Get the RED Out

Anyone who has ever been around entrepreneurs and early-stage companies knows that early-stage business projections (revenue, cash flow, profit) are overly optimistic. Experienced investors always cut them down before analyzing the company. And experienced investors also know that a top-down set of projections (such as, “We’ll get .5% of a $10 billion market and that’s how we’ll become a $50 million company.”) are virtually worthless.

But I’ve just identified another type of problem–I need to come up with a clever name for it– that for now I’ll call RED (Revenue-Expense Disagreement). RED is when the expense line doesn’t match up to the (usually overblown) revenue projections.

Let’s say you had an idea for a new type of body scrub made from the broken pieces of cookies that are at the bottom of the bag. Nobody eats those anyway, right? Its a free raw material, so your margins will be huge, right? My point here isn’t to evaluate the merits of this particular innovation, but rather to use this as a hypothetical example of a RED error.

I chose this example because, according to Hoover’s, the beauty products industry is a $10 billion industry. You’d only need a minuscule, should-be-easy-to-achieve .5% market share to make the numbers work.

Suppose you come up with a revenue model that gets you to $50 million. You just need to sell 10 million bottles per year at $5 each. Simple. But is your pro-forma P&L statement internally consistent? Do you have enough employees built into the model to give an accurate portrayal of the headcount you’ll need at $50 million? Do you understand how much you need to spend on marketing to support that level of sales? How will you get your product into the 13,000 beauty stores? How much working capital will you need to finance the inventory that’s required to support that level of sales? Do you understand the credit terms in this industry because they will have a profound effect on your cash flow. Answering these questions will make the difference between getting your business financed or always wondering why “they don’t get it.”

New business ideas sometimes get shot down because the ideas seem outlandish. I actually think that most great ideas initially merited a reaction of “You’ve got to be crazy.” I’m talking to a lot of young entrepreneurs these days who are very eloquent and spirited about why their vision makes sense and why the world needs their idea. I’m not trying to convince anyone that their idea won’t work. Who am I to make that judgement?

But I see a lot of RED errors in their presentations. I worry that when they go out for funding, they’ll get shot down not because their vision isn’t meritorious, but rather because they haven’t described a financial model of the business that will make sense in the long run. Good investors will spot this.If you’re susceptible to making this kind of mistake, be sure you get some assistance from a good financial modeler and someone who knows the industry.

A crazy idea rationally presented with a solid financial model has a chance of getting funded. A sensible idea with inconsistent financials most certainly will not. Are you seeing RED?

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The Importance of Scaling

A watershed moment happened to me in December 2009 following a pivotal customer meeting. I was the CEO of a nanotech company and we had a meeting with our executive sponsor at a company that, at the time, was our largest customer. For several years they had been evaluating our technology and offering it selectively to their customers. We, of course, were eager to have them offer it broadly throughout their product line. Keep in mind this was a $2.5 billion global company with 40% market share in their space.

The executive said to me something along the lines of, “We believe…we’ve tested your technology every way we know how, and we like it. We see its value. We understand what it can do for us and our customers.” I clenched my first as though I had just kicked the winning goal in the World Cup. There was a pregnant pause and I knew there was a “but…” coming. He went on to say that he had major concerns about whether our company could serve them as a reliable vendor if they really got behind the technology. They were concerned (justly) whether our 15 person company with one location would be able to meet their needs if they really turned the crank. He proceeded to rake me over the coals with valid criticisms of our unimpressive track record of meeting their delivery and quality expectations. I walked out of the meeting and instinctively knew that our company was at an inflection point.

My epiphany was that our success from that point forward would have little to do with our technology. Our R&D 100 Awards, technical articles, invited talks at technical conferences–none of that mattered any longer (except for marketing purposes). Our customer acknowledged that our technology had value, that it was better than the competition and it worked. That box was checked. Our critical success factors were going to be all about execution and meeting the expectations and demands of global customers. My life flashed before my eyes and all I could see was the need to implement ERP systems, quality control, ISO 9000 certification, engineering change forms, CRM, getting our phone system to work, and the like. Up until that time the nexus of our company was all about the technology and pushing its boundaries. Going forward it was going to be all about our business performance. And I also realized in that moment that we didn’t have the team we needed to make it to the next level because we had plenty of people who knew the technology well but not enough people with the operational expertise that was now needed.

We always had investors ask us whether our technology would scale–meaning, “Could we make our products in high volume?” I never worried about that. That was a risk that was easy to grasp, and easy to focus on. Walking out of that meeting in December 2009 I recognized that we needed to turn the ship and invest heavily in businesses processes–scale the business–to make good on the promises we had made to our stakeholders. Going forward that would be our critical success factor. The 18 months that followed that meeting were painful. They involved a lot of changeover in people, new investors and a reconstituted board of directors.

It’s interesting to me now that I am working with several early-stage companies with emerging technologies how pervasive this issue is. And I am personally aware of several venture-backed companies that are about to hit a wall over this very issue. Proving that there’s a value proposition associated with your technology does not guarantee you a successful business unless you also can get the operational metrics right.

Hot and Spicy Lemonade

My first entrepreneurial venture, back in 1993, was a barbecue sauce company. The backstory is that my grandfather, before World War II, had a barbecue restaurant on the west side of Chicago. As a kid I would constantly hear from his contemporaries how great his barbecue sauce was. Over the years different people in my family made the sauce (my grandfather was still alive at the time), and every time they did, friends, family and other people would always ask for the sauce and frequently said things like, “This stuff is great. You should bottle it and sell it.”  Every family has a story like this.

So when I got out of graduate school and was searching for things to do (the job market was pretty terrible then), I saw a bottle of the sauce on the shelf that my uncle had made and I thought, “Why not?” So I started a business to make and sell the sauce. I started by making it at home, which was probably illegal, and that quickly turned out to be a painful experience because it was way too labor intensive to be practical. My next step was to rent out a commercial kitchen, where I and a staff made several hundred jars at a time (but I still had to put each label on by hand…not fun and not good for my metacarpals). Finally I realized that the way to go was to hire a contract food manufacturer (called a co-packer). I’d give them the recipe and the labels, and they’d give me as many finished cases of sauce as I ordered…in jars with labels on ready to ship. I was blissful thinking about the freedom this would give me.

But first I had to turn my grandfather’s home brew recipe into an industrial recipe because the co-packer was buying tomato paste by the 55 gallon drum and spices by the pound. I found a food chemist who deconstructed the grocery-store bought ingredients into their industrial components. And I scaled up the recipe. And the co-packer made the first batch. For reasons I no longer recall, I wasn’t able to be there to witness the first run. When I went to pick up the hundred or so cases they made for me, the sauce tasted rancid. It was unpleasantly spicy and lost all the notes of the original spice blend.

Naturally I accused the co-packer of screwing it up. How could I possibly be wrong? He assured me that he had followed the recipe correctly. So I again accused him of screwing it up. And he again assured me he followed the recipe correctly. So I double checked the recipe and again accused him of screwing it up. By this time he said that if I didn’t take the shipment, he would sell it to a wholesaler who would dump it on some discount house. My brand would be ruined (the labels were already on the jar), and I’d effectively be out of business. But I also couldn’t afford to pay several thousand dollars for the inventory and trash it. Either way I was screwed…and probably out of business. So I checked the recipe for the third time…and discovered that I had screwed up. I misplaced a decimal, and there was ten times the normal amount of cayenne pepper in the batch.  Continue Reading…