The New Normal: Adventure Capital – In With 5 Out With 50

This was originally published in my blog and generated a lot of activity.

The asset class known as venture capital has been swirling around the drain since the dot-com bubble burst ten years ago. Like all forms of private equity the nature of these funds require decade long investment horizons and their investors demand opacity. Now, a decade after the bubble burst, the carnage is becoming apparent as the results slowly see the light of day.

There have been two recent articles articulating the details that make the point really well. The first is John Jannarone's WSJ Heard on the Street article "Venture Capital Should Shrivel Away" and the other Steve Blank's "Welcome to the Lost Decade (for Entrepreneurs, IPO's and VC's)."

The real question is can the asset class survive? Note by the nature of the question I'm taking the view of the limited partner investor in the funds, not the typical entrepreneur looking to secure an investment. The world is rife with urban legends on how venture capital works, and all of them come from the entrepreneur's view versus the fund investor's perspective.

Explaining the industry and what's going on takes the form of several audiences; one being the overly-optimistic entrepreneur who still has aspirations of raising capital to get their company to a liquidity event, another being the up and coming venture capitalist in training (think decades long training cycles) who recently finds themselves a free agent as the asset class shrinks and wants to start their own fund, and the final being ambitious MBA's switching careers and see venture capital as the preferred destination.

It all comes back to the asset class. If returns are low and the risk component high capital stops flowing. In this case index funds, with their objective diversification, minimal management fees, instantaneous liquidity and flat returns over the last decade have trounced venture with its negative returns, narrow diversification, high management fees and illiquidity over the same time period. It's all about risk-adjusted returns and in the case of venture, the asset class flat out isn't performing.

Responses to this reasoning point to specific deals that have produced good returns, news of quarterly increases in capital invested, and new funds being formed. The challenge is the consistency is not reliable hence the asset class is not producing. There are and will continue to be death kick strategies and tell-tale signs of life; smaller more narrowly focused funds, deal-by-deal funds, and a focus on trendy categories like life sciences and alternative energy.

Okay, so now that I've shot down the current model, let's look at the new normal for what was venture capital. I call it "in with $5 million, out with $50 million." Exit events today for venture backed companies are no longer IPO's and their typically $150 million plus exit values. They are acquisitions with typically a $50 million or less exit. This means the lifetime capital raise for the company must be less than $5 million given the exit value will be under $50 million. This investment math yields a 3-10X return on that individual investment depending on when the investment was made.

This gives the new normal investor the same returns as the old normal institutional venture investor but on a much lower capital outlay. The economics of a venture fund pretty much dictate a $150 million exit to cover the overhead (management fee paybacks, administration, covering bad investments and overall fund return expectations). So the new normal is a similar percentage return on a smaller gross investment.

This naturally pushes early stage investing to smaller investment sources; angels and government sources like SBIR's, economic development funds, and state focused specific funds for a start-up's first round of investment. This is typically a one comma capital investment (measured in the hundreds of thousands of dollars) and in many cases, thanks to the way government sources are structured, can be non-dilutive. The new normal requires significant revenue traction on this level of investment, and if that is achieved the two comma capital investments (meaning millions of dollars) will flow from sources that are typically angels and smaller, more focused venture funds that are still scratching out a living.

What's the evidence that this model works? The most substantive results are eight deals done over the last 5 years that I have been involved with coming out of the University of Texas at Austin's Texas Venture Labs. The formula has been consistent across these deals using the new normal outlined above; all eight companies raised one comma, typically non-dilutive capital, executed well and raised follow on two comma capital. Two have been sold and two more will probably sell in the next year. And for those of you with quizzical looks, I need to point out that in all cases these companies raised capital over the last five years when it's been scarce, and this was done by freshly minted MBA's, who in most cases are still at the helm. If someone with 10 years work experience can do this in a tough investment period following this approach, a team with more experience and execution intelligence should be able to readily best them.

So, the new normal is what I'm terming adventure capital or in with 5, out with 50. And you have two options; the first is to hang onto the old model in the vain hopes it will resurrect. The second is embracing the new normal and exploit it before the world catches on.

Your move.

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Beyond the Idea; Why Execution Intelligence is What Matters

A quote from my last post on Inc.com generated some significant responses. 'This explains why management teams are so important; if new offerings are commodities it's execution by the management team – what I like to call execution intelligence – that makes the difference in the market.'

What does this mean? It means that a management team has to be focused enough not to be distracted, while at the same time flexible enough to respond to the market. It means there is a management team not a single super-hero entrepreneur, but a super-hero entrepreneurial leader that has developed a management team with collective execution intelligence. This collective execution intelligence covers all the key business areas critical to the business category you're operating in.

How do you develop a team with execution intelligence? It just doesn't show up because you think or talk about it. It needs to be a conscious, step-by-step assembly process. That's why this is so important: Keep execution intelligence in mind when you build the management team and bring on advisors and board members.

Because twenty people will have the same great idea for a business, the idea is not the key. The idea is not what wins. What does? The ability to build a team that can execute.

Execution intelligence has the following characteristics.

• Domain knowledge. Experience in the market space equals special insight into customers' unique problems. Is your management team experienced in the market space where you will compete?

• Fast-growth scar tissue. Growth is hard. The more you've experienced it, the more effective you'll be. Without it, you can't deal with the ups and downs of rapid growth. At some point, a large, well-financed competitor will loom up overnight and bellow loudly. Can you deal with that?

• Experience in competitive markets. Appreciate the competition. Know how to handle it. Know how to respond judiciously versus reacting emotionally.

• Risk management. Those who can anticipate market trends can adapt more easily to market changes. Shifts in strategy or product lines are inevitable. Are you nimble? Can you cope?

• A comprehensive experience profile across your management team. Marketing. Sales. Product development. You also need solid advisors. Taken together, your team members must have the marketing, technical, sales, and executive expertise it takes to grow and run a company.

• Leadership know-how. Who can hire, motivate, and retain strong employees? Great leaders. As you grow, your corps of employees will expand faster than you can imagine and leadership will be critical. Can you recruit, retain, and effectively manage these people?

The following profile on Dell is from 'A Good Hard Kick in the Ass, Basic Training for Entrepreneurs' by Rob Adams (Random House/Crown, 2002) pages 30-32.

If anybody illustrates the truth that ideas are commodities, it's Dell. Here's a company that had the 'great idea' of selling something as ubiquitous as paper clips. As you can guess, it was hardly this idea that served as a breakthrough. What did? Execution to dominate. Read on . . .

Ideas are a commodity. Execution is scarce.

Nobody embodies this fundamental business principle more fully than Michael Dell. As much as any Fortune 500 company in operation today, the company he founded in 1983 vividly illustrates the fact that when it comes to starting and running a successful business, execution counts for far more than a unique idea.

Michael Dell originally began Dell Computers based on a simple concept: Sell high-performance PC computer systems directly to buyers, avoiding the middleman. 'The direct model is based on direct selling,' he has said, 'not using a reseller or the retail channel— and it's not new. Mainframes and minicomputers were originally sold directly, but [manufacturers] used the retail channel or resellers to sell to their lower-volume customers. We, however, sold—and continue to sell—directly to all our customers.'

So, the difference was not that Dell had the idea to sell direct. That, after all, wasn't new. What was new was the way Dell creatively implemented the old idea—the way he combined an existing sales model (direct sales) with an existing computer market to create a revolutionary way to sell computers. All of this in a low-margin, highly competitive, commodity-oriented space.

While Dell was first to pursue the notion in a major way, this first-to-market advantage had little or nothing to do with the company's success. Within a year or two of being in business, the landscape was littered with competitors aiming to dominate Dell's space.

What made the difference? Why did Dell triumph and most of these competitors fail? One thing: execution.

Early on, Michael Dell recognized the elements of execution intelligence that were needed to supplement his own—and wasted no time recruiting experienced business executives to advise him and help lead the company. Lee Walker, a former venture capitalist and management executive, signed on as president of the company; a strong early advisor was George Kozmetsky, co-founder of Teledyne and former dean of the University of Texas school of business.

From those early beginnings to the present day, Michael Dell has executed relentlessly, based on his belief that 'the key is not so much on a great idea or patent as it is on the execution and implementation of a great strategy. '

'Look at Wal-Mart or Coke,' Dell continues. 'You can understand their strategy—it's really not that complicated. But it's genius! It's completely comprehensible, yet few companies can really replicate their success.'

'Why? It's all about knowledge and execution.'

 

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Ideas Are a Commodity, It's Execution Intelligence That Matters

Working with high growth companies means constantly sorting through new product and service offerings to find expansion opportunities in the market. Whether it's an established company with diversified revenue sources, or a company getting off the ground, the new offering process is a never ending exercise; in today's markets you need to either expand or die.

One characteristic I run into when sorting this out with companies is an obsession around the uniqueness of the idea. Somehow there's an urban legend that has denigrated to an obsession that the idea is king; it is what will make or break the new offering. The idea somehow must be unique and stand-alone in its market. The simple act of describing it needs to cause people to take out their wallets and give you money –or- cause your competitors to copy it. Prepare to be disabused of that notion. Your idea doesn't matter.

First of all, ideas are commodities. Look at any industry, any product or service offering, and what you really see is improvement on the existing standard versus uniqueness in the offering. These improvements can be continuous or disruptive, but in either category, to the customer they are nothing more than incremental improvement around the financial return, usability, quality, or experience of your competitor. This explains why management teams are so important; if new offerings are commodities it's execution by the management team – what I like to call execution intelligence – that makes the difference in the market.

A real world example is Dell. PC's are as ubiquitous as paper clips in today's office environments. They are constructed from commodity status suppliers, lead by Intel and Microsoft, with storage devices, screens, keyboard and mice all undifferentiated and widely available from multiple suppliers. Dell's current performance can be debated, but their innovation for many years was their ability to deliver a commodity status product using an innovative business model through a management team with superior execution intelligence.

How can you spot this Idea is What Matters syndrome? Here are the symptoms.

• Is your idea a cool feature, a nice product, or a sustainable business? Features need product to live in and products need businesses to give them life. What do you need to build for your company?

• Are you worried about someone stealing your idea? Don't worry, not one wants to take something that isn't proven. Get successful and you'll find them very interested in what you're doing. So don't waste time worrying about your idea getting stolen, spend time making your idea successful.

• Do you think you have no competition? Any opportunity worth pursuing has competitors and substitutes or you don't have a real opportunity. And don't forget the biggest competition right now, a customer keeping their money. Make sure you have competition or you may find you are the only customer you have.

 

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Market Validation: Why Ready, Aim, Fire Beats Ready, Fire, Fire, Fire, Aim

You're working with an established company and looking to launch a new offering, or you're a new company trying to muscle its way into a market. Or you're just a savvy business person trying to figure out more about the markets around your existing products.

If these descriptions fit you, you need the book If You Build It Will They Come? Three Steps to Test and Validate Any Market Opportunity (Wiley, April, 2010) . More than 65 percent of new products fail. And that's just in established companies with other established products and deep resources. If we switch over to start-ups, the failure rate takes a huge leap to 90 percent. The amazing part is, we're not looking at data related to recessions or other tough business circumstances. These numbers have been stubbornly constant for thirty years.

Here's the bottom line: these numbers are simply not acceptable. Based on the percentage of new products that fail, $260 billion is lost in the U.S. alone.  That is dollars right down the drain. What a phenomenal waste of time, effort, capital and business resources.

Why do products fail?

Products fail because they don't generate enough money. Of course. But why don't products generate enough revenue?

Because they don't sell well enough. Customers aren't willing to pay for them. Customers feel they're not compelling enough, or not worth the value given the price. They can't generate enough revenue to cover their expenses. Not, as many urban legends suggest, because the parent company or outside investors won't fund them. As an experienced investor and former corporate executive, I can assure you that corporations and investors will back promising products and services that show market traction. But companies have to prove customers want the products for this to happen.

Clearly, if a company's first product fails, that's the end. If a new product fails in an established business, the company may or may not survive.  It all depends on the strength of other revenue streams, and on how many resources were burned on the failed product.

A company fails because it doesn't sell enough product or services. Outside investors or a parent company might cover shortfalls for a while, but ultimately the offering must stand on its own. It must generate returns that justify the capital—and the risk—that went into creating, marketing, and selling it.

So whether you're in a start-up or an established business, if you want your company to succeed, you need to consistently get your product or service offering right.  This book was written to address this issue head on. It will show you how to cut your chance of failure. It's not a magic bullet—just a big step toward significantly improving the likelihood you'll succeed. It's also not a theoretical method, but a pragmatic system I've used with great success.

The process is Market Validation

Market Validation is a series of common business practices, assembled in a unique way, that prove the validity of a market before you make the product investment.

The concept was initially introduced in my first book, A Good Hard Kick in the Ass: Basic Training for Entrepreneurs (Random House: Crown Books, 2002). In that book I covered Market Validation basics in one chapter. The response to that high-level treatment has been significant and led me to write a book exclusively dedicated to Market Validation.

Use Market Validation to probe, test, and validate your market opportunity—before you invest all that money in product development. It is a systematic, proven approach. And it will make or break your business.

As you will see, there is nothing esoteric or magical about the Market Validation process. Like everything in business, there are no easy answers; if there were, business would be easy and all new products would flourish. Conceptually, Market Validation is easy to understand—but it takes discipline and effort to get it done.

Whether you are designing, building, or selling products, whether you're in a large corporation or a tiny start-up, whether your business is service- or product-based, Market Validation will significantly increase the likelihood your product will succeed in the market.

To win a free autographed copy of Rob Adams new book If You Build It Will They Come? Three Steps to Test and Validate Any Market Opportunity (Wiley, April, 2010) tweet this message: I want Rob Adams book on #MarketValidation from @incmagazine http://ow.ly/1Dd2H. We will randomly select 12 people to win.  Winners will be contacted by direct message for mailing address information.

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100 Phone Calls

To find out is there is a market that is large enough to sustain a new line of business, you need to make 100 phone calls.

To your target audience.

Right now.

The usual reaction here is Whoa! What!? Where am I going to get those names? How will I get them to talk to me? What if they don't want what I'm selling?

That's it! That's exactly what you do want to know; and know it now before you spend too much capital designing and building the wrong product.

So where are you going to get these 100 names? The exact same place you're going to get them when you're ready to unveil your product. You need to know today who your customers are going to be, how much your cost of acquisition per account will be, and how many potential customers exist. You not only need to know how many names you can get your hands on, but you need to know how productive your leads will prove to be from a marketing-response standpoint. If you're going to sell through telemarketing, for example, interviewing 100 potential customers will give you a good indication of what your future sales forecast should be.

By the way, the industry average response rate for direct response methods is 0.8 percent--yes, that's 8/10 of 1 percent--so typically you'll need to obtain a really healthy number of names to make your telemarketing operation productive. If you can't find 100 names now, how will you find many more names a year from now when your product hits the market?

The next step in the 100 calls regimen is to come up with an interview script. You need to write down all your questions in advance. This is so that you can take every interviewee through the same set of questions, ensuring consistency of data . And be prepared to throw away a lot of material. If a potential customer doesn't make it to the end of the process, you can't use that interview. In my experience you need to be off the phone with them in 15 minutes; if your interview stretches much beyond that, your hang-up rate will go sky high.

You're probing the market to understand how your potential customer addresses the problem you're hoping to fix. Your mission is to find out what pain your customers really have, and to ask them how they fix the problem today. You want to find out how satisfied they are with their current solution; ask them to state the three best and worst things about how they address this particular problem today. And ask them how about your competition; if they use another product or service, ask them to rate it on a scale of 1-10. Find out how important fixing the problem is on their current list of priorities.

One thing to keep in mind: No matter what, avoid the temptation to discuss the new product that your company intends to bring to market. Mention no names, and no features, not even a hint that it might exist. You will find not discussing a new product to be an incredible challenge. It's your natural instinct to sell. But keep in mind: You're looking for the pain your potential customers suffer from. Looking for pain means not proposing how to fix it. If you start talking about products, customers will stop telling you what they really think because they'll feel like they're being sold something.

And here's the good news: interviewing potential customers is far more productive than selling in the early stages. People at the other end of the phone are far more responsive to being asked questions about products than they are about being sold products. In my experience you will get 2-3 times the response rate interviewing by phone versus selling by phone, so factor that into your sales and marketing program productivity numbers. Stick with the plan and you'll come back with an incredible understanding of what's happening out there in your market.

I think you're getting the idea. Ask these kinds of questions of 100 people in your target market and you'll find yourself developing a much different offering than before you asked these questions. Take the time to invest a little in market validation and you can save a lot of the headaches that innovators face when they devise products having never soliciting ideas and information from the very people they hope to serve.

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Understanding the Competition

In my last post I talked about market validation as the tried and true process for figuring out if there's a market for your new product. It's the "Ready, Aim, Fire" approach to getting products out the door; versus the "Ready, Fire, Fire, Fire, Go Out of Business" process, which most companies use. I also covered the first step in that process, figuring out if the market is big enough to enable you to hit the revenue target you need in order to be successful.

If you passed that part of the market-validation process, it's time to take a hard-core look at your competitors. This is one of the most under-looked ways of validating your market: If someone is in the market with a successful product, that's a good sign that a market for your product exists. But don't get too cocky.

My experience in working with companies is that they typically put down their competitors as mindless automatons that accidentally got into the market; they denigrate the management team, the quality of the product, and claim the company just plain can't execute. It's time once again for me to give you a good hard dope slap. The truth is that most competitors are clearly doing A LOT better than you; they're in the market, they already have a product, and someone is buying what they have.

For you, then, the goal is to be objective and to learn as much about the competition as you can. Scour their websites. Talk to their salespeople. Contact their distributors. Talk to their customers. Get aggressive and do everything you can to analyze their offering, their target market, their features, and how they position themselves.

A few important points: When sizing up the competition, you must include substitutes for your product or service under the umbrella of "competitors." If it competes for the same budget dollars you're going after, it's clearly a rival. No. 2, you must also consider the biggest and most consistent competitor around, a guy who affects all companies of all sizes in all markets—his name is "I just want to keep my money," and he does particularly well in a tough economy. You want to know how much of a competitor he is before you enter a new market.

As you begin to assess the competition and compare your product against theirs, make sure you understand how your customers define success. In my experience, entrepreneurs radically underestimate the return on investment most customers expect from making a new product or service; CEOs typically expect that a 30 percent ROI will get a customer excited. Not so. The reality I've experienced is that it usually takes between 200 and 300 percent (meaning a 2-3 X return on the cost of a product) just to get the customer to pay attention to what you're saying. You need to figure this out before you go to market.

So where are we here? First, you've got to know who all of your competitors and substitutes are. Then, learn everything about them that you can learn. Remember that "I just want to keep my money" is the biggest competitor you face. Finally, understand the economics needed, from the customer's point of view, to consider your product worthwhile. You'll be amazed what you learn from conducting this kind of rigorous competitive analysis.

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New Product Launches: "Ready, Fire, Fire, Fire, Aim"

When considering launching a new line of business, how can you figure out if there's really a market for a product?

The technique that's served me extremely well is one that I like to call "Market Validation." Market Validation is a systematic approach to evaluating your market before you jump in with a product. I call it the "Ready, Aim, Fire" approach to getting your product out. Most companies' take more of a "Ready, Fire, Fire, Fire, Aim" approach, sucking up huge amounts of capital and lots of management bandwidth. Like Yosemite Sam indiscriminately using his six-shooter, eventually, by chance, you might hit a target of one sort or another. Using Market Validation, you're more like a sniper, taking a little bit of time to sneak up on the target, study and evaluate it, aim, then take your shot. This gives you one product, one market; versus the alternative of multiple products, and no market.

How do you do this? It's a combination of tactics that involves thinking and doing a little bit of rational thought before heading off to market; thinking before you act. I can hear the entrepreneur moaning now: "Wait a minute, I've got to get to market now before the window of opportunity closes." Well, I'm gonna give you a good hard dope slap and tell you that if your supposed market opportunity can't stand a time investment of 60 days to get it right, you really don't have a market to begin with.

Let's look at the first step. Revenue is the ultimate measure of success here, so how much revenue do you want to generate? You should build a three-year forecast of what you expect it to be. Then you need to answer some fundamental questions. How big is the market? Is it big enough to meet the revenue expectations you've set for the product? How much market share do you need in your first three years to stay on target with your revenue plan?

The reasoning here is pretty straightforward. I can't tell you how many product plans I see where, in order to be successful, a new product needs 200 percent market share in Year Three. That's nuts. You've got to understand the current size of the market and figure out if it's big enough to justify getting into. For example, say the U.S. market for a certain kind of widget is $100 million a year, and growing around 6 percent a year. What kind of penetration do you need in Year One to be successful?

If the answer is $1 million dollars in revenue, that's probably doable with a strong product and a real marketing budget. But if the answer is $10 million (or any other double digit penetration number in the first year), that's pretty doubtful for a new product, even with a huge marketing budget.

Let's look out three years. We've already established that the market in this example is growing 6 percent a year. What's your expected growth rate? If it's at or below 6 percent, and you have an average sales and marketing budget, assuming a competitive product, you could reasonably hit that. But if you expect to grow faster than 6 percent, what kind of additional investment in sales and marketing will you make to justify it? If your competitors spend 40 percent of gross revenues on sales and marketing to grow at 6 percent, how much will you spend? Can you reasonably expect to devote a sum equal to 60 percent of sales in order to hit a growth rate above 6 percent? Where will that investment come from? How long will you have to make it to be successful? How much market share will you need in Years 2 and 3 to hit your numbers? The rule of thumb I've always followed is single digit market penetration in the first three years of a new product is doable; getting to double digits requires a lot of sales and marketing money and an incredible amount of luck.

The conclusions here? Make sure the market you're going after has enough room in it to support your product ambitions before you build and launch that product. And make sure you're budgeting enough dollars for sales and marketing to grow at the same rate as the market.

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The Only Thing That Matters

In my last blog, I talked about my experience getting companies off the ground, which really translates to making sure their first product is a hit in the market (I've been active in the founding, financing, or acquisition of more than 40 companies representing more than a billion dollars of capital, and involved in the launching of at least 100 products). The conclusion I've come to, reinforced time and time again, is that getting the product right--your first one, and hopefully each subsequent one--is the key to making your company work. The technique I've termed "Market Validation" is by far the most effective way to get this done, and here let me start with the big picture view of how to do it.

Why do companies succeed? They succeed because their products sell in the market. They have built something that gets customers to open up their wallets and part with their money on a regular basis. The bottom line is they generate more revenue than expense; sure. this is an overly simplistic statement, but the key is getting your company's products to play in their markets. Any successful business person readily admits that strong revenue makes them look like a genius and covers up lots of missteps. On the flip side, these same entrepreneurs will tell you cutting expenses to meet reduced revenues is not the way to make a company work; budgeting your way to prosperity is not an effective business strategy.

The point here is that, in order to make your business successful, you should focus on your product and its viability in the market. A lot of human nature will drive us to do the small things that make us look busy and feel like we've somehow contributing to the company. These are things like focusing on the books, or the costs of goods from suppliers, and other items that matter to the company, but that are not related to generating revenue. It's hard to call up a customer and get to the bottom of why he dropped you as a supplier; but in the end you need to hear the real reason and that's a lot more important than the time it takes to save another 5 percent on office supplies.

So Rule No. 1 — Focus on revenue, the top line. Make sure this is where you're spending the majority of your time. Don't get caught up in the tangible, feel good aspects of knocking off a large to-do list of important items to make your business work unless, of course, all those items are directly related to getting your customers to buy more product and services.

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