Thursday, November 01, 2007

Investor Funding, (much) later than you think

This is a guest post by Bijoy in the Nov 2007 issue of Austin Business District Magazine.

Most business schools teach us that the first step in starting a business is to write a business plan and raise capital from investors.

Except in a few very rare and exceptional cases, this is just about the worst thing you can do for yourself and your fledgling venture. To understand why, we must explore the critical stages of a business and what occurs in each stage.

How do Businesses Emerge?

Contrary to business mythology and corporate marketing departments, Michael Dell didn’t start his company because he saw the need for a direct approach to counter an inefficient PC distribution channel; Bill Gates didn’t start Microsoft with the vision of a PC on every desktop; Herb Kelleher didn’t start Southwest Airlines because the hub-and-spoke system was broken; Pierre Omidyar didn't start eBay because there was an untapped market for buyers and sellers; Howard Schultz didn’t start Starbucks because he saw the need for a “third space.”


And, Larry Page and Sergey Brin didn’t start Google to “organize the world’s knowledge.”


Google, an overnight success, only started generating substantial revenues five years after its inception. The first version of the Google search engine went live on a Stanford University server in August 1996. It was based on Page’s simple insight that websites have an inherent ranking based on the number of incoming links from other websites.


Google simply counted the links and presented the “most voted” at the top of the search results. Unlike other engines which showed pages upon pages of results, Google’s engine provided the most relevant ones in the first few pages.

By 2000 Google had built incredible momentum with an ever-increasing and loyal user base. Yet it faced a fundamental challenge: how to generate revenue. They clearly could not charge users to run searches.

The founders had earlier considered and rejected the idea of blending advertising with search as they felt this would compromise the user’s requirement of a trustworthy search result and bias the site towards advertisers.

However, Google’s many attempts to license the engine to portals received little to no traction. Worse, the bursting of the Internet bubble through 2000 meant that there would be no “exit” for the company through a sale, as the founders and their VC backers anticipated.

The company had to try something new to become self-sustainable.

As a desperate last measure, it launched AdWords, copying, with a twist, the idea from, a rival search engine. Bill Gross, the founder of GoTo had the insight that people and organizations that wanted to be found would pay for that privilege and had advertisers pay for keywords online.

Unlike the GoTo engine or the old Google engine, the newly-modified Google site was in fact two engines – one with the familiar Google results in the main body of the page and the second with paid results clearly marked at the top and right.

Google’s story is not unique. A close inspection of any of the aforementioned companies reveals a similar pattern.

Companies go through two critical stages before they reach the nirvanic and sought-after Growth Stage: Ideation and Valley of Death (VoD).

In Ideation, the company founders do not start with a grand vision, but something more prosaic; a simple demo. Like Google, the cofounders of Microsoft created a version of the BASIC programming language for the Altair. When Altair went bust some years later, Microsoft had no revenue for a year (VoD). Its seminal deal with IBM in 1981 to provide an operating system for the IBM PC happened accidentally and Microsoft resold an operating system, Q-DOS (quick-and-dirty operating system) it had bought from another company in Seattle.

The greatest of success stories in business do not start with clarity about what their business will become.

The idea that anyone can know this is not only borne from arrogance, it is foolhardy.

The business emerges through the VoD, and it is precisely the constraint that creates the key innovations. Furthermore, the VoD continues for an unknown duration.

So when are you in Growth?

Your venture emerges from the VoD and into Growth when it has developed a systematic and reproducible way to serve its customers and get paid doing so. This is finally the time when you can focus on scaling what you’ve learned.

The team can easily produce all the key elements of a business plan without making up the numbers and the true essence of the business has become clear to all. Pithy descriptions like “a PC on every desktop” ring true because they are. Not only that, you know with reliability what must be done to achieve growth.

To bring it full circle, most business schools concern themselves with the domain of growth – HR, marketing, leadership, management, infrastructure, information systems, customer service, culture, process. A crisp marketing message can now be developed because the value proposition to the customer is clear.

The unique culture of the organization must be reliably transmitted to new employees. A strong management team must be built, etc.

Right Action Right Time

Capital has one (and only one) important property: it is an amplifier. Whatever the organization is doing, an inflow of capital allows it to do bigger and faster. Moving a venture quickly in a particular direction in the first two stages creates momentum in the wrong direction and withers the organization's ability to quickly shift course, adapt and try new things.

In growth, however, capital provides the needed fuel for a correctly-pointed rocket. Meanwhile, the suppliers of capital seek one thing: a significant return on their capital in a predictable time period.

The Ideation/VoD business cannot deliver this and you will find yourself selling investors and spending all your time doing so. However, in Growth they will court you. Finally, you will retain control of your growth-funded business and not your Ideation/VoD-funded one.

Investor capital is the foe of the venture and the founder in Ideation/VoD and their friend inGrowth.

Have the discipline and courage to delay the funding event for as long as you can until you have emerged from the Valley of Death.

It will be painful, but you will be glad you did.

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