A look at how companies like Palo Alto's Lunar Design are seeking the long-term payoff by taking equity instead of cash for their services.
True wealth doesn't come from working for a paycheck. A new generation of service companies, like Lunar Design, have figured out that it's all in the multiple
By most outward measures, Lunar Design would be considered a success. A Silicon Valley-based industrial-design firm, Lunar employs 40 people and last year generated more than $8 million in sales. The company's austere Palo Alto headquarters, with its starkly curved lobby walls, showcases its inspired labor for the likes of such techno-heavyweights as Xerox, Silicon Graphics, Hewlett-Packard, and Motorola. The firm played a key role in the design of Apple's Powerbook and recently gave shape to an ergonomically exquisite $5 toothbrush for Gillette's Oral B division.
But for all the firm's high-toned, West Coast cool, Lunar's success is, in part, more surface than substance. Industrial design is a competitive business, especially when you locate yourself in downtown Palo Alto, where office space goes for $4 a square foot per month (as opposed to half that in an industrial park three miles outside of town). "Margins are thin in this business," concedes Lunar's president, Jeff Smith. That has pushed Lunar into generally accepting whatever jobs walk through the door. "You're always doing someone else's work," adds Smith wistfully, rather than having the freedom to pursue independent projects.
When the firm opened its doors, in 1986, drafting tables were pretty much state-of-the-art. At the time, it cost Lunar about $2,000 to equip a single designer. Now, with the latest CAD software, the cost of setting up a designer can run as high as $50,000. The high cost of keeping current ensures that Lunar will have to continue to accept whatever work walks through the door—just to cover operating expenses. For all its apparent success and cachet, Lunar Designs seems to be running in place, albeit with plenty of style.
The Power Of The Multiple
The sense of running in place was the conundrum that bedeviled Smith, one of Lunar's three founding partners, back in the late 1980s, when he began talking up meaningful change with his two partners, Gerard Furbershaw and Bob Brunner. What would it take to change Lunar's business model to give the earning statement some upside pop and the design team a creative lift? Brunner, who left Lunar in 1989 to become Apple's chief designer, recalls having conversations with Smith about how they spent a fair amount of their time giving counsel and strategic advice to start-up clients, almost as if they were venture capitalists. If that was the case, then why not partake of the spoils?
So Smith and Furbershaw set out to liberate Lunar by hitching its fortunes to something more hopeful than the fee-for-service treadmill. Stock, not cash, would become the energizing and value-building force, the coin of their realm. The partners knew that $1 in cash taken as payment for design services would never amount to more than $1 in sales—and a lot less of that in profit. On the other hand, a dollar in equity taken in exchange for services rendered could someday multiply into $5, $10, or even $20. The value of a share of equity is limited only by the ultimate valuation of the company. By setting up deals in which Lunar would receive equity-based compensation from its clients, the founders could tap into "the power of the multiple"—the ability to turn what might have been simply a fee-for-service payment into an equity stake worth much more in the long run.
'We want talented people to participate with us simply to garner more passion and energy,' says Smith. Not only is the process more inspired; it's also less costly.
While Lunar Design is ahead of the curve in thinking about how to supplant cash with the exponential possibilities of holding equity, it is far from alone. It is simply at the advance of a powerful wave that represents a radical new way of thinking about how to transact business. Tapping into the power of the multiple is, in fact, becoming more apparent every day as an efficient way to operate. As the stock market approaches the once seemingly unreachable 10,000 level, as employee-stock-option grants explode, as mutual funds proliferate, and as Social Security begins its slow migration toward inevitable privatization, a broad understanding that equity is the path to enduring wealth has taken hold.
Leveraging an equity stake becomes a means to take better advantage of skills and to build wealth. It becomes a way for a company not just to control its destiny in a chaotic economy but to simply do a better job in a world where quality and timeliness count all the more. It amounts to more than just taking stock in lieu of cash. It's about integrating a company's fortunes with its customers'—and, ultimately, making work more creative and meaningful in the process.
Providers of all sorts of professional services, once happy to settle for fees, are now asking their clients for stock. Their clients, for the most part small, start-up companies, are responding, knowing that stock is a cheaper currency in the short run and a powerful motivator over the long haul. Consultants, lawyers, designers, public-relations specialists, and even bankers see not only more upside reward via equity but also a chance to make their work more varied and relationship-based. (See "The power of the Multiple: A Sampler," on page 52.) Jim Sweeney, a former consultant who was recruited to be the CEO of health-care start-up Bridge Medical, says, "This is a hot topic for all consultants right now." Sweeney, who is currently working with consultants from Parthenon Group, in Boston, believes that those who don't want to embrace it "will become competitively disadvantaged." Parthenon's CEO, Bill Achtmeyer, agrees: "Businesspeople make return-on-investment judgments every day, and CEOs are often incented by the rise and fall of the stock price. If we think we can provide good strategic advice, then we ought to take similar risks." In the case of Bridge Medical, Parthenon took all of its fee in stock.
The multiple is also a democratizing force. It unleashes the wealth-building potential for service providers—and their employees—that traditionally was held by the select "money" people: investment bankers, venture capitalists, angels, and high-growth companies dabbling in strategic partnering. Now a firm like Lunar, ostensibly tied to one narrow discipline, is assuming a far broader and more textured identity—a multiple personality of sorts. Lunar has become a de facto venture capitalists and is about to start developing its own products to entice others. It looks for good ideas wherever they may occur—in small start-ups and large corporations, and inside the heads of its own designers. It has built a virtual network of experts that it can tap to get an idea from concept to market as quickly as and as cost-effectively as possible. As it puts together projects Lunar retains as much of the equity as possible, keeping it in the hands of the people who have actually created the value. The sense of shared ownership and common reward is the unifying principle behind the power of the multiple.
Opportunities for companies like Lunar have been increased by a fertile investment niche opened by a mismatch between the high degree of entrepreneurial innovation in today's economy and the changed demands of venture capital. "There are a tremendous number of really good ideas out there that don't get done," says Gary Cantu, a high-tech entrepreneur who is currently working with Lunar Design. "Venture capitalists used to support seed-level deals, but that has changed drastically. Ideas in the $250,000-to-$1-million range are harder to fund because venture capitalists are looking for bigger chunks of stock and bigger returns."
That is where Lunar Design and its virtual network of partners fit in. Together they can pool their capital and invest smaller sums in the start-ups that are flying below the venture capitalists' radar. "We want to back anybody with a good idea and the right technology but who does not have the resources," says Smith. Lunar wants the ideas that would otherwise fall through the cracks.
Smith and Furbershaw have codified the process with an appropriately descriptive name: "venture design." And the energizing principle behind that has a name, too—Big Bang.
Big Bang means getting to an idea or start-up company at the beginning, exchanging industrial-design services for equity at the garage or even the back-of-the-envelope stage. Then Lunar can add enhanced support—and an infusion of capital, if necessary—as the prospect blossoms, by hooking it into Lunar's virtual network of technologists, consultants, and other business experts.
Big Bang's trust—aside from getting to a prospect early and becoming vested—is to lure motivated people to work on just-budding ideas, giving them an equity stake to spur them on. "We want talented people to participate with us simply to garner more passion and energy," says Smith. Not only is the process more inspired; it's also less costly. "Doing a transaction for equity this way gets you a lot further, and quicker, down the road than otherwise," Smith adds.
Since embarking on this initiative, five years ago, Lunar has made five Big Bang investments. But now it's stepping up the pace, expecting to make three or four annually, totaling about $250,000 each year. (Smith and Furbershaw have also invested personal funds in the Big Bang projects.) Lunar will take a portfolio approach, much like that of a venture-capital firm, setting return targets (30% a year over five years for each investment). The expectation is that a few big winners will cover the bets that bomb.
From Lunch To The Global Market
Lunar's first, and now most mature, investment began in the mind of Gary Cantu, formerly an engineering manager at Silicon Valley company Spectra Physics and Molecular Dynamics. Six years ago, Cantu retired to Bozeman, Mont., where he stayed retired for all of about three months. One day, during a visit to the dentist, Cantu began thinking: What if you could replace dental X-ray film with a laser-based sensor technology, thereby reducing harmful radiation and eliminating heavy metal waste in the process?
Seeking an industrial-design concept for the product he had in mind, Cantu called Jeff Smith at Lunar. The two had previously worked together, and Cantu knew that Lunar had the right stuff. He came around at just the right moment: Smith was pondering how to propel Lunar into venture design. Over lunch in November 1993, Smith's eyes widened as Cantu laid out his idea. "Jeff could immediately see that the market was huge," recalls Cantu. Smith and Furbershaw became early-stage investors in the company. (In 1995 Lunar would buy 14,356 shares of its stock at $1.60 apiece. Eventually, Lunar would get another 4,503 shares at $4.37 each.)
Then the three set about leveraging the company and creating the Big Bang. DenOptix, as the new company was called, subleased 1,200 square feet in a research-and-development consultancy. Lunar did the industrial-design work and engaged an East Coast company, Product Genesis, to do the initial mechanical design. Much of the rent and the consultants' work were paid for in DenOptix stock, meaning that the company spent only $45,000 of its precious cash during its first year of business.
And by the end of that first year, DenOptix had a working prototype that proved to be so compelling that Cantu was able to raise $1 million privately from dentists in less than three months. Then DenOptix ramped up. Four months later it had three market-ready units in the field—and it had spent less than $500,000. "We went from proof-of-concept to functional prototype to commercial unit in five months," says Cantu. "That's significantly compressed." He says that normally the whole process would take close to a year, but having expert players, all with an equity incentive and moving in concert, made the difference. Even more startling, a total start-up investment of $1 million took DenOptix to the break-even point. In 1997, DenOptix—which had been renamed ALARA—licensed the technology to Dentsply International, the world's largest distributor of dental equipment, and Dentsply is now selling the product around the world. DenOptix's first product would generate $25 million in retail sales in 1998. And the company's sales are projected to double to $50 million in 1999, with all of that growth in sales funded out of cash flow.
Just as surprising is the fact that because DenOptix was able to so efficiently leverage the talents of its creators, Cantu still owns roughly 20% of its 4 million shares, even though he has not worked day to day at the company for two years. He says that most Silicon Valley founders are lucky to keep 10%, or even 5%, of the stock—and that's if they stay with the company. Lunar Design, meanwhile, owns 18,859 DenOptix shares, valued at about $10 apiece—a roughly sixfold return to date on its original investment.
Cantu has gone onto create another five companies, all based on the Big Bang model. Lunar Design has invested in two of them: ReSponde Systems, a company that uses global-positioning system technology for a series of consumer products; and PhorMax, which is taking DenOptix's solid-state X-ray sensor technology and moving it into medical markets. "It's the exact same business model as DenOptix's," says Cantu.
On a deeper level, Cantu sees Lunar's embrace of the power of the multiple not just as a better way of doing business but as a new chapter in his career. He says that he spent 10 years at Spectra Physics, a $300-million company with an ample research budget. "After I got pulled into start-ups, I had a real hard time for three months, but then it clicked," he says. "This is where I want to focus the rest of my career. The energy, the level of desperation, and the excitement can't be matched. Everyone is unified and moving in the same direction." To Cantu, an engineer, a self-described "connector of dots," there are other thrills that come from working in the vanguard of venture design. "You are working with cutting-edge technology," he says. "You get to see things two to five years before the market sees them, and you get to play a big role in their development."
Moonshine and Moonrocks
Smith and Furbershaw plan to grow the venture-design portion of Lunar's business from its current 2% of sales to 30% in the next 10 years. Moreover, Smith envisions a second stage to this strategy, which he labels "R&D," and he expects it to account for another 10% of sales, also in 10 years' time.
At Lunar, R&D relates to internally generated ideas, ones that will be developed and taken to market in the same way DenOptix was, with Lunar in this case being the major shareholder, just as Cantu is with DenOptix. Tog et the process rolling, three years ago Lunar set up an initiative dubbed Moonshine, an effort, says Furbershaw, to get staff designers engaged in "design exploration." through it, the Lunar staff entered various design competitions. "Moonshine had a marketing focus," says Lunar's vice-president of marketing, Kris Bailey, "but it also was the blue sky. It gave our designers and engineers an opportunity to play around with various concepts." It became a way to energize the staff and get them thinking not just about designing products but also about developing them.
Last year Smith and Furbershaw introduced a second internal initiative called Moonrocks. Says Furbershaw, "Its charter is to come up with ideas for products that we would develop." The nomenclature, Furbershaw stresses, was important. Moonrocks connotes something tangible, real, and unique.
To keep the initiative rigorous, Moonrocks is working with Cheskin Research, in Redwood Shores, Calif., specialists in the market segmentation, to ensure that ideas picked up by Lunar are aimed at sufficiently promising and well-defined markets. Karl Ulrich, professor of product development at the Wharton School, is another adviser on the project.
At present the project has "a bucket of 50 or 60 opportunities," says Ulrich. That number will be boiled down to the six most promising ideas. "From there we'll do design work on two, and then choose one to commercialization." That systemic process will be completed by this summer. Ulrich says that one important criterion of the selection process relates not to the design but to Lunar's ability to first identify a "channel partner" at the outset—a company with sufficient distribution power to move the product broadly into the market. Once that has happened, Lunar as the major equity holder will begin paying its development partners in stock, thereby controlling their own destiny, not just relying on clients.
Another Lunar initiative, begun in mid-1998, is Origin Group Inc., which helps develop speculative ideas spawned inside much larger companies. "It's a way to approach major corporations and do things for them that are out of their bounds of risk tolerance," Smith explains. Origin Group was founded by Dave Bayless, an investment banker and a part-time consultant to Lunar. Bayless, who specializes in later-stage private-equity placement, says, "Origin Group allows larger companies to utilize the advantages of being small and flexible in order to attack problems created by their bigness."
Smith helped Bayless launch Origin after realizing that Lunar works so closely with clients and prospective clients that it has a front-row view of some of their most innovative—and riskiest—work. "We are able to get into these companies and sniff around," he notes. Accordingly, Smith came to see Lunar as part of a virtual corporation comprising of Lunar customers and prospects whose annual sales approach $50 billion in the aggregate. He knew that buried within that hefty volume of sales were inspired ideas languishing for lack of a champion able to negotiate the bureaucracy endemic to large corporations. Origin is an agent of change on that front. Notes Gary Cantu: "We have talked to Fortune 100 companies that have discovered us, and they're blown away. It takes them three to five years to spec a product and get it into sales channels. It takes us a year to 18 months." Cantu adds that Lunar produces commensurate savings, both in time and in dollars, for these large companies. "They know we can become a product-development resource for them."
A Richer Mix
Jeff Smith's vision is a radical one when you consider how he foresees that venture design will reshape Lunar's business mix. He expects that five years from now venture design will account for 40% of the firm's revenues—and 60% of its profit. That means that its current fee-for-service work, which now accounts for about 98% of revenues, will drop to 60%. In terms of the bottom line, if the venture-design components of Lunar's business become bigger—and more profitable—than the fee-for-service work, it will more than make up for the revenues that Lunar passes up on more-routine assignments over time. Will Lunar have to give up a near-certain revenue stream in the short term in the hopes of changing the business model over time? Yes. But making the transition possible ultimately falls to Lunar's partners, Smith and Furbershaw, in two ways. First they must conservatively scale up the venture-design effort—and the increased risks associated with it—so it poses no undue risk to the firm. Second, they must continue to educate the design staff about the present risks—and the presumed larger future rewards—associated with venture design. If Smith and Furbershaw accomplish both tasks successfully, Lunar will be increasingly free to become involved in more exciting projects.
By harnessing the power of the multiple, Smith, in turn, hopes to do more than merely change his business mix and fatten the firm's margins. He wants to revolutionize his business. First, because of both the appreciation in the firm's equity holdings and the above-market returns on those holdings, annual revenues per employee will rise from $200,000 to $300,000 in the next five years. In practical terms, that will free up the design staff to do more creative, speculative work because it will take fewer traditional "billable" hours from the staff to cover the firm's operating costs. (Smith calculates that if the return on the equity holdings matches his expectations—an annual return of 30%—fewer than half of the hours actually worked by the staff will have to be directly billed to clients in order to cover Lunar's yearly operating costs.) "It's a much richer mix," says Smith. Designers will be free to do more experimental work, even community service—and their compensation will go up, not down, because of the increased revenue per employee (not to mention the commensurate increase in profitability). "There's an emotional/psychological component here," says Smith. "We'll be able to keep people more interested. We won't be just tending other people's gardens, but our own." And as Lunar's designers are freed to develop some of their own ideas into real, market-meeting products, Lunar will develop an identity founded on a greater sense of authorship. Says Smith: "Wouldn't it be cool if we could show people things and say, 'We invented that'?"
Avoiding Lottery Fever
Darrel Rhea of Cheskin Research says that taking an equity approach shows a greater sophistication among service-based companies—an awareness that, in today's complex business climate, they must transcend their narrow disciplines. "I choose to work with Lunar because they have a real thirst for strategic understanding," says Rhea, who has been working on the Moonrocks initiative since its inception. "Not a lot of people in the design world think about the business implications of what they do."
Rhea notes that in the past five years "The number of opportunities to participate in this kind of activity has doubled every year." He sees the service economy following what he considers a "Hollywood" model: "You have a large network of very talented people coming together for a year or so to produce a product. No one has the expectation of working together forever. But there is something satisfying in being able to maintain your independence and focus on what you do best." He adds that ultimately this way of doing business is much richer and more satisfying than the current model because it thrusts together highly talented people for shorter periods of time‚—and holds out loftier goals and richer rewards.
Lunar is a virtual company, tapping into its "parallel universe" of specialists such as Rhea, in Redwood Shores; Ulrich, in Philadelphia; and Cantu and Bayless, in Bozeman. That, too, is by design. These consultants each pay into the pool with their expertise and draw out stock with potential future value. "This allows us to grow our company backwards," notes Smith. "We have the complete ability to make products virtually and not be in a big corporation where you end up doing the same thing every day."
But the downside of such exhilaration, cautions Ulrich, is lottery fever. "You've got to be careful with these projects." People develop an inflated sense of what an idea is really worth. Companies that freely offer equity often have little of real value. "You have to control the amount of spending you do. Don't allocate too much to this or you'll go out of business," says Ulrich. "Somebody gets passionate about an idea, diverts too many resources, and imperils the company."
In fact, Ulrich's role with Lunar is that of outsider-skeptic. One question he asks repeatedly of Lunar's management is, What business does a design firm have really being in venture capital? "An economist would say you go to venture capitalists to raise money because that is the professional service they get paid for. I'm always asking Lunar, 'Why do you think you're any better than the people up on Sand Hill Road?'"
Ulrich says that question is often not easy to answer. But, he adds, "at a gut level I believe in this model. It gets the designer to have some skin in the game, and now he has a very different motivation." As a result, he says, the client is often willing to offer more in equity than the equivalent in cash "because the [designer's] motivation and the quality of the work could be better."
By the same token, the onus is also on Lunar not to make impossible promises to its employees. Ulrich notes that Lunar has tight controls and an open-book management style. That is key, given that the firm is located in a high-cost area and because it has many young employees who need cash—not speculative equity stakes—to meet their living expenses. Thus the equity participation they have must be limited, and the risks spelled out clearly. At present, all staff members participate in the equity upside only via the bonus pool; investment losses are absorbed by Lunar's partners.
Tad Toulis, a senior industrial designer at Lunar, says, "This [model] doesn't make the design staff uneasy because of risk, because the information is widely dispersed and it's a small percentage of the whole picture." He says it's a way "to build flexibility into our work and offer a big recoup on the back end." In addition, says Toulis, in the venture-design model the designer "is more centrally located in a project. This allows us to get in touch with and work with clients in a way we otherwise might not be able to."
Another Lunar senior industrial designer, Dave Laituri, adds, "The model is robust. It seems to me it makes good, sound business practice to qualify business candidates in advance."
Ulrich says that it will remain management's responsibility to ensure that the staff—and the management itself—understands the risks in venture design. "At Lunar every designers can see the instrument panel. He knows how much has been made, what goes into the bonus pool, and how much goes into the speculative stuff." But ultimately, Ulrich says, the Lunar experience is "less about getting rich. The kinds of bets being placed here create an environment that's exciting for people. And that's a competitive advantage for Lunar."