Ethics of failure and the rule of transparency

Benedict Evan’s outstanding recent post “In praise of failure” pointedly demonstrates how startups and venture work: a few big successes making up for many failures (and some middling outcomes). This is like no other business – imagine a world where Fortune 1000 companies posted for Senior Directors of Operations who are “right at least 50% of the time”.  Startups are as much or more about failure than success… and so startup ethics are too.

downloadWhile the power law of venture is well understood, ethics in the context of this asymmetry are much less discussed. The basic business code of ethics that we learn in our early careers is designed for the established company, the going concern. Is it any different for startups? Recent fraud and ethics accusations about Theranos and UBeam, Penny Kim’s recent expose of startup employee scamming, as well as a few positive recent experiences got me thinking about this. Lots of startups spend time outlining their values (a critical exercise), but few explicitly consider ethics in this exercise. They go hand in hand.

The rote modern core of business ethics says when working with customers, employees and investors alike:

  • do what you say you’re going to do
  • communicate directly
  • be honest; don’t steal
  • be diverse and embrace diversity
  • don’t break the law
  • do no harm to the external world (society, environment, etc)

These seem good and obvious, but ethics are not about the 95% of unethical situations that are black and white – stealing from the till, sexual harassment in the workplace, swiping confidential information – they are about the gray areas: (1) promising something to a customer you think you have a 50% chance of delivering on-time, (2) influencing a customer RFP process outside of the rules, (3) signing up for a competitor’s account or demo, or (4) not telling your employees you only have 9 months of cash left (how about 6 or 3?). These situations come up in Fortune 1000 companies, but slower growth trajectories, established products, hierarchical command/control, and years of established process reduce the frequency and breadth of the gray area. Not so in startups. The two common themes that permeate these examples are an asymmetry in risk consciousness (as in (1) and (4), you are aware of risks that others aren’t) or hidden conflicts of interest as in the case of the customer RFP.

If I polled 100 startup founders and VCs on each of the four gray areas above, I would expect a lot of disagreement over what is ethical and what is not. Okay, I did, and here’s what they said:

CLICK HERE FOR RESULTS

Here is the thing about gray areas – there isn’t a right answer. I certainly have my opinions and offer some guidelines below, but I know startups that operate consistently on either sides of these ethical dilemmas. Given the “front page of the newspaper” rule, tracking on one side or  the other is not just a question of preference, but also a question of how much risk a startup takes. Within a startup and across its employees, approach should be consistent as to what path a company takes – the high road, or the less-high road. An ethically lower-risk organization is only as pure as its weakest link; conversely, if you decide to take the less-high road, you’ll need to find employees who are comfortable with that added risk. My view: it’s best to avoid the gray areas with transparency.

Avoiding ethics gray areas with “the rule of transparency”

I think about startup ethics along their three main constituencies: customers, employees and investors. The rule of transparency is simple; being transparent with these groups tends to resolve conflicts of interest and risk asymmetries that create ethical gray areas.

Transparency solves almost every ethical issue with investors and employees. When you take on new investors, make sure they know the risks of startups, and then communicate, communicate, communicate as you go. Few who understand the risks up front – and who are kept informed along the way – will fault you for bad news you’ve warned them about. Experienced angels and VCs know what they’re getting into, but the rub can be with “friends and family”. They may not understand the true level of risk at a startup. Think twice about having Uncle Joe or Aunt Marge on the cap table unless they’ve done a lot of startup investing before.

Employees follow a similar vein. Most startup employees are fairly wise about the level of risk they are taking in a new job. They have clearly signed up for medium and long term risk, so there is little asymmetry on risk perception when an employee starts, assuming you are being honest about the current state of the business (something Penny Kim didn’t benefit from). The trouble comes with short term risks during employees’ tenure, when you are running out of cash in a few weeks or a few months. Be transparent. Employees probably already know about problems through the rumor mill. If you habitually communicate and then eventually have a big layoff, your employer brand has a better shot at weathering the Glassdoor gauntlet. I’ve also seen employees rally and drive big turnarounds when they truly understand the risky state of a company. There is nothing like a good shared crisis to drive progress.

The customer constituency is more complicated. Your investors and employees know from the beginning that you are more likely than not to fail, but should customers know this? Herein lies the tension: If startup customers knew there was at least a 50% chance a startup fails, startups would never have customers… or at least not many. So evolved the “fake it until you make it” mentality in startups. It is simply not practical to telegraph every risky point in a startup’s arc to customers, but that’s not an excuse to leave customers hanging if your startup is about to hit the wall. Indeed, founders, executives and boards should take heroic efforts to provide continuity for customers in the down state. We owe them that for taking the risk on us.

I recently saw this in action when a company we were involved in reached the end of its runway with all paths exhausted and employees soft landing at another company. With nothing left for founders and investors, the Board shifted focus from traditional “shareholder” interests to ensuring continuing operations for customers, finding someone to acquire the asset for a song to keep the lights on. Despite the big fail, this is one of the most inspiring startup moments I’ve ever seen.

This is not to say looking out for customers at the end absolves you of being transparent along the way. It is a fine line to walk, but customers are often more forgiving and understanding the more they know. If you didn’t have a better/differentiated product, they would just go to Salesforce, Oracle, or Cisco – that’s why you have their attention in the first place. You can then induce their taking some risk with discounts, development partnerships and strong personal selling.

If you haven’t already, check out the ethics poll results HERE and please share your thoughts below on this topic.

 

Career advice: don’t listen to it, but if you must…

For endeavoring on a career with a statistically low chance of success and being qualified for little if I fail (a good motivator), I receive a surprising number of requests for career advice. My first rule on career advice is not to listen to anyone – it is easier to give and receive advice on almost any other topic where there is a specific problem, set of options and relatively quick feedback on outcomes. Careers, however, take years to play out, are immensely idiosyncratic and are as much a matter of the heart as the mind. Career decisions lend themselves not to prescriptive advice but to frameworks that guide decisions, to be applied and ultimately answered by the beneficiary (or victim)!

There are four questions/dimensions that I think matter most in framing a career opportunity decision:

  • People: Do the opportunity’s people energize, teach and motivate you?
  • You: Are you a Judge or Builder, and does this opportunity fit your preference?
  • Immediacy: Is this a stop on the journey or a final destination?
  • Optionality: Is this opportunity “option expanding” or “option limiting”?

In visual form:

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This framework evolved through my own career as follows: I went to college to EXPAND MY OPTIONS. With an engineering degree, I could have done many things (engineer, finance, consulting, academia). Not knowing much about my options, I became a mechanical engineer… seemed obvious. This was OPTION LIMITING as it’s hard to move out of the tech side of big business once you’re in.  I was lucky to learn early, however, how working with incredible PEOPLE multiplies your own experience, growth and enjoyment. By chance, my bosses and co-workers at Raytheon and GE were phenomenal. In my five years as an engineer I also found the first evidence that I am a JUDGE and less so a BUILDER. While 90% of mechanical engineers design and build stuff, I found a fit in analyzing others’ designs to see if they would break or overheat.

In 2008, I went to business school because I wanted to (re)EXPAND MY OPTIONS. Engineering was too narrow. I wanted to see how the whole business machine worked and did a number of internships in b-school – JOURNEY PITSTOPS – to learn and try new things. Several internships were in analytical investing roles, JUDGING. New to business, I wasn’t ready to pick a path at the end of b-school and so went into management consulting at BCG. This was both a JUDGY and OPTION EXPANDING decision.

Something else happened in business school. I found an incredible business partner, Ira Weiss, and the taste of an enticing career in startup investing as a venture capital intern. While Ira was the PERSON I probably would have followed into anything, fortunately we both settled on tech investing. Since 2012, I’ve been a VC, which is very OPTION LIMITING but I also hope my FINAL DESTINATION. I love it and will stick with it as long as it lets me.

PEOPLE: Much has been written about choosing the right colleagues, so I won’t go deep here, but certainly picking the right people to work with is something often overlooked amidst other factors like activity of the role, title, compensation, commuting distance, etc. Spend time with the people you will work with both 1:1 and in team settings. Talk to others who have worked with them.

BUILDER vs JUDGE is less obvious. Do you like creating products, teams, relationships or companies? Or do you prefer to review and analyze others’ work. Here are how a few professions fit in:

Builder:

Salesperson – build a book and relationships

Engineer – build a product

Executive – build a team and a business

Marketer – build a brand

Startup Founder – build a company

Judge:

CFO – analyze finances and judge performance

Accountant – analyze financials

Strategy analyst – analyze new opportunities

Investor – analyze businesses

HR – analyze people

Truly this is a spectrum, not binary. I do have some builder in me, and that’s why I was drawn to building a new investing firm with my partners rather than joining another. Yet 90% of what I do is judging. I’ve seen builders trapped in judge roles itching to go start something new. Fit is important.

JOURNEY vs DESTINATION is a classic tradeoff in career opportunities. Is the opportunity a pitstop on the journey to your aspiration or is this the aspiration itself? Many suffer through banking to get into private equity or work at a scaling startup to better position as a founder of one themselves.

OPTIONALITY in a career opportunity is often overlooked. Does the role qualify you for many new positions or paths later or reduce your flexibility to switch roles or careers? As an example, venture capital is one of the most option reducing careers: we don’t manage people, have P&L responsibility, create products or execute large projects – at least in the common sense. Consulting, on the other hand, is the ultimate option expanding role. Following, you can work at a big company, become an investor, jump into a startup, etc. Time in a role is also a factor; optionality tends to grow the longer you are in an option expanding role and decrease the longer you are in an option reducing role. Using my timeline this looks something like below:

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It is worth remembering that optionality isn’t a measure of whether you can move to other roles or careers, but rather the ease of doing so based on qualifications, personal network and experience. Anything is always possible.

Balance the dimensions, but don’t compromise

It is best not to compromise at all on people or much on builder vs. judge fit. Giving in on those begs unhappiness, and your significant other doesn’t want to hear about it every day.

The other two dimensions (optionality and journey vs destination) balance against each other as shown below:

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In a perfect world, we would all be in the upper right nirvana quadrant – in a role we see as our final destination that ALSO creates optionality. This can happen. I know some Senior Partners at BCG and highly successful executives for whom this is the case. Most of us end up in quadrant II or IV. I am in quadrant II, happy in an option limiting role that I want very much to be my terminal career. As a consultant, I was in quadrant IV (career growth) and also happy, but there as a stepping stone. In general, it’s okay to limit options if you think you are somewhere for good, but if your stay is fleeting, you should be growing your options. Quadrant III (limiting your options on a pitstop) is high risk. Even if it’s a step on the way to where you think you want to go – a singular egress can pile up with bodies when a company’s fortunes shift or the market turns.

I haven’t mentioned money at all. If you are motivated and energized in your work, monetary rewards will follow if they are important to you.

 

What startups can learn from Brexit

As a startup investor, I am pro-trade because my companies benefit from selling software anywhere in the world. I am pro-immigration because my companies need the best talent no matter where it may be found. It’s not hard to figure out where I would land on Brexit were I a Brit. But I’m not, so who cares?

In the past few days I’ve been asked by several people what Brexit means for Hyde Park Venture Partners’ portfolio. With all of our investments either in the US or Canada, we really don’t see much upside or downside from Brexit itself, but I’ve come to see Brexit as allegory for certain pitfalls of decision making we see in startups. We can learn from it:

“Anything but this” is not a strategy

What surprised me the most about Brexit was not the win itself but the lack of definition of what a Brexit win meant as citizens were voting on it. As we’ve all learned, it will take the EU and UK two years to negotiate the exit and possibly another two to effect it. The UK voted on and elected to do something largely undefined. I call this the “anything but this” approach to decision making. “Anything but this” is quite common in personal relationships. Most of our adolescent and early adult lives are littered with romances ending with an “anything but this” decision, but in business and startups it is dangerous.

“Anything but this” happens in startups when things aren’t going well – a company is missing plan and running short on runway. Investors blame the management team, management team blames investors, and each board member blames the others. This often leads to a cursory decision to try something, someone (eg, CEO), or anything new. In a way this is rational: If what you’re doing isn’t working, and you have enough cash runway to try something different, then by all means roll the dice. But ask yourself, are you running from something or to something? The latter is better. It’s good to have a destination or at least a route.

Small changes have non-linear impacts

The Bloomberg chart below is breathtaking. With polls showing “remain” well above “leave” for many months, only at the very end did Brexit emerge as likely. Decades of Britain in the EU and only in the proverbial last hour did a difference of ~600K votes change the course of history. Why? One strong explanation is the Brussels attacks. After the attacks on March 22, the undecided vote declined steadily and shifted to “leave”. That one event may have changed the course of Europe for decades to come. For history buffs, you will appreciate that this seems to be a habit in Europe.

Brexit Polling Trends – Bloomberg

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Source: Bloomberg, Brexit Poll Tracker

In startups, we see both the good and bad sides of non-linearities. The right hire at the right time – for example an amazing VP of Sales or VP of Customer Success – can triple revenue and halve churn in a year. Collectively that might triple the valuation of a startup in turn. This is what makes startups so exciting; any team member can have a non-linear impact by creating a new feature or winning a big customer in a few weeks or months. On the other hand, the loss of a key customer or key ecosystem partner often scuttles startups, as we saw in the wake of LinkedIn shutting down its API. This is to say that, like politics, startups are unusually susceptible and reactive to idiosyncratic risks – they are fragile – but also uniquely benefiting of opportunities.

Beware the tragedy of the commons

The smaller the ownership piece something is carved into – a pasture into grazing rights, a country into citizens’ votes or a startup into shares – the greater the risk that a tragedy of the commons occurs. Very loosely defined (more precise see here), a tragedy of the commons is when individual “piece” owners do what is in their immediate personal interest but opposite to system health, resulting in system decline in the long run. In Brexit, this is exemplified by a London construction worker voting for Brexit to reduce labor competition he sees from immigrants. His vote is arguably system sub-optimal because Brexit likely reduces GDP growth and so construction and occupancy. In the long run this probably hurts the construction worker, even if immigrant labor is stemmed.

In a startup, shareholder (eg, voter) alignment is critical to company growth too. In the most direct sense, you need different thresholds of votes/signatures to raise capital, elect a board, sell a company or take other corporate action. While thresholds can usually be met with a few votes of larger shareholders, new investors and acquirers like to see any long-tail shareholder base consenting as well to avoid shareholder problems later.

Separate from the technicalities of voting, it is not unusual for a few small shareholders to create problems for a company due to personal differences with management, investors or strategy. The ensuing calls, politicking and “getting people on board” may satisfy the concerns or needs of the small shareholder(s) but also distract management and the BoD from increasing the value of the whole company… a sort of tragedy of the commons. Of course large shareholders create problems too, but you probably really needed them at some point. In most cases, startups can forgo or aggregate the tiny checks.

 

Cash-flow breakeven: Controlling your own destiny?

There’s a phrase I’m hearing in startup-land that I haven’t heard for a long time: “control your own destiny.” It means get your startup to cash-flow breakeven (CF BE), and then you’ll have lots of choices.

The last time this was common speak was during the ‘08-09 crisis. With a recent flight to quality in Seed funding and a crunch in Series B funding, the pursuit of cash-flow breakeven is a very worthwhile consideration now, though not a panacea. In general, the funding environment you launch a startup into – and the cash burning or saving culture it breeds – changes a startup’s path indelibly. Depression babies behave very differently than Boomer babies!

Using YC cohort and Pitchbook funding data, you can see below what happened in the last cycle. When the ‘05 to ‘07 Seed and Series A growth trend reversed in ‘08, the 2008 YC Cohort had more limited access to capital, and their failure rate doubled. After that experience, it seems YC leaders wisely coached companies in ’09 and ’10 to be more cash efficient and assume the worse for funding, at least early on. The result? The failure rate approximately halved in ’09 despite continued difficult funding dynamics.

VC.pngSource: Pitchbook, Seed-DB YC page

Wow. What a difference a year can have on one’s perspective. I’d love to hear YC’s take on how the funding environment changed their coaching then and now…

So does this mean every startup should try to get to CF BE as quickly as they can? The above case study supports that it’s a good idea if your goal is not shutting down (avoiding dead). But for many startups and pretty much every YC company I know, that is not the goal. The goal is to build a big, or a at least meaningful, company. Then the decision to drive to CF BE is more nuanced, even in today’s funding environment. Getting to cash-flow breakeven is a terrific idea when:

The target market is small, or the product is really a “feature”. In this case, proving the economic model through overall profitability, avoiding raising much capital and chugging along with 25-75% growth a year can be very value optimizing for founders who are pursuing a $25 to $75M exit.

Capital is or is expected to really dry up. Okay, this is the premise of this article and kind of an obvious. However, all funding isn’t disappearing right now. Rather, there is nuance by stage. Series B is getting harder to get, so middle-of-the-pack Series A startups might be wise to reach profitability. The same is true for very late stage startups who won’t have access to as many monster rounds in the new funding paradigm. Late stage profitability seems pretty smart right now.

When you are very early OR very late to a market. AI, IoT and vertical SaaS are raising lots of money now, because those markets are hot (at least in investors’ minds). Five years ago that wasn’t the case. On-demand marketplaces, social and horizontal SaaS were the rage. At that time, AI and IoT companies should have been hunkering down near profitability to buy time. Now in turn, it’s time for all but the best and fastest growing on-demand marketplaces, social applications and horizontal SaaS startups to consider CF BE. The best of these companies, however, can still raise tons of capital as they emerge as category leaders in these more developed markets.

While cash-flow breakeven always expands and extends options – you can keep growing organically, raise capital later to spike growth, get acquired with a smaller capital stack – there are risks too that every startup team should consider:

When scale or speed matter, slowing down to get to CF BE can undermine ultimate success. While all tech companies have returns to scale because software code has zero marginal cost, startups and products with real network effects (marketplaces, some consumer SaaS, social, etc..) can find huge enterprise value benefits to getting bigger faster with capital. Further, many markets with network effects are winner-take-all, so hunkering down takes you out of contention to win.

The slow growth spiral is also a big risk of CF BE. Startups often target CF BE because they can’t raise capital. They often can’t raise capital because they aren’t growing fast enough. Then, once they get to CF BE, they are likely to be growing even more slowly, further reducing their ability to raise capital. Vicious cycle. The best bootstrapping companies we see in the $0.5-2M revenue range are growing at 50-75% per year. This is an incredible accomplishment without outside capital, but we are typically looking to invest in companies growing >200% YoY at this stage. This suggests that getting to CF BE may, in-fact, preclude the option to raise capital later.

How do you later find your way out of CF BE if you decide to go there now? Walk before you run. I’ve met with a few amazing companies recently that are doing just this. They have a $1-2M in revenue and are growing at 50-75%. They can’t raise the normal $5-8M venture round at this stage because they don’t have the growth rate to give VCs confidence of hyper-growth. So they are starting small by raising a $1-2M angel round – there is a segment of angels that love CF BE businesses growing at 50-75%. These startups will use the cash to prove they can burn effectively to achieve high growth, bump growth to 200%+ for a year and then have the metrics to raise VC capital if they want. There are also private equity, growth capital and strategic investors who might prefer a company with more moderate growth and less burn. Venture is not the only model for capital.

Podcast – The teaming of founders and investors

Recently, my friend Jeremie Bacon invited me on his podcast series, Journeys. Jeremie is a serial entrepreneur, including founding and leading one of the first SaaS solutions for the financial services industry, Backstop Solutions.

His latest venture, Synap, is based in Chicago and is focused on aggregating all customer engagements and communication on a single platform that ties seamlessly into your email and CRM. We are beta users… highly recommend.

In our time together on Jeremie’s show, we cover the following and more:

  • Founding team dynamics and characteristics of success
  • How finding the right investor is like getting married
  • My perspective on company valuation and its significance for the entrepreneur
  • The investors of the investors – investors’ obligation to our limited partners

If you’re interested in watching, here’s a link to the the video.  

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