The Rationalist: The Death of Gut Instinct
It's not as if Larry Broderick flatly ignored what his heart was telling him about the kind of start-up he should try. Not at all. There just happened to be a few factors -- OK, so there were 34 -- that came before "gut feel" on the list of criteria he had devised to help him evaluate his options.
But Broderick will be the first to point out that even though you had to read almost the entire 37-item list before you got to it, he had scratched two tiny stars next to #35, signaling its elevated importance in his mind. About half a dozen other criteria merited one star apiece, among them "location of business," "price stability of products," and "exit-ability."
Furthermore, Broderick insists that he wouldn't have gone through with any deal that he didn't intuitively feel right about. Well, probably not. "If I had come across a business that was really attractive and my gut feel was not to feel right or to feel nervous, I don't know if I could have done it," says Broderick, now CEO of the SteelWorks Corp., based in Denver.
That said, Broderick didn't invent such a list for himself because he was worried that the left side of his brain would get the better of him during his 18-month hunt for a business to start or acquire. He was just trying to guard against a certain overpowering emotion. "I think it's a huge mistake to love a business," he says. "When a business gets to be like one of your children, you can't be objective and you make a lot of bad decisions."
Yes, he's serious. And he's not the only company builder who rejects the let's-do-hunch mentality. "I think this whole idea of 'I have a gut about this, and it's going to work' is a bunch of hocus-pocus," declares M. Frances Sponer, a Las Vegas-based entrepreneur who has founded 16 companies. "But that's what people do when they are starting companies. They just keep talking about it, and pretty soon they fall in love with it."
But wait. Isn't that, as the song says, the way you've always heard it should be? Budding entrepreneur falls in love with idea and naïvely embraces misguided assumptions about the cost, the time, and the customers needed to turn said idea into a viable enterprise. Entrepreneur then unearths the fortitude to repeatedly change those assumptions until aforementioned entity thrives. It's the proverbial roller-coaster trip, with only one force that's powerful enough to keep the rider strapped in for those 90-mile-an-hour drops: passion.
"I think it's a huge mistake to love a business. When a business gets to be like one of your children, you can't be objective and you make a lot of bad decisions."
In fact, nobody's disputing that someone needs to have more than lukewarm feelings to risk a mortgage or spend down a savings account for the honor of possibly losing a house or a nest egg in the ensuing endeavor. But especially now, when unparalleled technologies and unprecedented sums of money have converged to create the opportunity for more and more people to follow their passion (hey, who says it's too late to start the best Web site devoted to selling baby gear?), there's a case to be made that such passion needs tempering. Badly. "When there's a ton and a half of money around, you can be passionate and charge off, and you'll have investors who will follow you," says Jack Derby, president of Derby Management, a Boston coaching and consulting firm. "But now that the air is out of the balloon and the market has corrected itself, passion alone doesn't get you there. There has to be a baseline amount of excitement, but then you need to build on that."
The tool for doing so? A comprehensive (read exhaustive) list of criteria that fledgling entrepreneurs can use to analyze start-up opportunities as they present themselves. The method, which takes various forms, may sound a bit detached. But those who've come to use it are absolutely unequivocal in their enthusiasm for the results it produces. If starting a business is like choosing a lifetime partner, they argue, then the risk is that you'll end up marrying for love -- and nobody can afford to do that more than once (well, nobody besides Larry King). "If your goal is to be profitable and grow, then you need to give up your allegiances," says Joel Nichols, CEO of Apollo Design Technology Inc., a maker of specialized lighting products for the entertainment industry, which he founded after following his own list of 12 criteria. "You've got to filter out your biases. Absolutely."
No self-respecting entrepreneur ever aspires to be the guy. In the parlance of venture capitalists, that's the disciplined person who comes into a young company and, unencumbered by any of the entrepreneur's emotional baggage, makes the necessary but hard moves. (The label, needless to say, is genderless -- one of the foremost examples of the breed is Meg Whitman, who succeeded eBay's founder as president and CEO in 1998.)
Typically, it's that person who -- far removed from the passion of the entrepreneur -- instinctively reduces a business to a series of checklists, sometimes for its own good. But in the current environment, in which investors are bringing their own newly rigorous criteria to bear, it makes more sense than ever for a nascent company builder to take at least some of the fun out of starting a business -- before someone else does. For entrepreneurs "it comes down to channeling their passion," says Derby. "They've got to start thinking about management focus and team-building focus and investment focus. They've got to want to get it right."
Not surprisingly, the impulse to get it right comes from the experience of having gotten it wrong. "You can make a spreadsheet say anything you want it to," admits Sponer, who, at 53, is president and CEO of Ascentra, a $16-million family of health-care companies she either founded or cofounded. One of her earliest efforts, a company that set out to provide health care for prison inmates, never broke out of the start-up phase because its prospective customers weren't actually interested in its central proposition: saving them money. "I fell in love with it, and I talked myself into it," Sponer says. "I wasn't being analytical."
Not long after that, in 1990, she opened a sleep-disorder clinic that turned into a small nightmare. Even when the four-room center was fully operational, she discovered, after-tax profits amounted to an unacceptable 8%. Sponer says she got "bad information" from equipment vendors about the level of reimbursement. "We were so early in the market, the insurance companies hadn't determined what they were going to pay," she says. "I was naïve."
From such naïveté, however, rose Sponer's clarity about her goals in building a company. "Why do you start a business? It's to make money," she says. That sense of purpose clearly comes across in what she titles "Francie's Criteria for New Ventures," a checklist she employs to analyze each potential endeavor in terms of its profit-making potential. "I don't look at my company as a part of me," she says. "I look at it as a vehicle for me to use to meet my goal of making a profit."
If Sponer's list forces her to remain focused on profits, Nichols's 12 criteria served to remind him of just what he didn't want to get into back in the early 1990s, when he was looking to start a company: a horse-and-buggy operation. That may sound like a metaphor for a slow-growing (or no-growing) company, but in Nichols's case it was more than that. He and his wife, Keersten, actually made a business out of giving tourists carriage rides around downtown Fort Wayne, Ind. "It took five years before it sank in that we were never going to build this thing to be big enough to put our kids through college or anything like that," says Nichols, now 37.
After selling the business, "I really said, 'Let's take our time and do it right this time," recalls Nichols, who had worked nights at a local steel mill while he and his wife ran the buggy business on the side. Many of the criteria he applied -- he wanted a business in a growing market with no geographic restrictions and unlimited growth potential -- sprang from his awareness that "the profit-making potential of one horse, one driver, and one buggy isn't even that much under a perfect scenario."
The criteria you end up applying when launching a start-up, it seems, have as much to do with your previous business as they do with your next business.
If the last venture was a reasonable success, then the reason for the next one is that much clearer: to create wealth (as opposed to just making money) or maybe to leave a lasting mark on an industry (as opposed to just being a boss). These days it's not that uncommon for even first-time entrepreneurs, their heads stuffed with stories about glamorous start-ups, to adopt the yardstick formerly reserved for entrepreneurial veterans: What I'm after, they'll say, is a billion-dollar valuation. And they usually need it to happen before final exams distract them.
So, contradictory as it sounds, such entrepreneurs create paperwork for themselves -- an inventory of criteria that serves as a bulwark between themselves and their dangerous, if natural, inclinations. Given what Broderick had been through, it wasn't at all surprising that he felt the need to draw up, and continually consult, the nearly 40 criteria that he had written down on a piece of blank ledger paper. Before he founded SteelWorks, his most recent venture had served only to underline the stink in gut instinct. "It wasn't as if I had gone out as a success in the previous business," he confesses. "I really didn't want to rely on my intuition anymore."
In 1980, Broderick went into the industry his family had worked in since about 1900: wholesale lumber. The company he founded, Rivendell Forest Products, rose to peak sales of about $135 million before it crashed to the ground in 1991. A victim of declining housing starts and dropping lumber prices, the company ended up on the wrong side of its banking covenants. "We figured we'd better liquidate it before the market sank even lower," says Broderick, who was then 45. "It was horrible. I was determined I was going to bite the bullet and go into a new industry, and one with a better economic model than the stupid one I'd had to work in."
"I don't look at my company as part of me," says business founder Frances Sponer. "I look at it as a vehicle for me to use to meet my goal of making a profit."
The absence of stupidity was far from his sole criterion, of course. With help from members of his CEO peer group, he drew up a checklist. For every business he considered, he placed plus signs or minus signs next to the items. He listed the characteristics under five broad categories. The first one, "Specific Business," encompassed the most items -- 17 -- from location (as a divorced father of three, he wanted to stay in Colorado) to geographic market (he'd learned through experience that "the larger the scope, the more insulated a company is") to customer type ("You don't want to be selling to a lot of mom-and-pops," he says). By the time he decided to start SteelWorks -- a maker of metal shapes sold to do-it-yourselfers through home centers, hardware stores, and lumberyards -- he'd carefully assessed the condition of the two companies whose assets he ended up acquiring. He'd ranked such areas as sources of supply (neutral), existing relationships with customers and vendors (a minus), and price stability of raw materials (a plus). (For a complete list of Broderick's criteria, see "Broderick's List," below.)
Says Joel Nichols, the former buggy driver: "The list is important because it forces you to take the first step. We were more aggressive in saying 'These are our criteria' than we were in looking for a business. Once we had the criteria, it was like walking through the woods and looking for a nice tree. We weren't walking and measuring every tree and comparing it to our criteria." Indeed, Nichols's checklist, a much shorter variation on Broderick's, prodded him to think about how closely the company under consideration matched what he knew he was after.
Granted, Nichols's criteria were more than slightly idiosyncratic. Aside from looking for a venture with low start-up costs (how does $2,500 sound?) and few competitors, he and his wife also wanted to work "relatively normal business hours," Nichols says. If that sounds like an impossibility for any fledgling business owner, rest assured that Nichols usually spends part of Saturday in the office. But it's nothing like the buggy business, where "if there's a family event happening on a Friday or Saturday night, you know you're not going to be there." He also wanted to start a manufacturing business, claiming to "personally enjoy the challenges of manufacturing" -- though, until he started the business, his only related experience had been as a lathe operator in the steel mill. "It takes a more determined and focused person, with a better skill set, to go into manufacturing," he claims. But the product he made couldn't be a commodity, as spelled out in one of his criteria. Maintaining a high-level service component, he says, "creates one more barrier for people who want to compete with me."
Of course, to find a business that came close to meeting his guidelines -- which he did, thanks to a friend who showed him the product he ended up making -- Nichols had to venture far beyond his expertise. In other words, he ended up exactly where he wanted to be. "Long term, I believe everybody learns how to make money, so the more I run my business, the more I learn about it," Nichols says of his $3.2-million company, which ranked #166 on last year's Inc. 500. "So, assuming the margins are there, I would rather go into a business I don't know anything about."
Not Sponer. Her list of items, under five broad categories, includes very strict parameters regarding whether each item should be rated as a "pro" or a "con." "I use the criteria to keep myself grounded," explains Sponer. "You don't want it to be like one of those surveys in Ladies' Home Journal that asks 'Are you psychotic?' You have to stick with objective criteria, or you get way off into all those touchy-feely things." Indeed, there's nothing remotely squishy about the six-page checklist that Sponer first began developing in 1986. "Gross margins," for instance, have to be at least 40% and durable -- as opposed to less than 20% and fragile -- to earn a positive rating. "Attainable market share" has to be 20% and local. "Time to breakeven"? No more than two years. "Maybe someday I'll be so secure, it won't matter to me," she says. "But I'm not interested in building a monolith. I just want to make money."
Sponer even has a section devoted to what she calls "fatal-flaw issues." They include such factors as a very small market for the product (which can only be positive if there's a "current window of opportunity in our target area"), overpowering competition, and a high cost of entry. Sponer doesn't simply check off a column in each of the categories; she actually ranks each venture on a 1-to-10 scale (the higher the number, the worse the outcome is) in each category. However, she claims that the final score matters less than the process she undertakes to reach it. "I'm forced to get down to reality and think," she says.
And thinking -- as opposed to feeling -- is what the start-up-by-the-numbers system is all about. Even for a venture she hasn't yet started, Sponer is already considering her exit. It's her favorite criterion, in fact. "Because I know why I got into this," she adds proudly. Broderick, too, knows why he ended up forming the SteelWorks Corp., which grew to sales of $25 million last year. "Once in a while, someone will ask me how I got into this, but they usually don't want that much detail," he says. "If they persist, I get into the guts of it but not before warning them that it's going to take awhile."
Joshua Hyatt is a senior editor at Inc.
Larry Broderick knew that he wanted to run his own company. To guide him, he drew up an exhaustive list of criteria
Among the many criteria Larry Broderick used to help him decide what kind of business to start, one mattered far more than the rest: Is this the sort of enterprise that will rip my heart out?
Not that Broderick, who spent about 18 months searching for an opportunity that suited him, actually listed that quality among the 37 characteristics he ranked. But his underlying reason for so carefully evaluating each potential venture stemmed from his experience with a wholesale-lumber company he had previously founded -- and ultimately liquidated, in the face of steeply dropping housing starts. "I was not a neophyte in terms of business," he says. "I knew some things about business that I did not like and I did not want to get into again."
In other words, he knew just the kind of business model to avoid: high risk, low margin. Once his lumber company had failed, "the risks associated with that business model became crystal clear to me," Broderick says. "I knew there were much better models out there."
His determination to find such models is plainly reflected in the criteria he developed. "I was very nervous about going into a new industry," says Broderick, now CEO of the SteelWorks Corp., a Denver-based maker of metal shapes. "But I was on guard not to let my emotions get in the way." After coming up with the list, he analyzed opportunities by placing up to two plus signs or two minus signs next to each characteristic. Then he added them all up.
Fewer than half a dozen of the criteria grew out of personal concerns about compatibility, such as location of business and type of business. Many of the criteria, which he divided into five categories, reinforced his resolve to find an industry in which profit margins were ample but competitors weren't. Such businesses, he reasoned, were bound to be less vulnerable than the one he had worked in, in which "the margin for error is very, very minimal."
1. Specific business
Broderick's biggest category, Specific Business, included market (local, state, regional, national, and international), among 16 others. Having had his previous company wiped out by a market downturn, he was convinced that "the broader the scope, the more insulated a business is." He evaluated sources of supply (type, quantity, and quality) and customers (type, quantity, and quality) from the perspective of not wanting thousands of supply sources and customers, but definitely wanting more than a few. "The more solid and sizable they are, the better," he says, speaking about customers. For nature of products (repeat customers, one-time sales, and consumable), he knew he wanted "a steady flow of business," he says. "In lumber, there's no loyalty. It's all price."
Nor did he want to worry -- as much as he had in his lumber business, anyway -- about the price stability of products (raw materials), another criterion. Understandably, "I was interested in avoiding an industry where the value of my inventory could drop 50% over three months," he says. He also wanted to avoid the high costs of human inventory, which is why he included capital-intensive/labor-intensive among the criteria. "I'd rather run a business with fewer people, because of all the issues associated with employees," he notes. He weighed hiring union versus nonunion employees because he definitely wanted the latter. "We wanted as much control over our destiny as possible," he says. Wanting that freedom of movement also prompted him to include environmental concerns ("They can bankrupt you," he warns) and regulatory environment in that section.
Given the amount of capital he figured he'd be able to borrow, Broderick fully expected to be engineering a turnaround if he bought a company -- or created one from assets he bought. (He eventually formed SteelWorks after acquiring the assets of two companies.) To measure the magnitude of the challenge he'd be taking on, he included among the criteria existing relationships with customers/vendors (after all, "we would have to convince them to stay with us," he notes), quality of personnel at target (at the companies whose assets he ended up buying, "the people were weak"), and available personnel to bring to target. "It was important that I have key people I could bring in," he says. "I knew I could get my key management people from the lumber company back if I could get this deal done." That's because he knew that those people -- his chief financial officer, his VP of operations, and his VP of sales and marketing (who also happened to be his brother) -- would be reasonably comfortable with any company that got a high score on his list of criteria. Among those considerations, a key one was the basic nature of the company: Was it high, medium, or low tech? "We wanted to get into a low-tech product that had good margins, because the learning curve would be too long if we were making computer chips or fiber-optic cable or software," he says.
He wanted low tech but not slow growth. So he also considered where the target is in the business cycle (start-up, emerging, mature, or in decline) as well as the state of the overall industry. Was it declining or growing or growing fast? "Everybody thought this one was mature, but we thought it was just emerging," he says.
Of course, a growing industry is bound to attract others. In his second category of criteria, Competition, Broderick evaluated his rivals from three perspectives. Profile of competitors focused his thinking on whether "there were a number of very strong independent operators who would be very hard to unseat." His conclusion: there weren't. Nor was there too much mom-and-pop competition in the industry, which he considered a plus. "In lumber the small wholesalers were tough to compete with because all they had to do was make a living," he recalls. And given the size of the niche, which he estimated at around $40 million, large vendors weren't likely to cut out distributors like SteelWorks. The one remaining question in this section -- Will vendors go direct to consumers? -- was designed to address a phenomenon he'd had to fight in the wholesale-lumber trade.
The 11 items that made up Broderick's next category, Financial, enabled him to make a fairly straightforward diagnosis of the venture's fiscal health: Margins, is target profitable?, Float (how fast would he have to pay vendors, as compared with the terms he'd have to extend to customers?), seasonality, industry stability (cyclicality), cost of target (cash versus terms), size of target, control considerations (minority shareholders?), minimum rate of return on investment, cash flow (how much can be taken out of the business while still keeping it viable and prosperous and the banks happy?), and exit-ability.
Potential, his next category, helped him assess how he might grow the business. The three items in this section included growth potential (existing customer base versus total market), efficiency of target (cost-cutting potential), and computerization of target (room for improvement in hardware and software). "If anything, we underestimated the growth potential, the margin potential, and the efficiency potential" of his business, concedes Broderick. "But going into this, you couldn't make the kinds of projections that we've turned out to deliver and be taken seriously by anyone."
Broderick's research, however incomplete, was taken seriously by his fellow CEOs. He knew because he included adviser opinions among his three criteria in a section labeled General. The others? Personal experience/expertise and gut feel. "Right from the start, this felt like something I could be excited about and successful at," he says. After pausing, he adds, "But I like to think that didn't influence how I filled out the criteria."
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THE START-UP ISSUE