Morettini on Management

General Management and Marketing Advice for Software and Tech Companies

Month: July, 2005

Channel Conflict

As I’ve been reading the trade magazines recently, I’ve paid particular attention to the channel magazines. A big story for several months has been the change in leadership at HP, since Mark Hurd took over as CEO from Carly Fiorina. This change has been met with much interest and concern for two reasons: 1) HP is a VERY BIG supplier to channel and 2) The company that Mark Hurd formerly led, NCR, utilized the channel to a far less extent than HP. So the natural concern is Hurd may steer HP toward a greater percentage of direct business in their distribution model.

CHANNEL PROPAGANDA

It was interesting, especially at first, to watch various editorials attempt to “read the Mark Hurd tea leaves.” This started IMMEDIATELY AFTER his very first press conference, which ANNOUNCED his appointment as the new HP CEO. The better part of one issue of a prominent channel magazine seemed dedicated to trying to decipher the impact on the channel by interpreting his earliest words. Hurd basically said, “I don’t know yet”. His appointment had just been announced within the last hour, so that seemed to be a pretty reasonable statement! While certainly not universal, many a columnist and channel spokesperson interpreted this simple, honest statement to be a putdown of the channel’s role at HP, with dire consequences certain to follow if this held true. These wags even went on to warn him of how the channel will turn on HP. They pretty much threatened that he had better live up to recent HP channel executives promises to make the channel even more prominent in HP’s distribution model. It’s pretty ironic considering many HP executives will tell you that most of their business already flows through channels, sometime hampering their ability to gather good marketing data. To quote a high profile (and somewhat silly) primetime TV reporter, “I say give me a break!”

The whole thing was really jumping the gun, and frankly quite silly. As Hurd has had a bit of time to study the massive company he is taking over, these same channel players seem to be pleased with his follow-on statements, and the direction they believe he will lead HP with respect to the channel. I got quite a chuckle over a period of weeks reading the various stories. As I stated above, it’s ironic to me, since HP already pushes the great bulk of its $80B business through the channel. While doing this, their business is certainly not optimized, and the key competitor breathing down the company’s throat is Dell. Dell’s direct distribution model is clicking on all cylinders, moving down the line like a Japanese bullet train while attempting to blow HP out of the water. And if HP doesn’t make some fundamental improvements to its business model, it just might happen. You would think it might be wise to examine whether utilizing direct distribution more heavily might be good for HP to study.

Of course, my channel colleagues reading this will want to burn me at the stake for espousing such blasphemy! Go direct—how dare you say such a thing! That is the nature of channel conflict—all parties want the business for THEMSELVES. Much smoke is always blown by the various interested parties about what is right and fair, and commitments that were made and so on, but let’s face it—it’s basically self interest. They just want the business for themselves.

So what’s a company to do? Just sell direct, or just sell through VARs, or just sell through retail? Unless you have strict exclusive territories throughout your distributions system, problems will still arise. You’ll always have some kind of conflict (two direct reps or two resellers fighting over who should have an account), but at least you would eliminate cross-channel conflict, which can be particularly complex and nasty.

Well, limiting yourself to a single channel focus certainly may make your life less complicated, and less rife with conflict. But unfortunately, in most cases, you’ll be leaving a lot of money on the table. If you rule out natural channels that can sell your product, you won’t be maximizing your return on your heavy investments in IP, which should be one of the fundamental concerns of any business.

HAVE YOUR CAKE AND EAT IT TOO

So I say, sell through every channel that makes sense. If done poorly, it can, and almost certainly will, be very messy. You’ll be sorry you did it, and probably become a convert to a single channel, or at least less complex, distribution model. But it doesn’t have to be so. Yes, you CAN have your cake and eat it, too.

There are many potential channels for your products: direct, OEM, one-step through VARs, 2-step through distributors/VARs, retailers, independent sales reps, strategic partner referrals, and more. In extreme cases, ALL of these potential channels may be appropriate ways to deliver your product to the market. The question I am often asked by clients is “How do you make it all work without it blowing up in your face?” The way you can do this is to live by two very simple rules:

1) DON’T EVER SCREW A REAL BUSINESS PARTNER

It actually sounds pretty simple and easy. Yet humans can be greedy creatures, and just a little greed in partnering can quickly ruin reputations for a long time. There’s the greedy VAR who thinks he deserves a piece of every deal with any customer within a 100 mile radius of his office—a customer he might have only sent a piece of mail, or cold-called a year before. But more seriously, it only takes one weak-willed sales manager at a manufacturer or software developer, trying to make quota or maximize his income, to cause real havoc. If he attempts to cut a channel partner out of a deal that they drove, or had legitimate influence on—this is a mortal sin. Your channel partners will be outraged, and they will spread the word and not soon forget. Your reputation has been tainted, and that crucial trust that is necessary to make any business relationship work is now gone. Everything becomes harder. Partners aren’t willing to share information about what’s going on in accounts—maybe even withholding names on potential new deals. A struggle for account control, rather than teamwork, becomes the rule of the day. So if it is a REAL partner, one who is trying to drive business to your mutual benefit, do whatever it takes to make it right. Give up short-term profitability to maintain a long-term profitable relationship. Don’t ever, ever screw a partner in the name of short-term gain. It can ruin your channel business long term.

2) DO ALLOW BUYERS TO PURCHASE THE PRODUCT FROM WHOM THEY WANT TO BUY IT

If you are honest and fair with people, potential channel conflict shouldn’t unnecessarily stop you from maximizing revenue by using multiple methods of delivering your product to the market. There is a range of customer profiles in the market. Some want to buy everything through their trusted VAR/Integrator, who helps give them a third party evaluation of the product’s virtues. Others want to deal directly only with the manufacturer or developer of the specific product they are purchasing. A third category of buyers likes to buy as much as possible through their favorite large manufacturer—this is a great reason to OEM your product to the IBMs of the world. In each of these situations, the channel that is best positioned, via relationship or type of support, should and usually will get the deal. In each situation, if your product isn’t available in that channel, my may not get the deal. The last category of buyer, however, is different. This is the bargain basement buyer, the one who couldn’t care less who he buys from, as long as he gets the lowest price. These are the people that can wreak havoc on a multi-channel distribution system, if you aren’t careful.

BEWARE THE BARGAIN BASEMENT BUYER

It’s this price conscious buyer that will often
bring cross-channel conflict to the forefront. Since they are seeking the lowest price, they end up shopping the purchase across many potential sources for the product, creating great price competition among your channel partners. This is where conflict is often born. There are many tactical mechanisms to limit these situations (such as deal registration), which I won’t delve into. The main thing to have thought out is where these customers should end up buying. There are two basic approaches:

1) Tell your value-added channels that this price conscious buyer, who isn’t looking for any added value, isn’t going to buy from them. You might decide that this buyer is going to find the lowest price at retail, or maybe direct if they buy in volume. In this case, it’s important to set those expectations up front when you recruit channel partners. Let potential partners know where they fit, and where they don’t. They can walk away if they don’t like it; otherwise they’ve been warned. This is being fair and honest. Before potential partners invest in selling your products, they should have the real picture of what they’re getting into.

2) Conversely, you can strive for street price equity between channels. This gets tougher to do the more channel types you have, and also the larger your channel is in general. But it can be done. The main thing here is to avoid giving incremental channels discounts based upon volume. If you do, incentives are created for a channel player to discount to achieve volume—thereby lowering their costs, so they can win more business via aggressive discounting. This leads to a continuous downward spiral in your street price, and to unhappiness and channel conflict to such a degree that will drive you to drink, or at least a career change. It will get ugly. But if you limit your channels to those that truly are strategic for your product, and which add real value, it can be managed. The key is to set discount schedules based upon value-add and associated costs, rather than revenue or unit volume.

So there you have it. Sell through all the channels your product belongs in. Be honest and fair with you partners. Sounds pretty easy to me! Let me know if it does to you-post a comment below.

Phil Morettini
PJM Consulting
http://www.pjmconsult.com/

2 Comments by admin on July 31, 2005
filed in Business Models, Corporate Strategy, Distribution Channels, Retail, VARs

Tech-river.com

I wanted to let everyone know about a great resource: www.tech-river.com

The folks at Tech River provide a number of important services aimed high tech startups, including copywriting and PR. But best of all, it’s great “portal” site for early stage companies, with an enormous number of useful, free articles and links to other relevant sites. Tech River even allows startup companies to list their press releases and new product announcements on the site–all for free. The site gets a lot of traffic, so it’s a great place to publicize your products, while building good links to your site for search engine optimization.

Check out Tech River–as always, let me know what you think!

Phil Morettini
PJM Consulting
www.pjmconsult.com

No Comments by admin on July 26, 2005
filed in Marcom, Promotion

Layoffs and Bureaucracy

I’ve been reading the stories on the major layoff at HP this last week, and it really struck a nerve. HP announced this week that they are going to reduce their workforce by 14,500 people over the next 18 months. It was no big shock, since HP has been paring down their employment levels, and has been generally concerned about their cost structure, for the last several years. Their main competitor, Dell, is a lean and tenacious predator that has set their sights on crippling the HP computer and printer businesses. And actually, the cuts weren’t as deep, and the timeframe longer, than many analysts had predicted. Still, it represents nearly 10% of the workforce of this venerable technology company.

There are many reasons that layoffs occur, and sometimes they are well thought out, and necessary. I’m going to focus today, however, on a common situation I’ve seen repeated over and over, using the HP story as a model.

HP is of special interest to me because I’m an HP “Alum”, having worked there for 5 years back in the eighties. I have also worked with the company since I began my consulting practice. I have many friends and acquaintances still there, and have always had positive feelings about the company. So while I’m a long way from an insider, I’m also not exactly a dispassionate observer, either.

More than a special story, though, this is the very common one of a once revered technology giant whose growth has slowed. DEC, COMPAQ, WANG, IBM, the list is long and the downstream results mixed.

There are two basic ways to view this story, and I am on the fence between the two. The first looks at it from a financial point of view. HP, in the opinion of most financial analysts, has become bloated, with high staffing levels and other costs. This is undoubtedly true. It’s an unfortunate fact that when a company has a lot of success over a long period of time, inefficiencies and excess tend to creep in.

BUREACRACY’S BEGINNINGS

And make no mistake; HP was VERY successful for an almost INCREDIBLE period of time. Even today, the company is hardly a train wreck. It’s still making a lot of money, and to my knowledge, never had a money-losing year. That’s in a corporate history of around 60 years. It’s a very enviable record, and one that didn’t happen by accident. I’ll touch more on that later. With this kind of success, unfortunately, comes the freedom to be not very disciplined. One of the most common mistakes that occurs as a result is that PEOPLE GET HIRED BECAUSE THEY CAN. The cash flow allows it—so more people get hired. In this respect, companies seem to follow the same path as humans. You don’t see to many fat people in poor, developing countries where food or incomes are limited. The same with developing companies with limited cash flow–there are very few “fat” Bureaucracies.

When starting out as a company, there is always a lack of the people resources to optimize the business. So in the beginning, hiring with growth is a good idea. But at some point a line is crossed, and the net impact of those additional people becomes a negative, rather than a positive. This is the “Bureaucratization” of a company, and it’s a very bad thing. It’s not something that happens overnight, but more of an incremental, gradual occurrence. But once it does seep in, it changes your company culture in profound ways.

Discussions become more internal, rather than externally focused on the customer. Individual success becomes more reliant on internal political skills, rather than business skills such as increasing revenues, decreasing costs or creating great new products. In the extreme, this leads to “empire-building”, which happens when success is defined by the size of your domain, rather than its performance. At HP, Bill and Dave (Hewlett & Packard) instituted early on a policy of holding annual staffing growth to a set fraction of revenue and profit growth. I believe that this policy was one of the keys to holding off the inevitable bureaucratization of the company for a very long time.

Once started, the Bureaucracy is a self-sustaining organism. Because you have some many people and so much overlapping of responsibilities, the lines of communication grow ever more long and complex. So you need to add more people, to make sure that all of the busy work that is created in the process is done. It’s the ultimate vicious circle, and causes huge inefficiencies that permeate throughout the company.

Unfortunately, this seems to be the inevitable fate of every company that grows big enough. While not necessary theoretically, from an empirical perspective it seems to be a natural course of events. Some stave it off for a very long time by being cognizant of it, usually by keeping individual business units small and decentralized. HP became a very big company before its bureaucracy got a foothold—but it did occur. Often, but not always, the rate of bureaucratic growth is inadvertently quickened, when a small company that is growing fast decides it’s time to bring in “big-time” management. This inevitably leads to hiring senior managers from larger organizations, who are used to the trappings and management methods of bureaucracy. And so it goes. It seems that it happens to all companies at some point if they continue to grow, no matter how successful they’ve been. Companies grow so big that they eventually implode under their own weight.Bureaucratization, I believe, is the major phenomenon that leads to layoffs in large, successful companies like HP. The financial manager within me says that this layoff needed to happen and is long overdue. The company’s costs need to be brought closer to Dell’s or disaster is looming. I strongly believe the company has the ability to do more with a lot less people, as I opined in the discussion above. But there is another side of this that needs to be considered, and often is given short shrift by financial and industry analysts. Businesses exist to make a profit, and this must be the first and foremost consideration. So we’ll put aside the tremendous personal cost that is being inflicted on these affected 14,500 people being laid off, as well as their families. I strongly believe that these layoffs with cause a deep cut into the flesh of this company, one that will negatively affect competitiveness. In the case of HP, I feel this is particularly true. Here’s why.

THE HP WAY

HP had traditionally one of the strongest, most positive corporate cultures in high tech history, called the “HP Way”. It’s treatment of employees, and the loyalty they returned, are legendary. Having experienced it for myself, I can testify to its power. Frankly, it’s a little difficult to fully explain to someone from outside the company. But HP people know. At HP, you felt as if you were part of a favored, select family. The policy was to hire slowly and carefully, and the dismissal process was the same. People were valued and treated with great respect. The effects on an individual were generally considered upfront in any decision that might include them. PEOPLE were correctly viewed not as just an important resource, but the very flesh and blood of the company. The company was highly decentralized for a long time, and individuals were given great responsibility within their sphere of competence. No doors on offices, even senior managers, and NO LAYOFFS. I worked in a $350M division, but it felt like I was working in a small, entrepreneurial company. Decisions happened quickly and they weren’t handed down, but were likely to flow up the chain of command for approval. As a result of this culture, employees were unusually loyal, and worked on behalf of the company in a manner that an owner might—with the company’s best interests in mind. And most people at the time were not eve
n option-holders. If not completely unique, it was highly unusual within big corporate America.

And most importantly—it worked. HP had a run of great financial success that lasted more than a half-century. The creation of this corporate culture wasn’t some touchy-feely, social experiment—it was good business. Yet even today, most of the lessons of HP’s success, and other like-minded corporations, appear to be lost on corporate America. In most large corporations, employees are treated like expensive desk chairs. They are welcomed when new, but are worn down by usage by the corporation over time. When they become a bit frayed along the edges, or there are too many in number for the current level of operations, they are discarded quickly and without much regret. They are downsized, right-sized, or part of a reduction-in-force—an impersonal transaction hardly appropriate for the “flesh and blood” of the company. To some corporate managers, they are little more than another balance sheet transaction. Most corporate executives seem to see it as maybe a bit unfortunate, but simply a normal and necessary part of doing business.

A CONTRARIAN’S VIEW

I view it differently, as I’m sure you’ve ascertained by now. I believe in most circumstances major layoffs have profound, negative impact of the company’s long-range ability to maximize financial results. This is hard to measure, of course. The short-term impact on the income statement from large layoffs is comforting to senior management, since the results come quickly and are easy to measure. In the case of HP, the new CEO, Mark Hurd, inherited a situation—he didn’t cause it. He has been generally well received within the company, and seems a much better fit in style and substance than his controversial predecessor, Carly Fiorina. He was brought in to improve the company’s fortunes going forward, and I’m sure that he’s just doing what he believes needs to be done. There is a good chance that he will greatly improve the performance of the company in the near term. It’s been done many times in similar situations before—IBM comes to mind as one. IBM is a solid company, but not what it once was. Like IBM, HP has been changed forever, and I doubt it will ever regain its former greatness. I can’t think of another case where the major company has reverted to its prior form after a severe traumatic restructuring. The HP culture has been eroding for many years, and this latest layoff may be the final nail in its coffin.

So, should HP have executed this massive layoff? I can’t answer that—it’s a complex situation with good points to be made on both sides. Its competitive position has been weakened by poor expense controls, and as I stated previously, can undoubtedly operate more efficiently with fewer people. However, one has to remember that HP isn’t hemorrhaging cash—it is making money, and has plenty of liquid resources. So the other view can be taken that a massive layoff is a drastic step.

MANAGEMENT SHOULD DO A BETTER JOB

Either way, my takeaway message is that layoffs happen far too often, are to be avoided at almost all costs, and should be used only in dire circumstances—as a last resort. Most importantly, corporate management isn’t doing its job if it allows conditions that necessitate layoffs in the first place to take hold—the unrestrained growth of the bureaucracy, during periods of growth. Bureaucratization may indeed be inevitable, but it should be RESTRAINED and DELAYED as long as possible. Hacking large numbers of employees periodically during slow times doesn’t take much management skill, or creative thinking. Shareholders shouldn’t reward it. Mass layoffs have a hard-to-measure, but very REAL, negative impact on the company’s ability to compete in the long run. That’s my opinion—and I’m definitely in the minority on this issue. Post a comment and tell me why I’m wrong.

Phil Morettini
PJM Consulting
http://www.pjmconsult.com/

No Comments by admin on July 24, 2005
filed in Corporate Strategy, General Management, Mergers & Acquisitions

Partnering

Forming Partnerships, or Strategic Alliances, is one of the key elements that make up the business development function in technology companies. I believe that alliances are underutilized, in many ways. Conceived and executed properly, alliances can greatly extend the partner companies reach in the marketplace.

VARIOUS AND SUNDRY PARTNERSHIPS

There are many types of collaboration that fall under the umbrella of “Partnering”. Let’s examine a few of the most common:

Third Party Programs—Probably the best understood category of partnering. Partnering in this manner is generally low risk, but low reward for both parties. A program usually consists of many smaller partners gaining modest benefits from a larger company. The larger company gains (or at least the illusion) from having a large number of partners working with their product/technology.

Industry Consortiums—Represents another well-understood category. Mild benefits are usually obtained by the participating parties, including some publicity, a stamp of approval, and the opportunity to network with other consortium members. The unique aspect of this form of partnering is its one-to-many relationship, as opposed to “one-to-one” or “one-to-few” relationships found in most partnerships.

Sales Agents—Many people might not consider sales agent relationships partnerships, at least not strategic. But they certainly are. There is usually a minimum of entanglement here, simply a contract that provides a commission for sales generated or leveraged. The product doesn’t change hands between the partners, and there is often less training and support involved, relative to other partnership types used for product distribution.

Service Agreements—These agreements occur when a company doesn’t want to relinquish the sales function for its products, but for some reason it needs a third party for servicing. These agreements are common in high-end hardware markets, where 24/7 on-site support is critical. Storage Hardware or Mainframes are good examples. They are also seen in more commodity markets, where a company has decided that service/support isn’t their core competency, and that a third party can handle service/support at a lower cost. The use of Indian Call Centers by PC manufacturers such as Dell is a recent example of this concept.

Distribution Agreements—This is a common, but often poorly executed form of partnership. The errors usually occur when the Channel partner is treated like an end-user, rather than the true partner they should be viewed as. Distributors and Resellers need to be treated as an extension of a company’s sales force. Sadly, they often are not, leading to such misguided policies such as channel stuffing and over-distribution, which lead to problems that become extremely difficult to resolve.

Joint Marketing—Cooperation on marketing matters should be where most companies reap the greatest benefits. Partnering in this area is really low risk, can have great benefits, and is a great way to get started with a new partner. There are so many ways that companies can cooperate in joint marketing; the list is really only limited by your imagination. Some of the ways I’ve been able to utilize these types of partnerships include discounted product promotional bundles, trade show space cost-sharing, joint press releases (of course!), sharing of prospect and customer lists, referrals, and joint direct mailings. The great thing is that there are many areas to explore, to find overlap in the two companies interests.

Product Integration—Integrating the products of two companies is what often comes to mind when you think of partnerships. It can make great sense, and the potential rewards are great. However, there are some reasons for caution, prior to jumping straight into this, as I’ll discuss below.

POTENTIAL PITFALLS

As discussed above, a partnership or alliance can take many forms. As a result, there is a lot of confusion and disagreement as to what even constitutes a “good” partnership. Let’s take a closer look at two partnering categories, and some common missteps:

The PaRtnership

You see a great many press releases go out trumpeting the partnership between company A and company B. The release goes on to discuss the great benefits that will accrue to customers and the two companies making the announcement. The language tends to be vague and laced with terminology like “synergy” and “market leading value proposition”. More often than not, that initial press release is the high point of the partnership, and little is heard about it subsequently. You may have heard the term “slide-ware” to describe products that exist only in PowerPoint. This type of partnership is the alliance equivalent to slide-ware—I call it a “PaRtner-ship.”

Product Integration Fiasco

On the other end of the partnership spectrum, technical folks usually think of alliances in terms of product integration. Technical integration can be the basis for a great partnership. However, it’s a lot of work and a big commitment for both parties. The danger is that the partners too quickly dive head long into the product integration work, basing their decision on an impulsive belief that it “makes sense”.

In a typical scenario, the two products are complementary, and from an engineering (and often customer) perspective it looks like a marriage made in heaven. Several dangers are lying in the weeds, however. First of all, any product development effort runs a high risk of failure. When you put together two disparate engineering teams who have never worked together on a project, that risk rises exponentially. Usually both engineering departments have their own product releases to worry about concurrently, which are always higher priority. Lack of communication, low priority, cultural differences and ego can easily conspire to lead to a failed integration project, or at least one lacking the features to be of much leverage in the market. At this point, the partners have spent a lot of money and precious engineering resources with little in return, leaving finger pointing, and a search for scapegoats as the next step.

In addition, it takes much more than good product integration for commercial success by the partners. If there isn’t a solid plan for marketing cooperation and distribution (see above!), even technically elegant product integration partnerships will leave both parties disappointed. Alliances that are born from product integration, unless carefully thought out and efficiently executed, can lead to disappointment by one or both of the partners.

There are many “gotchas” involved with working together to push and pull the combined solution in the market. It helps to have some practice working together prior to making the big bet on technical integration. That’s why I often recommend to my clients that product integration be a step down the road in an embryonic partnership, not a beginning.

PARTNERSHIPS MAKE SENSE—BUT EXECUTION IS KEY

So are partnerships to be avoided? Not at all! They are one of the areas that can make be a huge differentiator for your company in a competitive market. But the take-away message here is that too many partnerships are conceived as great ideas—and peak right there. Like most business activities, the devil is in the details, and execution is the key to success. When I’m working with smaller clients with limited capital for marketing and sales, I often recommend an aggressive partnering program. If executed correctly, the company and its partners can gain cost-efficiencies and marketing economies of scale far exceeding their own siz
e. But I have two key pieces of advice before you embark on a new partnering program:

1) The very definition of a partnership is a “win-win” relationship for BOTH parties. Takers don’t build winning partnerships—givers do. Offer to take the first step, do the first piece of the project. A partner that believes you are acting in his best interests will be very impressed, and willing to provide support that you never dreamed of. Build that relationship by being the first to “give”; the trust you build will came back to you multiple times and set the stage for a profitable, long term partnership.

2) Do start, but start small. I’ve discussed above the many pitfalls of moving too fast. It’s best to pick something easy, with obvious benefits to both parties. Working successfully on a small project creates momentum, and helps build the trust and familiarity that is crucial to success on more ambitious future projects. I will often suggest a simple list swap of prospects as an initial step. If either party views even that with suspicion, a blind mailing can be done to each other’s list, where the actual lists don’t change hands. Building a prospect or customer list is very capital-intensive; by partnering with just one other company, you can both double your lists overnight. It’s almost a certain Win-Win, creating excellent leverage, and no financial investment by either party. It’s easy to succeed, and sets the stage for discussions on additional collaboration.

I’m sure you get the picture—does this make sense to you? Post me a comment below so we can get this discussion going.

Phil Morettini
PJM Consulting
http://www.pjmconsult.com/

2 Comments by admin on July 19, 2005
filed in Business Development, Corporate Strategy, Distribution Channels, Mergers & Acquisitions

Strategic Fundraising

Almost every company goes through it, except for the fortunate few. Some people have gone through it multiple times. While never easy, raising money for the second or third time (assuming success the first time!) is a picnic, compared to the first time.

The questions that run through an entrepreneur’s mind are nearly endless. Do I even need the money? Is my company fundable, regardless? How much do I need? How much should I try to raise? What’s the best time to start raising money? What type of investor should I approach, and what are their expectations? How should I go about approaching them?

I could fill up the rest of a page with salient questions an entrepreneur might have. This might be the most daunting process in the minefield of difficult steps to forming and building a winning high tech company.

So you’re a new entrepreneur, with a great idea, a prototype, and a vague notion that you might need to raise some capital. Where do you go from here?

NO COOKBOOK FORMULA

Well, like most things that really matter, there’s no easy answer. It depends on what type of company you’re trying to build, your own control and risk/reward mentality, as well as the dynamics of your market.

For discussion purposes, I’ll focus on an embryonic software company. Most of the discussion will be just as relevant to a later stage business, or an early stage manufacturing business. In a manufacturing business, you’ll need to raise more money to fund manufacturing in the ramp-up phase. But the initial fund-raising is very similar.

FUNDRAISING BASICS

First of all, let’s quickly cover the various categories of capital sources. There are many variations and shades of gray with respect to funding sources, but the following are representative of the basic categories available to new software companies:

1) Self-funding
2) Friends & Family
3) Angel Investors
4) Venture Capital
5) Strategic Partners

Hopefully, these categories are pretty self-explanatory. Next, let’s look at what TYPE of company the entrepreneur is trying to build:

A) Lifestyle Company
B) Solid Single
C) Home Run

A Lifestyle company is one in which you are often intermixing your personal life with your company life. There may be family members involved in the business, your write-offs and accounting are more aggressively aimed at reducing taxes than showing profits, and you aren’t interested in or planning to sell the company anytime soon. Solid Singles and Home Runs are similar to each other; the major difference is market size/opportunity.

Lastly, let’s talk about what outside investors look for in a fundable venture:

I) Management
II) Market size/opportunity
III) Defensible differential advantage

The three items listed above are all crucial, but they aren’t equal in importance. Professional investors look for strong management teams, but if there are holes in the current team, it isn’t necessarily fatal for many investors. They’re happy to help you fill out the team. Many, in fact, prefer it this way. But having a large market opportunity and strong differential advantage are non-negotiable in the eyes of investors. They are looking for big returns. It’s a long-held view among institutional investors that their own management time is the limiting factor in their own business. As a result, they don’t feel they can afford to invest in “solid little businesses”. If you don’t stack up as having big potential in both of these key areas, almost every professional investor will take a pass.

YOU HAVE TO LIVE WITH THEM, TOO

Another important consideration that many entrepreneurs fail to consider is how well potential investors fit with the company’s management. Management teams are often so focused on “getting the money” that they fail to consider that you “have to live with them”, as well. It’s a bit like getting married. You may be thrilled to attract the most prestigious investor (like the best looking potential spouse), but end up with business philosophy and personal conflicts that severely retard the company’s development. This isn’t a used car transaction, where the sale is made and the parties walk away. You and your investors are now intertwined, but may or may not have the same interests.

So ask yourself: Is this a good match?

Are you seeking a “hands off” investor, or someone that will get involved with the details—providing business guidance and contacts—for better or for worse? Many VCs, for example, have successful business backgrounds and networks that can make them invaluable as advisors. There’s another group, however, that don’t have the background or skills to run a company. Yet their arrogance leads them to believe they are eminently qualified to drive even the most strategic of decisions. Are they going to be so involved that it will take up much of your scarce management time that is needed to build the business? On the other hand, are the investors so busy that you won’t be able to get their attention when you need them? Which type do you want on YOUR board?

It’s true that the money that you raise is a commodity—but the people relationships that come along with it can make or break your company. Early stage fundraising, taken as a whole, is NOT a commodity function.

THE LIFE STYLE COMPANY

Now let’s look at the simplest case study. An entrepreneur has conceived a software business using his knowledge of a particular, very specific, vertical market. It’s a market he knows well, and there’s almost no direct competition. Unfortunately, the market, while attractive to him, is not large by software category standards. Yet the market is plenty big enough to support a very profitable company, particularly since there is almost no competition. He’s proven to himself that he has a solution that the market will embrace, allowing the building of a business. Yet he thinks he needs a little additional capital, to ramp it to the point of the business being self-supporting using it’s own cash flow. What should he do?

This is the classic example of a lifestyle company in the making. Sophisticated outside investors will have no interest, unless it’s for personal/hobby reasons. And since there is little competition, and as a result, little time pressure—fund it yourself. Take out a second mortgage, use lines of credit, or get an SBA loan. If you really have to, raise some money from supportive friends or family members.

This example makes up the great majority of software companies worldwide. There are many, many solidly profitable software businesses that will never be on the radar screen of the investor community. These companies often exist quite nicely, enjoying solid and relatively stable profitability with revenues in the $1-10M range. That’s fine—the problem lies when the entrepreneur doesn’t know what he has, or won’t accept it. He thinks his baby needs to grow up to be a fast-growing player. But it’s generally the case that the market is too small. There is little need to be distracted by trying to raise funds from outside investors—and it’s fruitless to try. It will only be a waste of time for the company and investors. And if by some chance it IS funded, there will end up being a lot of turmoil and hard feeling when the company doesn’t meet the lofty expectations that were needed to sell the funding deal. I’ve seen many great little companies screwed up in the attempt to become something they’re not.

THE SOLID SINGLE

Now we’ll examine the next step up—the solid single. This opportunity often presents as a bigger vertical than the life style company is att
acking, or possibly a horizontal, yet still niche, product. These are often the situations where the most difficult strategic decisions reside. And in fact, the great majority of software companies who seek outside funding probably fall into this category. The market size is just on the edge of what the professional investors will consider. And while there is a differential advantage, it’s not at the level that you’ll be able to “knock their socks off” in your slide-show pitch. There’s worrisome competition, but it’s not over-crowded, with 75 venture-funded companies. What’s a management team to do?

This is a tough call. Every situation is a little different, but my general advice is to work your way up the 5-part funding tree discussed earlier. Fund it yourself as long as it’s not crippling your progress. Then do a round starting with Friends and Family, as well as Angel Investors that are easily approachable via your immediate network. Once you go through this funding, hopefully you’ve built a rapidly improving business with good growth prospects.

It is at this point you may be able to attract money from a VC or private equity firm that has a later stage, more conservative risk/reward profile than the typical early stage VC. Professional investors might see in your company one that may not be a 10X return, but one that may be a 2-5X return in a shorter timeframe, with less risk. And this later funding may work to your benefit, because the opportunity in front of the company may be such that you need to manage dilution of your stake carefully, to ensure that at the end of the day, it’s been worth your while. A strategic partner may be even a better fit here. Often a company in this situation may be able to attract funding because their product is important to the prospects of a larger partner company, filling out a total solution or providing a key technology the larger company can’t quickly or easily replicate. In this situation, the company may even get a richer valuation that the “Home Run” scenario which we’ll look at next.

THE HOME RUN

Lastly, there’s the classic Venture-funded company, the one with “Home Run” potential. These are the companies that VCs are out seeking to fund. These are the hot young companies that you often read about in the newspaper or trade journals. A high profile engineer, or someone else well known has started the company, with some cache in their field. The technology of the company appears to have breakthrough potential. The market is new, expected to grow to be very large, and is very newsworthy. But the competition is expected to be very intense, both from established players and a spate of new startups. This is obviously a very different situation than the two discussed above.

In this situation, you’ve got to go get the money. Time is of the essence. Getting established in the market early is crucial, and economies of scale usually become important as well. So a company in this situation typically needs to raise as much money as possible, as early as possible. All the steps are compressed here; and the time between funding rounds may be only a few months in extreme circumstances. It’s best, if possible, to skip the more casual funding sources and go very quickly to where you can raise large amounts of money very early—the VCs, and possibly strategic partners. Care needs to be taken on how you approach VCs, however. Unless you know them personally, never approach them directly. It’s one of the peculiarities of the VC community, and considered perverse by most people outside the VC community. The VC community has their reasons, although their rationale is certainly arguable. But no matter–it’s one of the rules of the game. Always approach them through a service provider (Accounting firm, Law firm, etc.), or another entrepreneur who has been successfully funded by the VC firm in the past.

Until you can get a commitment from institutional investors, however, take money from wherever you can get it, within reason. Self-fund, friends and family money and Angels may all come into play if there is a delay in getting the institutional money to buy in. Don’t worry very much about dilution in this case. The choice is often one of potentially ending up with a small, valuable percentage of a company with a large market cap, versus a large percentage of a failure. As you can see, the advice in this scenario is almost the complete opposite of what I’ve recommended in the two previous examples.

A STRATEGIC DECISION

But it’s all fund-raising, right? Why such different advice?

The advice varies because fund-raising is one of the most strategic activities facing an early stage high tech company. Many entrepreneurs view raising capital as a generic operational activity, like choosing a bank or leasing office space. It’s viewed as just a necessary evil, because every business needs money to survive and prosper. This discussion was intended to demonstrate that raising money should be viewed as one of your most important strategic functions–a decision that is taken with an eye for its effect on your competitive position, no differently than choosing the best technology platform to adopt, or what marketing mix to use to outflank your key competitor.

I know that there are many of readers out there who have run the fundraising gauntlet—give us the benefit of your wisdom! Post a comment below.

Phil Morettini
PJM Consulting
http://www.pjmconsult.com

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filed in Business Development, Business Models, Corporate Strategy, Financing, General Management, Startup/Early Stage