Three Good Reasons to Start Your Own Company

Three Good Reasons to Start Your Own Company

The author of this article has started about six companies over the
years with collective and cumulative revenues approaching $100 million.
The author is on the Board of a high-tech company spun out of the MIT
Materials Science department.

Here are some tips for young people
starting companies.
Don’t start your own company because you want to be your own boss.
There are three ways in which a company can make more profit than an
investment in a Vanguard S&P 500 index fund:

  1. You know how to do something that nobody else can do (the typical MIT tech spinoff approach)
  2. You have a lower cost of capital than anyone else (the "my dad was really rich" approach taken by Bill Gates and others)
  3. You have a better understanding of one kind of customer than anyone else.

The problem with Way #1, knowing how to do something that nobody else knows how to do, is that there is no proven market for whatever it is you are doing. Maybe nobody has bothered to learn how to do this because it isn’t necessary to do. A lot of things that look great in the lab and in a scientist’s or engineer’s head don’t look good to a customer for reasons that may be impossible to predict.

Having rich parents is great. In fact, it is the best and surest way to get rich in these United States. Unfortunately, having a low cost of capital is no guarantee of success because, as society has become ridiculously rich, capital has become very cheap. Your competitors can probably get a home equity loan at 6 percent on their McMansions. How much cheaper can your cost of capital possibly be?

The most reliable source of supranormal profits is superior knowledge of one kind of customer (Way #3). Ideally this will be the kind of customer that larger companies are overlooking. The founders of SAP, for example, were employees of IBM Germany for many years and got exposed to the accounting challenges of large manufacturers. When they quit IBM, they were among the best situated programmers in the world to build an accounting system for manufacturing companies. It is not because these guys were the world’s best programmers that SAP is today bringing in $10 billion per year in revenue and has a market capitalization of $60 billion. It is because these guys were the best programmers who understood the problems of their customers.

If you don’t understand customers, consider taking a customer-facing job (think "sales engineer" or "product manager" rather than "cubicle-dwelling system internals programmer") at a company that already has the kind of customers you think constitute an attractive market. Once you’ve figured out what the customers needs, quit and start your own company.

Venture Capital and the Successful Company = High Risk

If you have an idea, two guys, and a PC, venture capital is great. You start with nothing but your energy and creativity. The venture capitalist adds money. If the company succeeds, you all get rich. If the company fails, you are back to having nothing (except for the venture capitalist, of course, who pockets two percent of the total fund he raised from limited partners every year, even if he never invests any of the money or if all of his investment choices prove worthless; at a $500 million fund that lasts 5 years, this amounts to $50 million in fees merely for showing up to work).

Unfortunately, most venture capitalists don’t like to take risks. They don’t know how to evaluate products, technologies, people, or markets. So they don’t want to fund a company until it has significant revenue. I.e., they only want to fund a company that is already worth a lot.

Suppose that you own the kind of company that is attractive to venture capitalists. You have $10 million in revenue, of which $1.5 million is profit. You could simply move $1.5 million into your personal checking account every year, but instead have chosen to reinvest the profits in your growing business. You are feeling a little tight on capital and worry that if one of your competitors, flush with venture capital or money from a public stock offering, gets intelligent and efficient, you could be snuffed out. But you aren’t that worried because you own an enterprise that is probably worth at least $10-20 million. You are a multi-millionaire!

Suppose that you decide to take venture capital. The VCs value your company at $25 million right now and put in $10 million for a minority share. Buried somewhere deep in the notebooks of legal documents that closed your deal will be something about "participation rights" for the preferred shareholders (the VCs). Basically it says that if the company is ever sold, the first $10 million goes to the preferred shareholders (them) and then the rest of the sale price is divided up among preferred and common shareholders (you) according to percentage of ownership. Some VCs get a little more aggressive on their participation rights and add a 10 percent annual interest. So if the company sells five years later they’d be guaranteed the first $15 million or so.

Now imagine that the strong economy that enabled you to grow to $10 million in revenue on your small initial investment begins to falter. Customers are deferring purchases. Perhaps the whole market segment is shrinking and becoming unattractive to investors. Your revenue is down to $5 million per year. Profits are down. Your entire enterprise is only worth about $5 million now (1X revenue isn’t uncommon for a private company in a boring market).

If you had not taken venture capital, you are still a rich person. You own something worth $5 million. It was better a few years ago, when you owned something worth $10-20 million, but you can still afford a Robinson R44 helicopter and to hang out at the local airport with radiologists and gynecologists.

If you had taken venture capital, however, your commmon shares are now worthless. It is very unlikely that your company will ever be worth more than the $10 million that was invested by the preferreds and therefore all that you will ever get out of this company is your salary. You are a wage slave even if you don’t realize it yet.

How can you cut down your risk? One obvious approach is to steer clear of venture capital and grow your company a little more slowly. Anything more than 25 percent annual growth tends to be chaotic. A less obvious approach is to insist that the venture capitalists buy some of your common shares at the time of the investment. There are a lot of venture capitalists and not too many good companies. If your company is attractive, you can probably find a firm that will agree to put $10 million into the company and, say, $3 million into your pocket. Then if the enterprise stumbles and ends up being sold for, say, $9 million, you won’t feel like a total idiot.

Everyone on the Board should have held Profit-and-Loss Responsibility

The typical white collar worker gets the job by having the right credentials and connections and then gets ahead by pleasing his or her boss. This worker might have a fancy education, a fancy suit, a smooth demeanor, and a political sophistication, but know nothing about making a profit or pleasing customers. The shareholders want profits, but the employee wants a raise and a promotion, things that can be most easily obtained by sucking up to the boss. It is very difficult to refocus one of these middle managers to think about customers and profits instead. Once the employee psychology sets in, it seems to be more or less permanent.

For your Board of Directors you need folks who are actual business people. A business person is one who has held profit-and-loss responsibility ("P&L" on their resume). P&L responsibility means that the person was in a position to determine the total profit earned by a company or a division and received compensation based on that profit, not based on what his or her manager thought.

Better someone who was the manager of a McDonald’s restaurant or a roadside shop in Hyderabad than an impressive former management consultant or middle manager from a big company. The Board makes important decisions and the directors need to have an intuitive feeling for what is going to make the customers happy and get them to keep coming back and paying. Membership on the Board should be limited to those who have founded companies, run companies, or held P&L responsibility in a division of a larger company.

Don’t be in a Rush to Hire Top Managers

If you’re reading this, you’re probably an expert technologist of some sort and perhaps you’re the CEO of your new enterprise. The most obvious step would seem to be to hire someone else to be CEO, someone with more business experience. Unfortunately, at this early stage of your company you’re not likely to attract any good managers. You might have a good idea. You might have a good technology. You might have a good group of engineers. You do not have a good business. A good business has customers, revenue, and profits. The best managers are attracted to good businesses. Ask yourself "If someone were any good as a manager, why would he want to manage my company, which has almost no resources to deploy, when he could instead manage a division of General Electric?"

It is always easy to hire more of the kind of stars that you already have. A company that revolves around great salespeople and has a few on board already will find it easy to hire more great salespeople. A company that revolves around Stanford-educated superstar engineers will find it easy to hire more Stanford-educated superstar engineers. Just because the smartest guy you knew from grad school wants to work with you at your new company, don’t be deceived into thinking that a competent manager will find your enterprise attractive. Business people will approach you wanting to get involved. Mostly these will be older guys who were discarded by their Fortune 500 employers and maybe some young guys who couldn’t get jobs at GE.

Larry and Sergei had to run Google, the fastest growing company in the history of the world, themselves for about three years before it was successful enough to attract a competent CEO. Bill Gates ran Microsoft for more than twenty years before his successor, Steve Ballmer, who had worked at Microsoft nearly the entire time, was adequately trained to take over the reins.

For an organization with tremendous institutional history and stability, bringing in an outsider at the top might be the only way to effect some needed change. That’s why you sometimes see the Fortune 500 bringing in outsiders and the American people often vote for an outside CEO to head up the Federal Government. An organization that has been recently and rapidly assembled, however, is very fragile and bringing in an outside CEO is tremendously risky. Much better to copy Bill Gates and bring in a COO then promote him or her to CEO when the individual has learned enough about the organization and vice versa.

Be wary whenever interviewing someone who isn’t like you. You probably don’t know how to evaluate them. They probably aren’t very good, otherwise they wouldn’t be interested in your tiny little enterprise. Use your network of Board members and top business executives to evaluate management candidates rather than relying on your own judgement and enthusiasm.

Text copyright 2006 Philip Greenspun.


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