Transcendental Generalization

This APM Marketplace article described the need for newspapers to search for a new business model.

The old adage that railroads needed to see themselves in the transportation business, not the train business seems relevant. Newspapers need to see themselves in the trusted information business, not the printing business.

Seems like an entrepreneurial opportunity!

One of the most thought provoking chapters of the book The 4-Hour Work Week is the one on product development. One  reason it is thought-provoking is that it recommends approaching product development in almost the opposite way that most entrepreneurs follow. Here is how most people seem to think entrepreneurship works:

1. Think of an idea
2. Raise funding
3. Build the product
4. Price it to cover your costs
5. Find the first customer
6. Find more customers

The 4-Hour Work Week recommends the following approach:

1. Take a close look at the people you know
2. Decide on a product that they would like to buy
3. Think of a price they would be willing to pay
4. Get people to place orders for your product at that price
5. Get the product built at a cost that is low enough to be profitable

Another reason the chapter is thought-provoking is that it recommends treating your existing network of contacts as your target market. People don’t normally think in these terms, but it only makes sense: if you cannot sell your product to friends, family, colleagues and others with whom you share a trusting relationship, then what hope do you have of selling it to utter strangers?

Many entrepreneurs believe there is no choice but to take venture capital. How are they going to build the product otherwise? There are alternatives, however. They may seem longer and harder, but in light of the dangers described previously, they may actually look more attractive.

At our meeting in December, Kanth described how some of the early funding for his company came from consulting engagements. I also recently met an entrepreneur interested in launching a venture starting from a consulting business. The idea is to solve specific customer problems and simultaneously build a core product that is usable by multiple customers.

Software engineers will readily understand this approach. If you write software to solve similar problems, it is usually advisable to “factor out” the similar or identical components. This makes the next problem easier to solve using those components, and improvements to them immediately benefit all solutions.

The consulting approach has a number of benefits:

• The venture remains in close contact with paying customers
• The entrepreneur begins to see patterns of similar problems, and the varying contexts in which they must be solved
• The consulting business itself may become so lucrative that launching a product seems unnecessary
• The customers become a core set of early adopters for the product if and when it is built
• The customers may be willing to fund the product development venture, especially if it will solve critical problems
• Customer references are always helpful in raising venture capital on attractive terms at a later date
• The existence of multiple customers for a core product proves that there is really a market for it, and helps to characterize that market.

The most important aspect of this approach is to get engaged and stay involved with customers. That is the sustainable approach. Chasing after venture capital distracts you from this involvement. And even if you succeed in raising venture capital, it is not a sustainable source of funding for your company. And the opportunity cost of pursuing it may be deadly.

It was the day after that December meeting that I found out I was being laid off.

Unfortunately, uncertainty about the hurdle rate only inflates the effective rates of return that entrepreneurs strive for. In order to attract venture capital, an entrepreneur must inevitably promise exceptionally high returns. If they do not credibly promise to exceed an investor’s hurdle rate, then they will not get funded—the investor will keep his or her money. It is only logical for entrepreneurs to assume that the more rapidly they can promise to generate large returns, the more widely they are “casting their net” for venture funding. As this presentation suggests, entrepreneurs must “demonstrate the opportunity for a 20X - 30X return on investment”.

Once a venture is funded, it is bad faith for an entrepreneur to say, “I changed my mind! I’m going to put this in a savings account and pay you 2.5%!” So, when you see or hear about entrepreneurs spending enormous sums of money and burning through cash at a phenomenal rate, don’t be quick to conclude they are idiots. They are most likely simply following through on a commitment to investors: to exceed their hurdle rate by generating large returns rapidly.

Of course, expectations that turn out to be wrong produce economic bubbles that pop. If the entrepreneur fails to generate the expected returns, the effects are wide-ranging. If venture money was used to hire people, they will lose benefits, take pay cuts, or get laid off. The entrepreneur may default on loans or leases. Certain assets may get sold for deep discounts.

Now, if every investor walked around with their hurdle rate tattooed on their forehead, the lives of entrepreneurs might be pretty simple. They simply wouldn’t bother approaching an investor unless their ventures could exceed the hurdle rate.

Of course things are more complicated…

• The hurdle rate is different for different investors
• It depends on the particular mix of return-generating assets they currently hold as well as the assets they have access to. Some assets are liquid (quickly and easily bought and sold, like common stocks) while some are not (like Manhattan skyscrapers).
• It can change frequently as environmental factors result in higher or lower returns on held assets.
• Investors make mistakes about rates of return: putting money in what turn out to be bad investments and withholding money from what turn out to be good ones.
• The hurdle rate along with tolerance of risk can also change after investors sell assets. This may create a “hole” in the portfolio, so the investor may seek low risk even if it means low returns.
• Some investors don’t try to be purely rational in their investments. They may spend money out of a sense of charity, as a gift, or to return a favor. This is more likely to be the case with individual “angel” investors, and less likely to be the case with venture funds that pool money from multiple investors.
• They may go through personal experiences that raise or lower their tolerance of risk.

As a result, many investors (including venture capitalists) do not know their own hurdle rate at any given time. Instead, they employ rules of thumb. For example, when considering a portfolio of venture capital investments, as this presentation suggests, investors assume around half of their investments will be totally lost, another four out of ten will fail to yield attractive returns, and only one or two will actually succeed.

Over time, investors will consciously or unconsciously move money out of under-performing assets and into the best-performing ones. The hurdle rate is like Adam Smith’s invisible hand. You may not see it, but for many practical purposes, it should be assumed to be there.

The weather is cold, the economy is tight, and Valentine’s Day is tomorrow. Gourmet hot chocolate is a relatively inexpensive thrill the whole family can enjoy. (However, my children turn up their noses at anything but Swiss Miss. It even has history!)

Courtesy The Oregonian, Thursday, January 22nd:

Andina used to serve xocolatl, but I don’t know if they do anymore

And if you prefer the comfort, convenience, and warmth of mail-order, Lynne Rossetto Kasper recommends the following:

L.A. Burdick Hot Chocolate, Dark
L.A. Burdick Chocolate
P.O. Box 593
Walpole, NH 03608
Tel: 800-229-2419
www.burdickchocolate.com
$11.50 for a 12-ounce bag with small whisk, $30 for a 2-pound refill bag.
MarieBelle Aztec Hot Chocolate, Aztec
MarieBelle
484 Broome Street, Ground Floor
New York, NY 10013
Tel: 212-925-6999
866-925-8800 (toll-free)
www.mariebelle.com
$18 for a 20-ounce refill bag
Vosges Haut-Chocolat Couture Cocoa, La Parisienne
Vosges Haut-Chocolat
520 North Michigan Avenue
Chicago, IL 60611
Tel: 312-644-9450
888-301-9866 (toll-free)
773-772-5349 (mail order)
www.vosgeschocolate.com
$20 for a 16-ounce package

Venture capitalists are investors, and all investors have a hurdle rate.

Their money is tied up in different assets: cash, stocks, bonds, real estate, foreign currencies, commodities, etc. Those assets are earning them returns. The returns could be

• interest paid on cash deposits or bonds,
• dividends paid on shares of stock,
• rent paid on real estate, or
• capital gains earned from the sale of many assets, including currencies and commodities.

The returns are generated

• at a particular rate
• over some amount of time and
• with a certain level of risk.

For example, cash in a savings account is almost guaranteed to return a small amount of interest from the bank (less than 5% annually) and a large amount is guaranteed by the FDIC never to be lost. Purchase of a foreign currency might return a large amount when it is sold, but there is a good chance the investor may actually lose part of his or her investment.

The investor expects a certain rate of return from his or her current holdings. For an investor to move money into a new venture, the venture must promise a superior rate of return. This minimal rate of return is called the hurdle rate. It is not rational an investor to invest money with an entrepreneur unless the entrepreneur’s venture can exceed the investor’s hurdle rate.

Have you heard of the hurdle rate? Do you think about it in your own investments? Feel free to post comments and questions below.

In December, a small group of current and prospective entrepreneurs gathered to discuss internet product development. I was invited to participate on the panel along with Kanth Gopalpur.

One of the first topics the group raised was how to raise venture capital. New and prospective entrepreneurs seem rarely to think, “I want to become an entrepreneur…” without following it with, “…but how can I raise venture capital?”

Kanth and I reiterated the fact that a sudden influx of money can be dangerous for entrepreneurs. Whether the influx comes from a round of venture capital or from an IPO, it can create the temptation to risk customer relationships in generating investment returns. The entrepreneur risks money rapidly with the hope of large revenues, instead of spending money slowly, with the assurance of small revenues.

Although I was only relating what I had observed of entrepreneurs, I later concluded that this behavior is almost inevitable. The next three posts will discuss why.

If you have observed entrepreneurs risking money rapidly (or not), then please comment below.

In November of last year, the company I was working for laid off 15% of its workforce. Although I was not affected at that time, I started thinking seriously about what I would do if the same thing happened to me. (Good thing, as I would find out later…) I had to at least admit the possibility that working for some one else was not the best thing for me. My conclusion was that in addition to looking for a new job, I would pursue an entrepreneurial venture.

I imagine lots of people out there are thinking seriously about what they would do if they were laid off. And many of them have come to the same conclusion.

The next few posts will discuss where this conclusion has led me. If you have strong feelings about this topic (positive or negative) please post a comment below, or e-mail me.

A friend and former colleague pointed out this BusinessWeek article about a course on happiness at Harvard. I also found this book by His Holiness the Dalai Lama to be practical and helpful: