Business 101 Series For Entrepreneurs

Business 101 – 2: Getting the foot in

Part 2 of the series. We now look at the simple problems that founders have when trying to find a viable business. The goal is clear: get a business up and running without equity financing. So what are the options?

A. The dry-cleaning business

Let’s start with the most interesting case study there can be. The single individual starting a small business that he runs on his own. It provides a strong foundation to discuss the ALST problem, or the Access to Loyal Subordinate Talent problem.

Access to talent

First of all, the dry cleaning shop as is is a fairly boring and unattractive business. You will not get a former CxO or VP from Google to run a small dry cleaning shop. You probably will not even find anyone with a decent education, drive and ability to run your dry cleaning shop for you. What you can do is to hire a regular employee or trainee for your dry cleaning shop and to build him as a successor. That alone is a task that almost all dry cleaners business owners do not manage to do. So getting access to talent alone is very hard to accomplish.

The very same problem is intrinsic in any small company. One of the first challenges of a young and yet unattractive business is to find talent. If the founder has to micromanage his employees and tell them what they have to do, he will have no time to focus on the more relevant aspects of business. That holds true from companies with 1 employee to companies that hold 1000 employees. The access to talent pool is a key element that any founder must manage. How do you know what a good talent is and how do you find it? A key question that all scaling startups face and where people find that it sometimes is better to pay a lot of money for a few very good folks in an expensive environment – such as Silicon Valley – vs having a billion of okay employees. Reminds you of the mythical manmonth problem, too.

Retention of talent

The next step is how do you acquire and retain talent? If you operate a boring and ugly interiorated dry cleaning shop and you let your employees work hard for 10-15 hours a day to maximize your return on their salaries, you will likely only find people that have no better option and their intrinsic motivation to drive results will be low. But those will be likely the only ones you can really attract. By building a stable dry cleaning business, winning the customers and getting capacity up to warrant hiring a new employee, you can potentially invest into a nicer location, with state of the art dry cleaning equipment, offer a coffee machine, a nice atmosphere, etc. and you might get access to the top dry cleaning talent in your area. And you might retain them if you can afford better salaries.

Good? Yes. But only as long as you keep them in the “specialist” mode and keep the real aspects of your business hidden to them. Something that dry cleaner folks and other small business owners really love to do. Just keep the people below you more stupid than you, so they don’t run away. But make the business a success, so you can retain them. Classic problem. And you will never live a day without actively working on your business. You are the key man.

Building your talented successor

Now comes the trickier part. Let’s assume you managed to get a strong stable position in the local market and you made the company work as such that people love to work for you and you have the best dry cleaning talent. You are still sitting there actively managing the business. What happens now if you train one of your employees to be a successor? Let’s assume you managed even this task -which still might be hard, given the overall low talent of even the best dry cleaning specialists – and you can get out of daily operations of the business. If this successor is talented and growing your business well, building another successor even to make himself available to become your advisor on better projects, etc.; then chances are high that this individual understands that cost of entering your dry cleaner market are low. And he realizs that he, having no equity and no participation in the return this business generates, is better off building his own dry cleaning business and taking the best employees with him. Oops. Shit.

If you are a large corporation, you have the power to drive him out of the market and that threat might keep him loyal. If you own all 100 dry cleaners in your town, same mechanism is at work. The guys will not unite and run you out of the market even if they are all quite talented as long as you keep them in check. But yeah, keeping 100 semi smart successors in check and happy is even more frustrating than running one dry cleaning shop on your own.

But maybe, if you are smart, you can convince him or them that you will create new and even more lucrative opportunities. And you tell them that they suck at doing them, by taking them out, introducing them to the new environment and setting them up to fail. Maybe they give up on it and trust you that you are super special. And that you will provide the best option they all have, to all of them, if they do not dethrone you. Then you can sell them on the idea that you pull them up with you to new positions and new opportunities. Maybe not all, Only the best ones. Which means the most loyal ones that snitch on their peers. So you can open the most loyal ones opportunities that you sell them as door openers and they believe they are better than the peers. So they will also not associate with them and use the power you granted them to keep them in check in their play against you. Perfect. But again, just think about running dry cleaners. This is very, very hard. And that all only works as long as your vision is interesting to that person and the progress you show him is in line with his greed and growth need. Otherwise, someone might just decide to study business or music and will leave your segment alone completely. Leaving you at square one. UNless you have a success for a successor. And the cycle repeats. Yes, it’s hard.

So the problem of the dry cleaning business is that it is unattractive in general, easy to copy by your star employee, you are too small to deter disloyalty and so forth.

The chance that a real talent will not be loyal and pose a threat to your business is so high that many owners attempt to keep their employees uneducated and small on the nature of running a business and they use their network to communicate the atmosphere of a threat. But that doesn’t resonate with strong individuals, it doesn’t resonate with the idea of building a successor.

Growth in such small nieche markets only works well for the mafia where the threat to existence of a non-loyal employee is high and plausible. And if you ease up the existential threat, you are operating a business out of fear. The key skill being to create fear from defecting and building talent at the same time.

The concept of loyal/subordinate talent in Silicon Valley

The entire picture changes if you are in a region of a high “subordinate talent density”. Meaning, you are operating in an area where talent is everywhere, and a larger share of that talent is by nature not a business man and enjoys being under the umbrella of a leader. Which is subordinate talent. This increases your ability to replace a disloyal employee easily, increases the ability to scale the business locally and be a threat to any attempt to create its own business by your talented employee and overall reduces the likelihood of the individual being a non-subordinate person and hence increases the chance that your successor is not even trying to be ambitious and challenge your business.

Moving over to talent density in general, we can see why Silicon Valley is a winning ecosystem. The talent density is so high, that you only get VC financing – the gate keepers to opening a business – if you are truly one of the best. The chance of winning a VC if you are just copy-catting your boss is low. This overall reduces the chance of someone defecting and trying his own thing unless he really is good enough to actually do it. The salaries and talent densities are so high, that people enjoy being in Silicon valley a bit more than leaving the valley. The cost of living in the area are so high, that nobody wants to start a company without securing financing down the road are dim. The subordinate talent density of those that choose to stay in the Valley is hence very high. Those that are not subordinate by nature and are high in talent, but not good enough to make it in the Valley are those guys and girls that leave the valley, start their businesses elsewhere and try to come back later on. All at the risk of not getting back and all by not directly competing with their bosses.

This makes the valley particularly unique and suited. Little top tier VC as a strong gate keeper, high talent density and high cost of living as a threat to defecting and you are getting a high subordinate talent density.

Subordinate talent in the rest of the world

You can see that the value proposition of the Valley Ecosystem creates subordinate high-calibre talent at the cost of needing equity financing and giving up a share of your company. Since the valley solves this tricky problem, it is a hotspot for ambitious founders that secure financing there. And it is not the place to start with 100 dollars in your pocket and scale up with a dry cleaning business.

The challenge as an entrepreneur that doesn’t want to give up equity for securing highly talented subordinates is to exactly focus on this problem. Find a way to secure high talent employees and ensure their loyalty and subordination. This can only be achieved if you are in an area with talent. People are bound to remain in that area. And you can give a reasonable story of growth and successes that show your employees it is safe to bet on you and it is a bad option to leave your organization and start competing with it. Apart from the positive subordination enforcement aspects of giving a mission, a growth story and being naturally strong in leadership, the negative aspect is keeping your employee weak enough for long enough as to have a basis of a defensible position against this employee. And to network in the local industry to establish a base of deterrance against the employee if he not only threatens to leave for a competitor business, but he is leaving to form a competitor business. You can also resort to active sabotage and other measures to deter leaving employees and build a brand for being ruthless. But of course, these negative measures destroy the attractiveness of being a high performing individual under your belt. Your brand should be empowering and positively framed.

If you are willing to win this game and it is worth the equity you save, you might have a shot at winning the end game.

B. The single founder start-up

The single founder dry-cleaning business is a business that requires talent to distribute work in entering the market. Subordinate talent density and management is they key challenge. Now what happens if you find a way around that?

The basics of the single-founder technology start-up

One of the issues that require a larger talent pool for your organization from the start is the complexity of the stakeholder ecosystem. If you are out doing door-to-door sales, lobbying local interest groups, building your network amongst peers, competitors and benevolant supporters and you need to develop product and so forth, you will have a hard time getting things done alone.

In comes the modern garage startup that requires no negotiation with suppliers, distribution channels, landlords, etc. The modern start-up that runs on your laptop untill the product is finished, is migrated to PAYG IaaS services and then requires only rogue marketing tactics to get a foot into the global market. Sort of like instagram, dropbox, etc. but with just a single founder. There are no gatekeepers, no suppliers and no issues to manage. All you need to do is have a sufficiently vast domain knowledge to drive the product development to the MVP level and you are running against execution. You don’t need to split R&D brainpower, you don’t need to care about time-to-market vs. competition. You are operating in stealth mode alone. Of course, this is more attractive and common with co-founders. But again, even co-founders are costly equity. Typically they want even similar share amounts compared to you. Provide the same useless amonut of start-up capital and you are bound to have coordination issues around defining strategies, roadmaps, go-to-market, etc.

We are in the equity preserving mode. And one entry strategy is to focus on a problem that potentially scales across the globe, is very simple that one person can finish it, and you can pull it off without any second employee or investor. If you manage to pull it off and you are able to get revenues in with reasonable marketing costs on your credit card, you are in. Once you obtain traction and people are running into your product, you have a position that your average Joe employee cannot easily attack. So the insubordination problem in building a successor is becoming less relevant. It is becoming only more difficult to find a successor. It is more probable to now hire talent that keeps day-to-day problems off your back and as you grow you might even find an actual successor.

The problem here is: the successor will be talented in the rage of grossing a six figure salary. So unless your revenues and cash generation covers this successor,  you will be bound to stay managing the operations of the business. The risk here is to (a) carry on with legacy issues you created by doing it alone for too long and having cost overheads later on, and (b) being so great at what you do that you are being copy-catted by someone with a substantially larger pocket size. The latter will then simply blow more money into marketing and may take your market before you.

And yet again, you will win or lose based on your checkbook and execution and Venture Capital guys or equity financing individuals will try to convince you to give up equity to tap into talent, faster growth and taking the market. If you manage to be cash flow positive and profitable, you will only win this game if you finance your growth using debt and debt and debt as you refinance and re-negotiate your cost of debt and credit line as you grow.

And still, you might also get some equity from a relevant investor. Giving 2% – 5% for a very highly relevant investor for this particular product line. But of course, you have to do some legal structuring. As you do not want this investor to control your privately held MNO hunt, you have to create a sub company, transfer this line of business and its IP and resources into the sub, and then raise money for the sub. Why? Because you want that money to build and scale the sub or that particular product, and not to control your MNO efforts on the HoldCo level. Would Investors want this? Of course not. Even if you are esentially operating HoldCo merely as a representative of your presonal interest for the moment, they will smell it that you want to use HoldCo to build new businesses.

You can easily see that coming from a financial background and having a Berkshire structure from the start, creating that sub and getting financing into that sub from your fund and network is easier. But both ways go. You can effectively start with this single company, single founder, massive and fast scale approach.

But you need a checkbook for this. 100k in the bank is easier than starting with 100$ and foodstamps and operating out of your parents garage.

Key classification aspects

So this kind of start-up will almost never be an R&D start-up, but a hack-it-out project focused on building a commercial product and getting it to MVP level and getting traction. That is the infamous start-up everyone is talking about. Get things running till you get first capital and then get venture capital to professionalize, scale and build your business.

The risks in this business are simple to name. First of all, as a solo founder, your execution and time-to-market is terrible. But you will have to be super focused on the most relevant aspects of your business to get anywhere in something you would call “due time”.

The second thing is that you will build things terribly. Similar to the challenge of finding talented employees, you will already admit you are a terrible and untalented employee in your own business under the many hats you need to wear.

C. The franchise

This is also a business line that is hard to do alone, but it is an alternative to the successor-find approach in the dry cleaner. If you are successfully building a dry cleaning business, have 2-3 capable employees and you are solving the dry cleaning problem in a systematic way, you might end up with a strategy that can leverage the franchise business model. What is it?

You build a recipe for a single small business. You are licensing this small business to franchisers. They will use their own money and hence will be incentivized to opreate efficiently as sole business owners. The task now is to install quality control mechanisms. Every frenchise must support the brand and value proposition of the franchise and the trick now is to get that quality control system up and running. This typically is costly on a stand alone business and a seperate ownership of the franchise by the franchisee will not lead to a big form of cooperation to support you in your brand and quality unity exercise. This is why franchises come with value-added services that lock your franchisees in and make them dependent on your service platform.

Your headquarter will continuously refine the business and manage the supplier negotiations, take care of logistics and operational controlling. It is essentially running the franchisees business by binding the licensing agreement to compliance with processes set out by the Core-Co.

In principle, the challenge here if you want to start without massive financing and without a huge capex and G&A overhead in CoreCo is to consider the franchise business as yet another version of the Dry Cleaner succession problem business. Only this time, the dry cleaner successor is your franchisee and he will not run away and copy cat your business, but he might dilute the brand and quality of your product and potentially fail. Your debt financing for your organization requires all your franchise branches to operate a repeatable model that leads to their success. Only if every franchise is basically running profitable and this profitability becomes predictable, you can start planning CoreCo/HQ services and obtain debt-financing based on the validated business model of the franchising units.

Now enforcing new processes and quality control measures onto you franchisees can lead to defects, attempts to build something similar without violating the franchise and so forth. So you still have a defect issue, this time created by the threat of you taking their profits and them understanding the business they operate. And you are not risking losing your single shop business, but reducing a share of your franchisee population and facing a risk to the cash flow from your better businesses, while potentially being stuck with the less-profitable businesses.

On top of that, every franchisee will require financial support and the onboarding will eat more resources. So there is a limit to growth given risk of new franchisees and limited funds available and risk of opening new franchises will deteriorate your credit financing conditions. At the same time, there will be copy cats if you are very successful with the business.

In any case, this model is a bit nicer for some people, because you can start with a team. You have the up-front capex and risk from opening the first store. You need to validate that store as a business and make it profitable. Once that is done, you need to perfect the entire system and build a mix of multi-sided platform (the CoreCo), repeatable recipe (the franchise) and quality controls (the communication between two) around it. Employees that are good enough to support you on this mission and trusting your ability to execute the franchising strategy is easier than finding successors for a dry cleaner business. But the risk of lock-in into a particular employee and the negotiation leverage in critical paths is of course also large and the risk of blowing up the scaling process due to it or losing equity on the way is existent.

But while organizational risk is a bit lower, the risk of penetrating the market with loosely coupled franchisees is not trivial and also needs to be managed. As the franchise grows, supplier negotiations and logistics optimization require a different skillset than building “one shop at a time” go-to-market that follows the dry cleaning business.

D. Buy and build

A last entry strategy into the market is a buy and build system. That resembles in principle an evergreen PE fund fully owned and controlled by you. The entire concept is to leverage a network and the power of debt to buy companies and turn them around, and integrate them into your larger MNO play.

This approach massively derisks many aspects of business that other entrepreneurs face, because the targets you are buying are essentially operating and fully functional businesses. They are just not functioning so well or their owners want to cash out or the market is difficult to navigate and the company might face bankruptcy soon.

The goal here is to identify the market for attractive investment opportunities, find ways to finance the transaction of buying the business with debt, restructuring the organization to become more profitable, turning it around to fit long-term business

What makes this approach risky? Well, you typically start very small – given your budget – and you will have access to low quality talent private equity transaction experts, the targets you are buying are low quality, having low quality employees. Just think about you buying up all small shops in a small rural town. The employee pool will always be the lowest since nobody will want to start his career in this kind of shop. Every new employee and potential leader has to be trained. Managing 10 – 20 businesses actively is hard and you are facing excessive risk from the customers that just might not want your shops products in the next years to come. Some start-up might disrupt the value proposition of the local shop. So there are tremendeous levels of risks outside of the domain of actually running a business well and the life cycle of an opportunity in your balance sheet might be short. There must, after all, be a reason, why PE funds are typically not evergreens and like business opportunities to open and close within a 10 year cycle. So if you are not in the business of buying, transforming and selling companies – which is classical PE – but in the conglomerate business, you are in need of understanding the microtrends that feed into your brick and mortar businesses and understand the macrotrends that determine the stability and health of your portfolio.

So realistically, you either find a very attractive, completely overlooked segment and build a strong long-lasting cash generation out of your play, our you need to identify sweat spot targets that start in the million range and are hard to get by with 10$ in your hand. And even then, buying a 1 – 10 million business requires intricate knowledge on how to manouvre and manage the stakeholders – suppliers, local actors, etc. – of that business. So this strategy externalizes most of the risk you are facing and puts you into the observer rather than the driver seat. Only if you are capable of obtaining and holding a larger portfolio of similar companies, you can invest in platform and shared service activities that you can use to drive synergies and overall competitiveness of your conglomerate.

Also not easy. Is it? But this strategy is the easiest to get by to get debt financing. Somewhat a paradox? But somehow related to how banks and their fixed-term loans and credit facilities operate. Even if your business starts failing on the market side after 4 years, you term loan might pay back its full principle under insolvency.

 

The things you struggle with

Everytime you struggle, there is an App for it. Eh, a company that helps you. Such as a VC fund taking your equity.

  • Instead of building a very strong support network with leading industry figures, those industry figures now want equity and call themselves Angels.
  • Instead of giving you access to financial services, financing and getting a foot into the door, the key networked individuals now all own funds, and invest into you, and call themselves Venture Capitalists.
  • Instead of getting you a ratpack of restructuring advise and helping you get ready for IPO for a fee, M&A advisors now are investors ,too, operating PE funds.

Everybody wants to help you nowadays. All for a bit of your equity. And pooling money with it to buy this equity.

The rule of thumb is: don’t get diluted beyond 15% by these fake advisors that now are into making bets and building their own portfolios without ever attempting to own what they invest in. Those quick flippers are opportunists and they don’t offer value apart from knight-swording you and giving you a platform to sell yourself after they financed you. Is this a reason to do an equity-based financing? No. It never is.

The reasons when and why you get equity capital are simple.

  • Hyperscale
    You need to scale up very very fast and very agressively, or your business is taken by a competitor. Yes, that is what venture capital loves and they create this scenario for you, just to get you to get their equity financing. And this poses a viable threat to those having found a goldmine product that is easy to copy.
  • Doors
    Supplier and buyer doors. In the old money days, private networks existed to do a tit-for-tat kind of transaction. Someone you came to know vetted you, you got a favor, you entered a door, and you had to return the favor. You only got that favor if that whole concept of you was working out. Now, with throwaway founders and the lack of those old networks, it is all about funding you for money and getting the favor returned as ROI.
    So, while it hurts and pains you, there is a clear problem you have to solve. Either you open the doors yourself and you know how to do it, or you are born into or raised into a network that opens doors and still uses favor-for-favor methods. Or you have to yield in and use financing entities as a door opener. But you should and must vet the s*** out of investors to identify if they are really opening these doors or they are just blindly and dumbly making introductions. In the favor-for-favor world, you are getting the door opened and you are able to step inside. But that is why you owe. Nowadays, by getting investors, you get a quick namedrop on a dinner party and you still have to sell yourself. It is not the same becoming a knight or having a handshake made. Unless your investor really knows a lot of doors and gets at least your foot into the room, you shouldn’t use this as a reason to get a particular investor.
  • Talent pool
    With all those throwaway entrepreneurs, investment opportunities and tech talent, and everybody hustling, having a company with a large brand and attraction to these hustlers is a turnkey. You can still do it alone, but talent pool access is still an area where you are matchmaked with people that are below the knight and handshake level, but will still be valuable to your business.
    You certainly only reach a fraction of the talent pool market without tier 1 investors, but you probably get 90% – 100% of the market of what tier 2 and tier 3 capital can offer you. So a VC fund with 60 years of experience and a vast talent network can be a value-adding tool. But only if you are willing to tap into that network. If you are in Silicon Valley and want former VP or C level folks from other well-known start-ups, you might think about top tier VC capital in the Valley as an option. If you are based in New York or Austin or somehwere non-US, forget about this aspect of the network.
  • Geo Expansion:
    While EMEA and US markets work “fairly” (-> still not exactly) similar, China and India are good example where things work different. You might just not get a foot into that market or a single hire done without a local investor and local VP/C level that operates in this vicinity.

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