Why Startups Innovate Better Than Big Companies is a piece I did in PEhub recently

With all their resources and talent, why do big companies have trouble innovating? How can a Blekko exist when there is a Google? Or a Tapulous when there is an Electronic Arts?

Even more puzzling, why couldn’t Yahoo create Facebook with Yahoo 360 instead of losing out to a 20-year-old kid from Harvard? A lot of innovation comes from tiny teams with only $100,000 in the bank, or often a lot less. The reason is they don’t fear breaking the rules.

In reality, there’s a lot of innovation happening at big companies. But most of it is incremental. The focus is usually on process optimization and efficiency improvement. In order to support the rigid, crystalline structure of a large enterprise, lots of rules and procedures are implemented and enforced. These rules are “The Box.” The goal of most enterprise innovation is to get close to the edge of “The Box” without touching the lines – like a child drawing in a coloring book.

A startup innovator doesn’t care about rules. He doesn’t care about “The Box.” His motivation is to achieve something that has never been done. Most innovators we meet have an explicit goal of changing the world.

Another key reason why big companies aren’t good at qualitative innovation is a combination of legacy and Wall Street pressure. Most large companies do not grow very fast. Their current customer base is large, and, by comparison, the inflow of new customers is small. This imbalance creates a disincentive to introduce change and innovate. Customers often react negatively to change over the short term, and Wall Street punishes companies for taking risks.

Startups, on the other hand, are unencumbered. There’s no aversion to risk. There’s nothing to protect.

Victor (pictured above) has seen this at RingCentral. For years, the RingCentral team has pushed the envelope with cloud telephony in an old-fashioned, highly competitive telecom industry dominated by huge incumbents. It would have been easy for RingCentral to start looking over its shoulder, and then stumble and fall. But the company kept swimming upstream, winning one innovation award after another (including the prestigious World Economic Forum’s Technology Pioneer Award) and adding more loyal customers. Now, the company is enjoying industry-wide acceptance and many of the industry’s largest names have become valued partners and strategic investors.

Ben (pictured left) saw this same dynamic as he offered advice to the Tapulous and Mesmo teams competing against the major game studios. Tapulous, for example, built out a massive network of freemium users in the same gaming market that created billion dollar businesses with Harmonix Music Systems’ Rock Band and Activision’s Guitar Hero. Neither franchise was able to embrace the iPhone as the new gaming platform, or freemium as the new business model, the way Tapulous did.

Only a few big company executives and boards have the guts to resist the pressures from shareholders and Wall Street. One example of a company that did is Charles Schwab under then CEO David Pottruck. Pottruck’s big bet was to see the Internet as the future. In the late ‘90s, Schwab offered a discount brokerage service at $80 per trade and an e.Schwab platform with reduced service levels at $64 per trade. E*Trade wasn’t yet a strong competitor. That changed.

Pottruck’s bold decision was to face rising Internet competition head-on and offer all customers, online and off line, the same service levels and the same reduced price - $29.95 per trade. This bold innovation cost the company about $100 million in profit the first year, and Wall Street punished the decision. Shares dropped by about 40%. But Pottruck and Schwab were right and within nine months the stock recovered and reached new highs on massive customer growth. Some of its competitors’ product strategies were a year behind. Stories like this are few and far between.

The startup environment is different on a fundamental economic level, not just because founders are more motivated and focused, but because anytime a startup does something big, the upside is uncapped and the downside is pretty small. If a company fails, an investor loses a few million dollars. The team goes on to get new jobs.

Big companies can look at the same project with the same economics and lose a billion dollars in market cap. Netflix is an example. The risk paradigm is reversed. For any qualitative innovation, a big company has an uncapped downside and a finite upside.

That’s why startups do what they do. They have nothing to lose, only upside. It is why they are willing to change the world.

(Victor Belfor is an entrepreneur and investor and currently runs strategic alliances at RingCentral. He can be found on Twitter @vbelfor. Ben T. Smith IV is a serial entrepreneur and investor and the co-founder of MerchantCircle and Spoke. He is available on Twitter @bentsmithfour)

Ben Smith: Building Startups Is Cheap But Never Run Out of Cash

A recent piece I did for PEHub

Internet startups have been getting cheaper to build for 10 years. So why is it more important than ever not to run out of cash?

We built MerchantCircle into one of the 100 most trafficked U.S. sites and I honestly never remember signing a purchase order for more than $10,000. But that doesn’t mean we didn’t fear the ever-present prospect of running out of money.

What kept us viable was our goal of building a small, tight and flexible company. We posted a chart in every board meeting because revenue could be volatile, asking what would happen if 50% of it went away. I always had an idea of what my minimally viable team (MVT) was - just how small we could whittle down our operations. When the largest Google algorithm change hit, we juggled to protect our cash flow and innovate through it, just as we had with every hiccup.

I remember sitting down as a team during the crisis of 2008 and concluding we were fortunate we didn’t need to cut and that we had a path to cash flow breakeven. I have no doubt that is what led to our success and the fact that we never had a layoff and grew cash right up to the company’s sale. Raising more money at the time would have been difficult and costly, as it may be again soon.

This kind of diligence isn’t always the case.

Consider SimpleGeo’s sale to Urban Airship for a reported $3 million after raising $8.14 million last year, or BuyWithMe being picked up for what some news reports say is $5 million after raising $21.5 million in 2010. Top teams like SimpleGeo’s might have persevered with more time. But running out of cash comes with grave consequences. You no longer can wait around until the timing is right

I entered the startup world by getting a similar knock on the head. During the last boom, I was investing in and partnering with startups for EDS, which a few years earlier had bought my employer, A.T. Kearney. In the winter of 2000, I sat with Marc Friend, then at U.S. Venture Partners, giving him an update on Casbah, a company I had supported along with some very big name individuals, including former Apple CFO Joseph Graziano. I had just bridged the company when a term sheet was pulled – and I quickly figured out the difference between a bridge and a pier. No new deal was going to come together. The company was out of cash. I then spent a few months as interim CEO learning about asset sales and liquidators.

Marc’s advice confirmed the significance of the situation. “No cash means no maneuvering room; never ever run out of cash,” he said in so many words.

This seems pretty obvious. But I am often amazed at the excuses people come up with to explain their failure. Here are a few:

• We had bad timing. With enough cash, you can persist through the bad timing and be there when it is good timing.
• We had the wrong model. If you spend small amounts trying different models and evaluate the data, you can adjust before you have committed all of your cash and find the right model.
• This was an expensive startup to build and we did not raise enough. If you find cheap ways to experiment until you find the right unit economics, enough cash will be there.

The reasons most companies fail are two fold: a lack of persistence and a lack of cash. Persistence is something found deep inside your founding team. It is there or not. The lack of cash is something you can control.

A few lessons on cash:

• Your personal burn rate is probably the most important indicator of whether you will run out of cash. It is tough to be persistent when you are living a life that requires more money than you can earn on the side working a day a week.
• Spending $2 million on stuff is a path to running out. This used to be Oracle licenses and EMC hardware, but it can be just about anything. You don’t want to find yourself writing “return to sender” on Sun boxes, as I did in 2000.
• Don’t invest in people you can’t afford to keep around. In 1994 with the defense shrink underway, I learned one of those lessons I will never forget as a 25-year-old consultant advising the Lockheed Missiles and Space Company. COO Dick Scanlon looked me dead in the face and said, “costs walk on two feet.” Your team is your primary asset and most of your expenses.
• Senior teams burn cash not just because they are expensive, but because they have a natural tendency to hire people.
• Rent less space than you need. The greatest thing about a small space is that it forces everyone to really think hard about hiring. Besides, building people always get paid, like the landlord who collected 50% of a 2000 startup asset sale.

Here are five tips for when money gets tight

• Have trusted relationships with your bankers, lawyers, and vendors so you can extend payment terms.
• Never touch benefits, office perks, or salaries. If you have to cut you are better off cutting down to your MVT and raising salaries a bit.
• Cut all outside contractors, but never cut public relations or customer communications. This is an asset that takes forever to rebuild.
• Outside of one or two key members, cut from the top down. Junior people will grow quickly when the shade above them is removed.
• Cut twice as deep and two times as fast. Then start hiring the next month.

Sharon Wienbar, a managing director at Scale Venture Partners, will give you a pretty straight answer if you ask her about the job of a startup CEO. “Make sure the company never runs out of cash; it is the fuel of a startup,” she told the top manager of a company we were both involved in.

I can attest. She knows what she is talking about.

(Ben T. Smith IV is a serial entrepreneur and investor and the co-founder of MerchantCircle.com and Spoke.com. He is available on Twitter @bentsmithfour.)

A recent article I did for PE Hub

One of the biggest misconceptions in technology is that small acquisitions are less risky and require less attention than large ones. It is not true.

When Reply bought my company, MerchantCircle, in May it put several of my top execs in key financial and legal roles. The move was a clever way to bridge the two companies without burdening either team with integration chores.

There are numerous other secrets to avoid the pitfalls of combining early stage companies. Offer attractive long-term incentives, for instance, or show respect for the target company’s culture. Another smart idea is to assign someone to “people issues.” Whatever techniques you use, remember that buying startups with less than 50 employees requires an entirely different approach to execution and integration. Small company deals can easily go wrong.

I have read as many as 50 merger integration books over the last 20 years as a partner at the strategic consulting firm A.T. Kearney, the head of corporate development at Borland Software, and an advisor and investor to a host of startups. There is no Cisco Systems gold standard for buying small startups, though clearly Google and Facebook are two companies we will look to for lessons and pointers.

There are numerous reasons why young company mergers are hard and different. Here are five:

• Eighty percent of a startup’s value is tied up in what it is going to do not what it has already accomplished. Startups are works in progress.
• Culture matters. The DNA and culture of a startup are strong and sensitive. But teams are not big enough to protect them. So you can destroy startup DNA very quickly.
• Everyone is important. Young companies have systems that have not yet been built out, and often only one or two people know how to handle specific items. Losing one person can be huge. So all employees are critical players, not just the senior team.
• Most importantly, teams are focused on the hope and dream of changing the world. Being sold is by definition not that. So it creates a dramatic shakeup overnight.

Unless you want to be the company that sells off StumbleUpon, Del.icio.us, or Bloglines.com after you bought them - or worse, shuts down your $200 million purchase two years later - here are eight ideas worth considering.

Eight Steps to Success

• If you want the business intact (instead of just the talent) leave the team alone as a separate unit with goals for integration over an 18-month time frame. If you want the talent, have it jump to a new project within weeks. You can see both these strategies playing out in the way Google handled YouTube and how Facebook managed some of its buyouts, like Parakey.
• If you move the team to a new product, show respect for what it already built and its customer relationships. These relationships are probably deeply personal to the founders. You can see best practice in the way LinkedIn handled IndexTank. LinkedIn leveraged the team for its search expertise and is transitioning the customers over time. It also open sourced IndexTank’s technology to allow it to live.
• Make decisions up front on the 15% who won’t fit in and who will leave in the first month. Then don’t lose anyone else. Get them excited about the direction and protect the culture they had before.
• Don’t screw with things that don’t matter even if you think it will improve efficiency. And make those things you touch better, not worse. Some things, like benefits, can be the third rail unless they improve, like they did for a lot of Tapulous employees after the Disney acquisition.
• Push retention incentives in the short term to everyone on the team – and at a level that matters. Demonstrate trust on the little things, so these are credible and encourage people to get over the things you do change.
• Put long-term incentives in place that are as big as what they received early in their company’s life so they still have the dream of winning.
• Put a couple of people on each team on the other side. I mentioned how this happened when Reply bought the company I founded, MerchantCircle. MerchantCircle people stepped into leadership roles and helped smooth integration while not swamping the teams with added work.
• Put a person in place who is 100% focused on people issues. These issues will come up. If an employee finds something worth communicating, it will be worth communicating ten times in ten different ways. This won’t happen unless someone is focused on it.
• Most importantly, opportunistic acquisitions rarely work, though they seem to come up frequently. At Borland, we put a process in place to look at areas and get to know key teams over a long period of time. Clear relationships and business cases developed before a deal ever started. There is no merger integration that can fix a bad deal.

Buying small teams has always been a huge driver of innovation in the valley. Do it well, and you have a competitive tool. But recognize that small deals are often as hard as large ones. And you can find 50 ways to mess one up.

Remember that list of 50 books? I’m not embarrassed to say I’ve turned to every one. In the end, though, nothing beats the experience of being on the buy and sell side of several deals.

(Ben T. Smith IV is a serial entrepreneur and investor. He co-founded MerchantCircle and Spoke.com and was a partner at the strategy firm A.T. Kearney. He is available on Twitter @bentsmithfour.)

Are the Billions Justified for Groupon? originally published in VC Journal

Groupon’s potential $15 billion valuation may seem astronomical, but its high price tag may be justified. Groupon is one of only a handful of companies that has seemingly built a viable model for serving the massive local online ad and marketing opportunity.
The opportunity is substantial, with about 25 million small and medium-sized businesses in the United State, most of which market their business in some way online. By 2014, companies are expected to spend $145 billion annually on local advertising, representing half of all ad spending, according to BIA/Kelsey. And while spending on traditional advertising such as yellow pages, print ads and TV commercials will decline, spending on local online marketing is forecasted to grow from $15.2 billion in 2009 to $36.7 billion in 2014.
This means that over the next few years, millions of plumbers, boutiques, salons and other local businesses will seek out or expand their Internet advertising and marketing. One plumber told me that before setting up a Web presence and marketing online, he missed out on 80% of potential jobs because nearly every consumer starts their search for local products and services online.
Having an online marketing strategy is now critical for these businesses, and companies such as Groupon that help connect merchants with local consumers will benefit from this expanding market.
But while there is no shortage of local services—paid search, mobile search, social media, banner ads, daily deal coupons, mobile check-in services, and more—not all of these "local" companies will survive, let alone reach a Groupon-level valuation. In fact, while VCs have invested more than $2 billion in locally focused Internet companies over the past 10 years, many never turned a profit.
Getting local right can be tricky. Small businesses can’t afford to spend much on marketing, as price points are typically low, while the cost of sales are typically high. It usually takes a lot of door-knocking and cold-calling to sign up local businesses for new tech services. Once you've got a customer signed up, you then have to contend with high churn, because many small businesses go out of business within two to three years.
Which brings us to Groupon. While a $15 billion valuation might seem excessive for what’s basically a coupon site, the company has solved the two main challenges that have plagued online local marketing for years—low price points and the high cost of sales. Groupon gets half of every sale, which solves the problem of low-priced, fee-based marketing. And while they have a large sales staff and a stable of copywriters, they don’t have to "go out and knock on doors" to sell the service. Their early focus on virality spurred growth and helped their brand become popular with target audiences. Local businesses are now waiting in line to be the next deal of the day for a chance to get paying customers through the door.
Many things have aligned in the online economy to position the current wave of local companies for success. For one, search has become central to people’s lives. Local search is the evolution of the Yellow Pages, which was once the only "local search engine" in the home. While Groupon deals "come to you" via email, many local companies are leveraging search today. Publishing and advertising technologies that help local businesses get "found" by Web searchers are positioned to become massive success stories.
Groupon gained early traction in the space by acquiring an extensive email list and deploying a substantial sales force. So far, the company's economic model is working.
As we look to the future, new models will arise that could one day eclipse even the exciting valuation numbers seen recently. A tech company that cracks the code on empowering small businesses to create a search-optimized online presence and launch mobile and social programs by themselves could easily reach a multi-billion valuation.
Add to that a limited sales team, a self-service model, and a search-driven technology platform, and that company could essentially become the "Google of local."

Ben T. Smith, IV is the chairman and co-founder of MerchantCircle, a Mountain View, Calif.-based social networking site for local businesses. He can be reached at ben@merchantcircle.com.
By Ben T. Smith, IV, MerchantCircle

My recent article in VC Journal

How to Blow Up an Ecosystem (and Prosper Within One)

Are you a part of an ecosystem or do you plan to destroy one? You must decide before plotting a path to success

During the four years we spent building MerchantCircle, I didn’t set out to work with Google. I just wanted to bring local merchants onto the Web.

But local is search and search is Google. And that put us squarely in the Google ecosystem. So working with Google became 75% of what I thought about every day and 50% of my dreams at night.

They weren't always pleasant thoughts. And they were frequently nightmares rather than dreams.

A lot of venture investing stems from the theory that companies and products are a platform, or rather an ecosystem. This is for one simple reason: a well-managed, well-cared for ecosystem can provide fantastic long-term sustainable advantage to build and capture value.

I know this first hand. After investing in Tapulous, I spent 18 months advisingBart Decrem, the co founder, as he built a company on his idea that “this iPhone thing is going to create an ecosystem.” He then sold to Disney.

If you invest in a startup taking advantage of an ecosystem or platform, you have a chance to make great returns. On the flipside, if you make an investment in a company mining an ecosystem and the ecosystem blows up, loses its prominence or fails to expand, you are going to lose on what was supposed to be a safe bet.

Three Ways To Destroy An Ecosystem

• You can destroy an ecosystem by not knowing you have one. Google seems to not really know it has an ecosystem. It does not proactively work to support the publishers who are so important to its AdSense/Adwords success.

• You can lose an ecosystem through abuse. As a company, you may control the ecosystem, but only so far as your partners let you. Step on them enough and they will help see that you don’t own it. You only have to look at theFederal Trade Commission investigation of Google to know what it looks like when ecosystem partners hire lobbyists to convince the world you are abusing your ecosystem stewardship.

• Competitors can outmaneuver you when you are asleep at the wheel. RIMowned an ecosystem and did a great job working with carriers to extend and capture value. Then Apple came around and made developers the center of the ecosystem. Tapulous was among the first to build on the iPhone platform with a set of apps including Tap Tap Revenge. We may see this shift again as Android competes against Apple’s closed ecosystem.

Most venture-backed companies don’t own ecosystems. But they should know how to be part of them.

Three Mistakes The Little Guys Make

• Pretending you aren’t part of one. I have seen 20 startups say they hate Google and are going to market directly to local consumers. This makes about as much sense as a game company, like Tapulous, ignoring the Apple ecosystem.

• Fighting vs. embracing. Companies that recognize they are part of one sometimes try to fight to escape. Winning often means accepting and figuring out how the ecosystem’s owner thinks. At MerchantCircle, I decided to embrace the “local was search and search was Google” concept rather than fight it.

• Misunderstanding your business model. I have seen a number of companies confuse “riding an ecosystem” with a business model. You only have to look to the disk drive companies that sold into the Sun Microsystems ecosystem in the early ‘90s. They no longer exist, despite once having billion-dollar valuations.

We all want to slipstream an ecosystem. It’s important to decide if you are really part of one and whether its owners are going to destroy it. Then plot a path to success in their world.

Remember, it is a Google earth, and we just live on it. For now.

Ben T. Smith IV is a serial entrepreneur, investor and a co-founder of MerchantCircle and Spoke. He is available on Twitter at @bentsmithfour.

I originally posted this on PEhub.

When gambling on high-risk startups, the more bets you place the better, right? Maybe not.

There is an unspoken discussion going on in Silicon Valley now about the value of “Portfolio” versus “Persistence,” especially among people who have never started a company. The claim is that you can improve the odds of a Facebook-like outcome by jumping from company to company until one hits, building a portfolio of startups (and stock options). I’ve even heard people scheme to switch startups every one or two years, ready to abandon the ship the moment the rain starts.

The alternative is to stick it out and persist through the seeming insurmountable difficulties of building any young company. I think persistence cannot be overrated. But it doesn’t seem to be in vogue.

In the last month, I have been part of discussions with venture capitalists about two super hot startups where the founders are looking to leave. One of them eventually announced a sale for way under capital invested. In both cases the founders wanted to go because they feared missing something big by sticking around another two years or more.

In a more extreme case, an entrepreneur well known in valley circles gave up eight weeks after cashing the final $50K check of a $300K seed round, announcing his decision to take a new job in a text message and burning a number of angels in the process.

I have fallen into the portfolio view, too, though my combination of obsessive tendencies, loyalty and curiosity leads to me to do things like stay on the Spoke board almost 10 years after I co-founded the company. I’ve adopted a portfolio model through a little bit of investing and an agreement to help a few companies.

But it is clear to me you have to be willing to sit through the rain if you want to catch a fish. The value of this kind of founder persistence has been well dissected by a number of successful investors, from Vinod Kholsa to Mark Suster, many a lot smarter than me. In the end, the common theme is that the one solution to bad timing is persistence. Bad timing is the most frequent reason great teams with great ideas fail. The solution is to persist your way through to the point of good timing.

The most important example of this is Steve Jobs. He had a vision for the role of technology in our lives and that vision could not be delivered in the early 80’s. He didn’t give up. Instead, he persevered through getting fired and many trying years at NeXT Software to deliver the technology of his dreams. I wish more of us had that persistence. Actually I wish I had 10% of it, and I look for it in teams I fund. Good exit timing is important. But so is the drive that keeps an entrepreneur trying to solve the same problem again and again and forever feeling like he or she gave up too early.

This became clear to me a decade ago when I spent nine months cleaning up Casbah after it hit a funding wall and its founders had parted ways. I was an investor and stepped in as interim CEO and the effort extended for many months, even after I returned to my day job. This was more persistence than I wanted. But it built loyalty with investors and board members I still work with today, along with teaching me a bit about persistence.

For startup teams, here are a few things about persistence to consider:

I have been amazed when team members leave how often they don’t exercise their stock. I have even seen this happen when an exit was possible. When you leave a start up, you have to “buy” your vested stock. If you leave multiple companies you are building a portfolio, but you are doing it at a real dollar expense.

The stock you get early has a pretty low exercise price. You can choose to go to another company, but until you turn that stake to cash, you will be leaving behind a significant portion of the value of the non-vested options that’s built up while you were working at the company.

The stock you got early may have a lot of value, but without you it may be worth nothing. Startups are built on team efforts. You are more important that you think.

The people who are there are going to get more stock. You walk away from your current and future ownership when you leave. On my teams, great people, especially up-and-comers, can end up owning 3x to 6x the percentage of the company they had on day one.

What’s more, there is an enormous psychological benefit to being there all the way. I remember thinking the day we sold MerchantCircle that it would have been a lot more fun if some of those who left had stayed around. I think we would have had a better exit, and they would have, too. Buyers often structure deals to incent the teams they will work with, not those people who left.

Of course with 10-year exits persistence can be tough. But sticking with it is the way to build great companies, and it can be better for employees, too. Just look at Angie’s List and the successful IPO it launched 16 years after its founding.