tom Finneran, Speaker of the Massachusetts House, saying, "I don't think the taxpayers should provide a 10 percent profit margin for every drug transaction that we make," while reducing the pharmacists margins by 12 points. Gross Margin is simply the difference between Selling Price and Cost of Goods Sold, expressed as an amount or as a percentage of the Selling Price. This isn't quite as simple as it seems, as Cost of Goods Sold includes the cost of a number of things besides the actual package that ships to the customer. Some of these are freight in, warranty expense, training and support expenses that are included with the sale, license fees, rent on the factory, depreciation on the manufacturing equipment, manufacturing salaries, wages, and fringes, and just about everything else required to get the product out the door. Thus Microsoft's Gross Margin is only 86% even though the shrink wrap package costs almost nothing to make and most Microsoft licensees are OEMs for whom there may be no physical deliverable. Anything over 85% is suspect for any software company and one selling big ticket software with a lot of training and support may do well to achieve 75%. Margins provide money for R&D, marketing, selling, and administration; these are all things that help differentiate your product or service from the next one who, after all, when sitting at the keyboard, can tell the difference between a Dell and a Brand X, when both are working? They provide space for mistakes, for the inexorable price erosion of Moore's Law, and, again, for the superior services that allow your product to compete with the Big Guy. While I like to see manufacturing startups with Gross Margins of 75%, feeling that you have to plan high in order to have some room for margin erosion, most real world manufacturers do well to achieve numbers in the 60% range Intel, in a good year, can manage this. On the other end of things, Dell, at 20%, has one of the lowest Gross Margins of any business operating according to its chosen model. It can make money by being one of the most efficient assemblers and retailers in the world, with inventories less than 2% of Cost of Goods Sold, and a highly automated factory floor. Amazon soldiers on, with a Gross Margin in 2001 of 25%, unable to make money, yet finding it difficult to raise prices. Historically, food stores have been low margin businesses, but as supermarkets continue to carry more and more non-food items, margins have crept upward to the 30% range, while department stores, like most soft goods retailers, normally operate around 40%. Which brings us to Mr. Finneran and the Massachusetts pharmacies. The old Medicaid reimbursement scheme, which Mr. Finneran thinks was too high, gave the pharmacy 10% above its nominal wholesale cost (this may or may not have been the real cost) thus the Selling Price was 110 and the CGS was 100, for a nominal Gross Margin of 9%. If Dell, one of the most efficient companies in the world, selling thousand dollar computers, needs a 20% margin to make money, how can a pharmacist, who must stock a large inventory and have trained professionals count every fifty cent pill, expect to make money at a 9% Gross Margin, much less the negative margin that is now law?

5. Seven Recurring Questions

There are a set of recurring themes in the comments at the Startup Clinic and at investor meetings very few companies looking for money recently have avoided all the pitfalls here: 1) Management Experience (or Lack Thereof). The 50K and other similar competitions notwithstanding, experience, particularly industry experience, is essential. We see this most often in hospital software we all know that hospital systems arent all they should be and several times a year a Startup presenter with lots of software experience, but none in hospitals, shows us how to fix all that and make a lot of money. Hospitals are the way they are for peculiar, industry specific, structural reasons, and people with no hospital experience arent going to fix them. 2) You Cant Get There From Here. My rough rule of thumb is that the stated size of the market has to be 100 times the total amount of money to be raised over the life of the company. This allows for the ten times returns that early stage investors want, a significant share of the company still in the hands of management at exit, the optimism of all market projections, and the fact that few companies actually get anywhere near all of their market. It is, I freely admit, conservative, and I have certainly made investments that required more money for smaller markets. Nonetheless, many business plans underwhelm us wanting to raise several million and projecting revenues of twenty million. You cant get there from here the market has to be big enough to support the capital needs, with a piece of the pie for everyone. 3) Nobody Brings 50% Down to the Bottom Line. About a third of the plans I see project fifth year profit (sometimes PAT, sometimes PBT, often EBIT) above 30% of revenue, some well above 50% of revenue. This puts a question mark over all of the teams numbers and their business savvy itself. No one makes that kind of profits, particularly in a rapidly growing company that is fighting for market share. Even if, somehow, you could, you wouldnt youd spend the money on marketing and improving your product to increase market share for the future. Most of the offenders say that high profits are needed to interest VCs because thats what makes the company valuable and justifies the money needed (see #2). Fact is, grossly unrealistic profits turn off investors better to show rapid growth and PAT of about 10% -- theres time enough to make profits when you get big, really big. 4) Even Software Costs Money to Make. Many software startups project gross margins (revenues less the actual cost of producing the goods, including warranty, etc.) well above 90%. Think again, please. Microsoft, an almost pure software company, had a gross margin in 2003 of 83% (sure they sell a few mice, but, in most cases, nothing ships but a short manual). Intuits was 78%. Gross margins above 85% are rare unless youre in the gold business. 5) Not Enough Marketing. Most successful startups spend a lot of time and money on understanding the market, what it wants, and what it will actually buy. Ralph Grabowskis research shows that theres a direct correlation between marketing dollars and success. Im not as certain as he is about marketing dollars causing success, but certainly talking to customers rather than inventing in a vacuum should be the model. Too many of our techie startups have a wonderful product in search of a market that they dont understand.

6) Focus, Always Focus. This is a two edged sword. Focus on one thing and youre a one trick pony; have a breadth of ideas and youre unfocussed. While most successful startups have heard one or the other of these comments, moderation is the key, and you must focus on a winnable market, not necessarily the largest one around. 7) Plan For Change. Aside from the difficulties of working in a world where you have to beat Moores Law deliver twice as much to the customer every 18 months in order to just stand still -- and all of the ongoing changes in an uncertain world, the startup must also plan for the changes it will make to its market and reflect those changes in its plans. Ive seen a lot of plans that say, Theres a billion dollar market for this, growing at 10% per year. Were going to cut the price to 10% of the current price and sell half a billion dollars worth in the fifth year. Aside from the difficulties of getting a large share of a large market, this math doesnt work. At 10% of the current price and the same unit volume, this market is $100 million today, $160 million in five years. Unit volumes will probably go up as price goes down, (the economist training in me cant resist saying it depends on the price elasticity of demand), but many plans dont even consider this, as though, somehow, the dollar market size is independent of price. James L. Woodward Editor jameslwoodward@mvfintry.com Summary: Seven Recurring Questions There are a set of recurring themes in the comments at the Startup Clinic and at investor meetings very few companies looking for money avoid all the pitfalls here.

6. The Quantity of Numbers

Ive written several times about getting the numbers right -- staying within the bounds of reason for profitability, headcount, growth, and the like. Theres more to good numbers than that, though. When I first raised venture capital, I did five year projections by quarter, by hand -- this was in the Dark Ages, just before VisiCalc became available. The next half dozen times, through the Eighties, I did five year detailed projections by month, using a lot of tricks to get 123 to recalculate in a reasonable time. Then gradually, while computers got faster and it was possible to write bigger and more complicated spreadsheets, my projections got smaller and simpler. My latest set shows only revenue, gross margin, and profit before taxes, by years. These are backed up with headcount numbers and a few costs, but little else. I spoke about this on a panel at TCN (www.thecapitalnetwork.org) last month and one of the VCs on the panel wanted more -- monthly or quarterly detailed financials. We didnt really get a chance to debate our differences, which is too bad, because Im feeling more and more strongly that detailed projections are a waste of time. This is mostly because Ive become very cynical about projections. I certainly havent ever been able to do a five year forecast of a startup that came true-- there are simply too many variables. We know that no plan survives contact with the enemy (von Moltke) and this is as true of business plans as it is of battle plans. Sure, you need to do enough thinking about sales and marketing to understand the sales channels, their costs, and how fast you can increase revenues -- its harder to grow if you use direct sales than if you use distributors simply because hiring the sales people and setting up offices is time consuming. But you dont need to spend any time on forecasting G&A -- 10% of revenue (if-sold revenue if its a service model company) will do fine, and R&D should be someplace between 5 and 15%, usually at the higher end. Trying to look at detailed costs of either of these is futile -- the one will cost what it costs and the other, while adjustable, will be what it needs to be to keep you ahead of competition, something very hard to forecast in detail from a standing start. There are some circumstances under which you need to do more -- notably businesses where the balance sheet is important -- significant capital expenditures, for example -- or where there is significant seasonality. Since most startups raise money to fund losses, you need to be careful in a seasonal business to have enough money to fund losing quarters even after a profitable year. Even in an ordinary startup, you need to look closely at the first profitable year to ensure that you have enough to fund the losses before the turnaround. So, keep the projections short, and forget the detail everywhere but Sales and Marketing -- concentrate your effort there to make your minimal projections realistic and credible. James L. Woodward, Editor jameslwoodward@mvfintry.com Summary: Dont spend a lot of time on financial projections that are more detailed than the uncertainties allow.

7. The Right Numbers

It is often said that venture capitalists and other investors never believe the financial projections that come with business plans. This is true, but it does not mean that the numbers do not matter. You wont get too many demerits for forecasting superfast growth, even wildly superfast, or for being optimistic about how fast you will get to market and to profitability, but the structure of the financials, particularly the income statement, reveals a great deal about your understanding of what will be required in your business. Recently I have seen a number of plans which show great naivet about the resources required to run a business. One that particularly sticks to mind proposed to run an Internet information business with total operating expenses sales, marketing, research, development, administration, and finance of less than 10% of revenue. You can guess the forecast profitability. Although there are several ways to approach getting to reasonable numbers, I like to think first about revenues per employee. How many people will it take to run a $10 million, a $100 million, a $1 billion business in your industry? More than you would guess, Ill bet. Many more. In very round numbers (all generalizations are false and there are a lot of them here), a manufacturing company will do around $100,000 in revenue per employee. While Microsoft manages to do better than $500,000 per employee, most of the large software companies are around $200,000. In the e-commerce world, Amazon amazes with numbers also above $500,000, while players like e-Bay are down in the $250,000 range. The bottom line is, therefore, that if you forecast revenues of $100 million, youd better forecast 200-400 people to carry it off; you cant get there with many fewer. Similar comparisons can be made of other aspects of your numbers. Where does one get the data? The Securities and Exchange Commission has all SEC filings detailed information on all public companies available at its web site www.sec.gov. They are also available in an easier to use form at http://edgarscan.pwcglobal.com/, among many others. Comparison with other companies in your industry is not a solution for dumb forecasting, but used intelligently, it can improve your credibility dramatically. P.S. Revenue per employee is usually calculated by dividing annual sales by headcount at year end. In very rapidly growing companies this distorts reality downward, so its better to look at sales for the first quarter, multiply by four, and divide by employees at the previous years end the beginning of the first quarter. (Quarterly SEC reports have revenue, but not headcounts you have to look at year end for those).

Promotion, Richly Deserved Trish Fleming, our Administrative Officer, has been promoted to Executive Director to more clearly describe the role she plays in running our $500,000 organization. With Trish now firmly in charge, we expect to be a $1,000,000,000 non-profit in 2003. Letters If from time to time you feel a need to respond to something you read here, send mail. We may experiment with a Letters column from time to time. The address is editor@mitforum-cambridge.org [Trish make sure this works or use something else]. James L. Woodward Editor

8. The Right Numbers Part II

In January I wrote about getting the importance of getting the numbers right in business plans, with a focus on revenues per employee. This time, Ill look at profits. This has been brought to mind by a variety of plans showing profits after tax in 100 million dollar companies on the order of 50%. While you may have a fantastic business in mind, such results are so unlikely as to be laughable. First, there are taxes. State and federal corporate income taxes total roughly 40%. While there are a wide variety of loopholes that can defer or reduce taxes, don't bet on getting your tax rate below 30% of profit before taxes. The only exceptions here are industries that have particularly good loophole generators representing them in Congress. To achieve a profit of 50% of revenue at a 30% tax rate mean that only 29% of revenue can go for all costs and expenses, which is hard to achieve. The more important factor, however, will be your own behavior. Imagine yourself running a very young $100 million business. You're running very lean, cutting all expenditures to the bone in order to maximize profits. Why, you might ask, do you want to maximize profits? It's not to help finance the business. A rapidly growing $100 million business will be easily to finance from either the public markets or private sources, including both mezzanine funds and insurance companies. Even if the world goes back to calculating valuations from earnings, rather than revenues, a profitable business will always be in good shape. Can it be that you want to help your competitors? If you cut both your R&D and marketing expenditures to the bone, you will make it easier for them to overtake you with better products or better market positioning. Wouldn't it be better to take advantage of your high basic profitability and spend a significant part of it on various marketing activities to get your business better known (SuperBowl ads?) and on development of better products, whatever they might be? Indeed, given high profitability, won't you want to spend money across the board to hire and retain better people, select better vendors, and improve customer service? As you look around today's rapidly growing companies, the most talked about have minimal profits. While there are limits on the Amazon strategy of indefinite non-profitability (which some of us think Amazon has passed), there is no particular advantage to very high profits. Where does this leave the business planner? I wouldn't forecast after tax profits of more than 15 or 20% of revenues in most circumstances. If the business is inherently very profitable (some really are) I would write a footnote to the financials calling the reader's attention to this and pointing out that x% of expenses are really discretionary and intended to help the business capture future market share. Most experienced business

plan readers will chuckle cynically at that, but at least they won't be laughing out loud at absurdly high profits. James L. Woodward Editor jameslwoodward@juno.com

9. The Right Numbers -- Part 3

In the last thirty years, Ive never seen a credible five year forecast that was built from the bottom up. Cant be done. Whenever Ive tried it, Ive ended up with expenses around half of what I know they should be and fudged upwards mightily to fix things. So, Ive stopped trying. I wish people doing the numbers for the business plans I see would do the same. Last week, I waded through a one year forecast that had been built up from the bottom, one line at a time. It had a lot of detail and I realized that this is where the process is so seductive and so wrong. You end up in what someone once called the coffeepot trap -- that the Board of Directors can approve a million dollar project in five minutes and then spend half an hour debating what kind of coffeepot to get because they have nothing relevant to say about the former, but think they really understand the latter. (OK, coffeepots arent really a Board issue, but you get the point). In the case of the forecast, you can forecast great detail -- Medicare will be 1.45% of payroll, for example -- and know that youre right. So, line by line, you build it up, all with great detail. All very reassuring. Then you come to something like salespersons travel and your experience fails, as it did in my one year example. Travel varies all over the lot. If you have someone who makes appointments first and then buys tickets, its expensive; on the other hand, the person who buys cheap tickets and then makes appointments to fill the slot can really save money. And so forth. You end up forecasting small things with great precision and large things as great guesses. So, how do I forecast? I like to start with headcount. Its easy for all of us to get our minds around. It drives most expenses. And, in many cases, it will drive, and be driven by, revenue. If you start with $250,000 in revenue per employee, you wont be far off. The mix should more or less follow the usual ratios on the income statement -- G&A 10%; R&D 15%; S&M 25% in hardware, 40% in software; Cost of Goods Sold 15% in software and 25-40% in hardware. Since the profit doesnt have any employees assigned to it, you need to add up the cost percentages and use that as the denominator to get the employee percentages in each department. Now you have salaries; add 10% for the mandatory benefits. Figure 200 square feet per person and you can figure occupancy. If youre actually calling on your customers nationally, then your sales travel will be equal to your salespeoples compensation. Dont bother with much more detail. Push these numbers back and forth against the percentages I quoted above. When they feel comfortable in the fifth year, then smooth them backwards to link up to where you are now, not straight line, constant growth curves, but a more or less constant percentage growth rate, perhaps a little faster in the later years. Everything else drops out of this. Unless the business is very seasonal, capital intensive, or is softwareas-a-service (pay as you go for the customer), you dont need a balance sheet -- your losses will be your cash needs, as you can assume that payable will finance receivables. So, please, please, dont try to figure out what your coffee budget is going to be in Year Four; do it from the top down and be sure to spend enough money James L. Woodward, Editor

jameslwoodward@mvfintry.com For more on Revenue per Employee, see: http://www.mitforumcambridge.org/archive/r_jan00.html#editor Summary: Bottom up budgeting doesnt work. Heres how to do it right.