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MONEY

At the Crossroads

An Inc. advisory board analyzes a company's growth, capital, management challenges.
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The founders of Independence Technologies, flush with initial success, now confront the decisions about capital, management capabilities, and growth ambitions that have wrecked so many fast climbers before them. Here, Inc.'s ad hoc advisory board weighs in

THE RULES

The Challenge In the course of a one-day strategy audit, advise start-up founders how to (1) maximize their net worth, (2) cash in their rewards, and (3) keep from making knucklehead moves in the meantime.

The Challenge Takers (1) A Silicon Valley deal-making lawyer, (2) a director of an active investment bank, and (3) a general partner of a Big Six accounting firm.

The Founders Three middle-aged engineer-buddy middle managers from a large corporation.

The Vehicle A three-and-a-half-year-old bootstrapped computer-systems developer in a hot new field, with annualized revenue growth of 68%.

The Setting The company's corporate offices in an East Bay industrial park near San Francisco; mineral water, sandwiches, recording tape abound.

The Session Three founders present history of the company, discuss intentions, and disclose financial, operational, philosophical details as needed; three experts ponder company's future.

The Result Inc. condenses eight hours' worth of experts' deliberations, publishes highlights here.

* * *

Started in may 1988 by Kalyan V. Krishnan, Jeff Stern, and Michael L. Dierker, Independence Technologies Inc. (ITI) has been entirely self-financed ever since. As of mid-1992 the company had no venture investment and no bank loans. Yet by 1996 the owners expect to have exceeded $100 million in sales and to have reaped their just rewards. "Our wives," they concede, "keep asking us, When are we going to get some money out of this thing?" Put to upper-management novices, it's a legitimate question.

ITI is already a leader in the burgeoning market variously called "open systems," "software reengineering," or "object oriented." The company designs and implements on-line transaction-processing (OLTP) software products and services. Generically, OLTP manipulates masses of data from hundreds of simultaneously active input locations and might be used, for example, in airline-ticketing and car-rental agencies, and banks. Once the turf of expensive mainframes, that market is now open to low-cost alternatives. ITI's main distinction is that, unlike other OLTP software (including products from established competitors like Unisys and Oracle), ITI's isn't restricted to a given hardware technology -- hence the corporate name.

ITI's first OLTP product was paid for by the company's first client, health insurer Blue Cross and Blue Shield of Philadelphia, which hired the three (then) engineers to develop a turnkey informational infrastructure. Not only did that consultation seed the start-up with $10 million, but the installation served as a cost-free sales demo, attracting a dozen major customers to ITI's leading-edge capabilities.

Sales momentum rapidly pushed the organization into engineering. Now numbering more than 100, staff engineers were recruited on a project-by-project basis, delaying the founders' intent to structure the enterprise as small groups focused on specific types of products. Instead, each project has been booked as a discrete cost center, so consistency of pricing is elusive. So is consistency of customer: "Should we go after a few $150,000 accounts, or lots of $20,000 ones?" the founders ponder. Partly to entice customers into one-stop relationships, and partly because it's "such easy money," the company acts also as a reseller of the computer hardware its software runs on. That relatively low-margin source of income has been responsible for an increasing percentage of total revenues. Even so, ITI has been able to sustain pretax margins within pure-software industry standards.

Following a break-even strategy calculated to leave competitors in the dust, management plows all profits back into the company, mainly into marketing to boost revenues. Despite such hectic spending, ITI's balance sheet has remained "very clean and very boring." But the founders are tempted to sully it at last with a couple million dollars of outside financing to "propel the company into a prominent position." With the help of someone else's money, they'll be able to cement their hold on a 10% share of an OLTP market expected to be worth from $1 billion to $5 billion in 1995. If they don't take in more money, however, they're guaranteed control, and they won't be dictated to by -- or, worse, risk dismissal from -- outsiders.

To reach and maintain that level of market share, the founders are shifting slowly toward an emphasis on "shrink-wrapped" retail products. (See financials, page 5.) They already have a jump on the field: one early packaged offering, an OLTP-applications-development tool kit, was a "best products of 1991" selection of a leading technical magazine. But it sells for prices starting at $10,000 -- grist for a direct-sales force. A wide retail market calls for prices less than $1,000 and the ability to distribute product.

Ahead of product development, expansion of sales and marketing is likely to sop up any capital infusion. At the start of '92, ITI had only three direct-sales offices in the United States, plus one overseas presence, a Finnish franchisee. Indirect sales and distribution channels had yet to be faced up to and budgeted for -- or even understood. "What we're most scared about is telemarketing and retail," the founders admit. "Those are models we confess we don't understand."

They also confess to "not knowing anything about accounting" -- a stubborn seat-of-the-pants posture for a company going on $20 million, in that it lacks a chief financial officer and much of a finance department. It also lacks a board of directors and a layer of middle management. The three founders are accustomed to doing everything themselves -- engineering, sales and marketing, product development, contract negotiating. "In the old days," they complain, "we were involved half the day in engineering discussions. Now we don't have any engineering discussions." Clearly, they're running out of time.

Nonetheless, as one expert was moved to declare at the close of the exhausting session, "You have thought through your strategy and business orientation more thoroughly than most start-ups. You have an unusually deep understanding of the principles that will guide your future. It's rare for a bootstrapper scrambling to meet payroll to have this degree of thoughtfulness. This is a big company in the making."

* * *

What the Experts Say . . .
The Inc. experts team includes Cristina M. Morgan, managing director, Technology Investment Banking, Hambrecht & Quist, San Francisco; Joan P. Platt, general practice partner, Coopers & Lybrand, San Jose, Calif.; and Craig W. Johnson, lawyer, senior member, member of executive committee of the Palo Alto, Calif., law firm Wilson, Sonsini, Goodrich & Rosati.

* * *

On Growth:
'Aim at Profitability, not Revenues'
Founders:
We don't have much of a business plan. Basically, we build things and sell them. We sell a mix of software, licenses, services, and a little bit of hardware. We try to plan ahead as much as five years, but it's murky. We go into every year thinking we'll grow 50%, and we grow 100% instead.

Johnson: Top-line growth can be intoxicating. It's tempting to postpone profitability by rationalizing that you're investing for tomorrow and need to capture market share before your competitors do. But growth isn't the issue so much as the discipline of managing and learning to make trade-offs. Sacrificing top-line growth to make sure the company is healthy from a bottom-line point of view will have a tremendously positive impact on your valuation downstream. Investors -- and employees -- need to know that you put the bottom line first.

Morgan: The ones who are apt to give you maximum valuation -- corporations and Wall Street -- pay for profitability first.

Johnson: A benefit of learning to grow within your resources is, inevitably you'll have to meet a crisis -- maybe a major account files for Chapter 11 just as you're counting on the receivable, and suddenly a million dollars disappears from your balance sheet. If you've established a history and company culture of putting profitability first, you're more likely to have access to capital or bank debt, which will allow you to survive and emerge stronger from the experience. The hardiest companies are the ones that have weathered a winter frost.

Morgan: One problem that crops up when a company is top-line fixated is, its salespeople literally start making things up. They don't dare go to a strong-personality CEO and admit they didn't hit the quarter. It's amazing how many officers, when they're stressing growth goals, neglect to communicate to their company that it's not OK to get there any way but first-class.

Johnson: I've seen successful entrepreneurs get awfully cocky; it's like watching an F-15 fly into a cliff. The entrepreneur doesn't see -- and isn't told -- what he's doing wrong, because no one dares criticize him. When the organization is being told, Don't mess it up, even the greatest companies start to bend the rules. You're building on sand if you take that approach. You should be trying to maximize a steady return to investors through a predictable bottom line, an ethical company, the best products, a great place to work. I guarantee that if you maximize those variables, you won't have any problem with growth.

Founders: You may not realize how eclectic our founding group is. People keep predicting we'll fragment, but it hasn't happened yet; even going on $20 million we're still close. An investor did come in here a while ago and try to tell us, This is what I'd want you to do: divest yourself of the consulting part of your business and focus on products. We turned him down.

Johnson: What you want to do more than simply raise money is to bring in expertise at this time. The quality of money is more important than the cost of money. The wisest decision you'll ever make is to find the right player and give that person a good piece of the action at a favorable price, and get that person's long-term participation in building this company. As good as you've been, you run the risk of being inbred and having blind spots in experience. The people who can help you most will come with a price -- and it's worth paying. Plan to diversify your board. Ultimately, you should have three or four people with differing points of view. They're not going to throw you out. No right-minded investor would ever change the recipe of a company that's doing well.

Morgan: If you put the right person on your board -- a person with whom you strike a chemical balance -- that person is not going to think less of you for listening to and then possibly ignoring his or her advice. Don't do any of this without feeling a philosophical concurrence. Get references. Talk to the officers and founders of the companies on whose boards that person sits today.

Johnson: Closely held bootstrapped businesses tend to look for retired executives, but one of the most dangerous directors is the person who's been very successful in only one company, because that person will come in with an absolute formula that may not be appropriate for your company. The main function of a board is to act as a check and balance against your being blindsided by something you don't see coming, so you want directors with diverse business backgrounds who've been successful but who have scar tissue and can save you from making the same mistakes they did. You don't want pussycats.

* * *

On Critical Strategies:
'Marketing, Money, Mix'
Founders:
We have more sales prospects than we have sales assets to go after those prospects. Two years ago we wanted that problem, but now that we have it, it's not enjoyable. Even in the service side, we're moving up in "productization": each sale has a higher percentage of products in it. In 1991 about 20% of sales came from reselling hardware, because our customers want a single point of contact -- software and hardware. When you're bootstrapping, you take money where you can get it.

Platt: A software company is sometimes asked to facilitate the acquisition of hardware for its customers -- i.e., do turnkey sales. The software company, however, often isn't structured to sell or handle hardware products. Therefore, what originally was perceived as an easy revenue enhancer becomes an overstocking of inventory that can't seem to be sold. A software company should become proficient at selling its software products and leave computer sales to the hardware companies.

Johnson: I would lean toward putting more equity on the balance sheet. But capital can be a vice as well as a virtue. One of the benefits of bootstrapping is that you learn the necessity of making trade-offs. Many companies don't appreciate the need for trade-offs if their access to capital is too liberal.

Morgan: Get out of resale fast. To the extent that pass-through sales hold down your percentage of after-tax income, they position you lower on the valuation scale than a business that does a higher percentage. You may have to sell through as many as five channels -- direct, VAR [value-added reseller], telemarketing, retail, franchisees. That's expensive but not unmanageable.

Johnson: The company should stay with its annuity kind of strategy, building relationships with major clients and delivering an expanding family of products that meet their needs for both present and future applications. That's a competitive position that's enviable. Over time it will yield increasing gross margins, very much the opposite of the reseller business. The annuity kind of business -- the idea that you have a "franchise" with large accounts that you can sell to again and again -- will be much more appealing to investors.

Morgan: Companies often do things when they need money and then later live to regret the fine print. Fortunately, you have the opposite problem -- an embarrassment of riches. You should look at financing like any other strategic item in your business plan. The hard part about formulating financial strategies is that it causes you to read the end of the novel before it's written. You'll see those salespeople you have to hire, that distribution channel you still have to build, some competitor raising $30 million, and you'll think, Do we want to face this by ourselves?

Platt: You should get capital to beef up your marketing and sales. And a high percentage of your income is from one source, so you need to broaden your customer base. If you try to raise financing strictly as a service business, it'll be difficult. The most value you will get for this company is through product -- but a standardized product that someone picks out of a catalog, not one you have to keep customizing.

Founders: We could do with $2 million, but good venture firms won't talk about deals under $5 million. And they don't seem to be interested in paying more than one times revenues.

Johnson: In the venture stage, valuation is more of an art than it is a formula. It isn't just, Go out there and get the money. Were you to wait a few years and your product strategy to become more solidly established, there's no doubt you'd get a better valuation. However, you can use the business advice and capital an experienced investor can bring you now. The best investor isn't always the one who gives your company the highest valuation. A good venture investor wants to be compensated for the time, experience, and credibility he or she brings to you, as well as the money. On the other hand, a corporate investor often is willing to pay a higher valuation than traditional venture investors will if a company fits into its strategic plan. I'm negative on deals in which only a corporation invests. I will always steer a company toward having a mix of venture capital and corporate partners, so the corporation doesn't have the attitude that the company is a captive subsidiary.

Morgan: Venture capitalists aren't apt to be as rigid as they first present themselves. It would come down to negotiation. Don't try the shotgun approach, though. Venture capitalists don't want to feel part of a massive shopping trip; some will turn you down on that basis alone.

Platt: Do you even need a venture capitalist? No. But as well as sound advice and input, you'll need access to capital markets and additional sources of investment, and you get those needs answered by a relationship with a venture capitalist. A good venture capitalist, however; a mediocre venture capitalist can be incredibly destructive.

Morgan: You are clearly between late-stage venture capital and what is known as a mezzanine round -- deals for companies that aren't seen as start-ups. You avoided a seed round, and you avoided that always-predictable second venture deal to get to first-customer ship. What is your true value? Package software companies have to earn their quarter every quarter they live. Such companies -- that is, companies that have risk in the top line -- sell at about half their growth rates. At the other end are companies that have most of their revenues already booked when the doors open every quarter -- recurring revenues that are simply being accrued, such as from subscriptions. Their multiple is often 100% of their growth rate, because the perception is, there's little risk associated with their earnings.

* * *

On Founders' Exit:
'Go IPO -- But Not Yet'
Founders:
We want to have fun with what we're doing, and we also want to have wealth. Our wives keep asking, When are we going to take something out of this thing? We tell them, If we run a successful company, we'll make a very nice cash income just through salary and bonuses. Because here's what scares us: A company we watch brought in investors who brought in a new president. The board had one founder as chairman, the new president, and the two investors. Its first action was to fire the founders.

Johnson: You don't control a company just because you own a majority of shares. Performance is the way you control a company. The important kind of control comes from the business's succeeding and your managing it. I've worked with public companies where the president owned only 2% of the stock, yet there was no issue that he absolutely controlled the company.

Morgan: Your danger is going out with a whimper, not a bang. You could easily have a machine that affords all of you an ample living on your W-2, or you could get liquid soon at a decent price and be very happy. If sales plateau, ITI will become a nice little company with a nice little growth rate that investors simply won't be interested in. Is that good enough? I'm not telling you it's not, but you also have the opportunity to hit a home run here. Whether you get taken out in a transaction in which someone buys this company, or you sell a portion in the public market and thereby drive liquidity over time, you could drive it the same way and pay out all the money to the partners every year if you choose. Don't assume you couldn't go public because of that history, that you'd have to operate as a profitable entity for years before anyone would believe you. Wall Street will understand the differential between the reported bottom line and the actual.

Johnson: This is not the time to sell this company. Think as if you're going to be independent forever. Do the next steps right and the future will take care of itself. You're not playing on one niche or one product. You're adding such value to the customer organization that this will be a big business for a long time to come. What you're doing is one of the fundamental opportunities of the '90s.

Morgan: I believe this company can and should go public. You have important products and a smart business mix. The good news is that a number of investors will understand your strategy. There was a time when you couldn't give away a consulting business; investors saw it as a time-and-materials, nonleverageable business. They now appreciate that it does leverage the product business. Whether or not it actually happens, think it through all the way to an initial public offering, if only to show an outsider your view of how you'll get there. You might end up selling for some fat number because you're offered so much you couldn't turn it down, but we'll worry about that when it happens; founders have been bought out of an IPO the night before they shipped the documents to the SEC.

Johnson: You'll find it's a great satisfaction to bring a bootstrapped company to the status of being able to go public. But what's interesting about watching entrepreneurs make a lot of money is, they don't change that much. When you wake up after the IPO and find you're worth $40 million on paper, you still have to figure out what you're going to enjoy doing. And usually it's the same thing you've been doing before: building a business.

* * *

A Final Word from Our Founders
The ITI founders team includes Kalyan V. Krishnan, president and CEO, previously vice-president of engineering at systems integrator Teknekron, responsible for launching its health-insurance business; Jeff Stern, vice-president, responsible for marketing, consulting, program management, and quality assurance, previously a development manager at Teknekron; and Michael L. Dierker, vice-president, responsible for platform technology engineering, previously director of systems software at Teknekron.

Do they take issue, feel misunderstood, wish they had never volunteered? To determine the effect of the torrent of advice that Inc.'s experiment poured onto ITI's heretofore untested founders, Krishnan, Stern, and Dierker were asked for their afterthoughts. Here are some collective reflections:

* * *

In General. The prospect of sitting down with the managing director of software of Hambrecht & Quist, a lawyer from Wilson, Sonsini, and a partner from Coopers & Lybrand -- each given Inc.'s explicit directive that there were to be "no holds barred" -- was, to say the least, intimidating. It required not only significant expenditures of management's time and energy, but, knowing the results were to be published, a fair amount of courage as well. It was an intense session, and at times uncomfortable, as we did not always agree with the positions of the experts. But the process was executed professionally, and the free exchange has given us valuable insights. All told, we are greatly encouraged by the team's analyses.

* *

On Growth. Although justifiably proud of our growth, we are not as top-line focused as the experts portray us. ITI's explosive growth was the result of pent-up demand in the marketplace, not of the founders' preoccupation with the top line. Our bottom line has not enjoyed commensurate growth because, with no venture capital, we have reinvested revenues in the company. As we build up our asset base, we will be in a better position to achieve the bottom-line growth we have been striving for since the beginning.

The points the team made about the pitfalls often associated with the entrepreneurial-mind-set dangers of becoming autocratic and hubristic are well taken. But we don't fit into that mold. From the outset we have consciously shared decision making, and the information critical to that process, with employees. Admittedly, that isn't as unselfish as it sounds; we simply feel it's the best way to tap into the diverse skills and experience of our employees.

* * *

On Critical Strategies. Concerning "get out of retail fast," we disagree. To the extent that some of our customers want a single-source supplier, we must be committed to serving that need. We do not understand the investment community's fascination with percentage profit figures to the extent of turning away real money that could be flowing into the corporation. That is a dangerous attitude that has the potential to make the United States uncompetitive with countries such as Japan, Taiwan, and Singapore, which do not operate under percent-of-after-tax-income constraints.

* * *

On Exiting. Our initial reluctance to obtain venture capital may have been somewhat misinterpreted. We adopted a reinvestment strategy for early-stage growth -- and it was successful for that. We do share the team's opinion that now it's appropriate to seek alternative funding to prepare for an IPO. And we'll seek experienced managers to augment our board, as they recommended.


INDEPENDENCE TECHNOLOGIES INC.

FINANCIALS (in $ millions)

PROFIT AND LOSS

1989 1990 1991 1992*

REVENUES $4.0 $5.8 $11.9 $20.0

Cost of sales 3.8 5.9 10.8 14.0

Marketing 0.0 0.0 0.8 4.0

INCOME AFTER TAXES $0.2 ($0.1) $0.3 $1.3

BALANCE SHEET

ASSETS 9/30/91 12/31/90 12/31/89

Cash $1.0 $1.1 $1.3

Accounts receivable 1.4 0.8 0.1

Inventory/prepaids 0.2 0.0 0.7

Total current assets $2.6 $1.9 $2.13

Net equipment and $2.0 $1.5 $1.7

other assets

Total assets $4.6 $3.4 $3.8

LIABILITIES AND STOCKHOLDERS' INVESTMENT

Trade payables/liabilities $1.4 $0.6 $0.4

Customer prepayment 0.9 1.2 1.5

Total current liabilities 2.3 1.8 1.9

Long-term liabilities 2.1 1.5 1.7

Retained earnings 0.2 0.1 0.2

Total liabilities and $4.6 $3.4 $3.8

stockholders' investment

(* projected)

Last updated: Jul 1, 1992




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