Wow I didn’t realize I’d taken a whole month off from blogging. We’ve been busy with the holidays (and spending time with the four of our five kids who are home from college). But also – more to your interest – trying to put together an angel investment deal. Looks like the deal is dead (but there is some slight hope so I don’t want to name names at this point).

I’m finding a huge disconnect between investors and entrepreneurs. And not just their needs – their entire outlook on the process. It seems like they both believe they’re doing the other a favor by offering them an opportunity to be in the deal. That may sound like a win-win but it’s really a situation where each won’t accept the other’s point of view. So it makes coming to an agreement difficult.

The other problem I’m seeing is that angel investors seem to believe they are just mini VCs. So they are looking for companies they can cash out in 5-7 years for 20-plus times their investments. The chances of that happening are not strong, so VCs hedge their bets by being in a lot of deals, and trying to cut their losses when things go south. But that’s not usually what the entrepreneurs want. Especially the large numbers of entrepreneurs who have viable companies that aren’t venture companies, yet need some investment. As Paul Graham has said VCs prefer a 20% shot at making 100 million over an 80% shot at making 10 million over 100% shot at making 1 million. Entrepreneurs prefer the opposite. [I can't find the exact quote, this is a paraphrase.] I found the quote: “The founders, who have nothing, would prefer a 100% chance of $1 million to a 20% chance of $10 million, while the VCs can afford to be “rational” and prefer the latter.” It’s from The Venture Capital Squeeze

Takeaway:

• I’m looking for a model where I can invest in a company (20K, 50K maybe 100K) and contribute my experience and advice in helping the owner grow the company. Then get a healthy return. Sure I’ll take a percentage if the company gets sold to Google for a billion and a half. But if it’s merely “profitable” and not saleable, I’d like a decent income stream from the profits. Some way to insure it doesn’t get wasted on fancy company cars, extravagant off-sites etc. If you know of such a model drop me a line.

[tags]Angel Investing, Finance, Raising Money, Capital,  Small Business, Entrepreneur[/tags]

I said last time that to function as a CEO, you need a team that doesn’t depend on you for day to day successes. It’s hard to build a team like that. Impossible if you don’t understand today’s topic.

Bigger is different – not just more
Companies don’t grow in linear fashion. The characteristics change along with the size. My friend Nick at The Black Sheep started out as a professional baker. He told me you can’t just take a recipe for 3 dozen cookies and multiply everything by ten. At that size you have to change the mix for it to work right. You know the same thing if you’ve raised a family. Going from a couple to having a child is not just 1/2 again as much. It’s completely different. And the quality changes again with your second child and your third. When you only have one kid at least there’s some quite when the little one is taking a nap. When the kids start to out number the adults it’s a whole new world.

Plumbing Plateaus
The best example of this in business is to consider a plumber. The one we’re imagining works from home, has a truck and a helper and is doing well. The two of them are busy 40-50 hours a week, making a nice living. The company grosses 200K per year (at $125 an hour you do the math), the helper makes 45K and the take home pay is decent for the owner.

The company is at what I call a plateau of profitability. So she (or he) decides to grow the business. You can’t grow a company like that by 20%. The boss and her helper can’t do 20% more work – there just aren’t enough hours in the week. And 20% isn’t enough to afford another truck, another plumber and a helper. If they expanded and only grossed $240K they’d loose money. So as the company grows it falls off the plateau of profitability and enters the canyon of negative cash flow.

So what to do? As the saying goes “You can’t leap a canyon in two jumps” The solution, as you’ve probably intuited, is to figure out how much growth is required to make it profitable to run a company of two crews, trucks, helpers and all. Let’s say with increased marketing, a bit of inefficiency due to communication between 4 people, and such it would take 75% growth to be profitable at grossing $350K. That defines the next plateau of profitability.

So now the choice is this: Keep the company small (one crew) or commit to grow it by 75%, and realize it will go through a time of bleeding till it gets to the next plateau. Don’t start on that journey till you have the resources to make it all the way to the next plateau.

Tired of working at Home
Let’s say our plumber makes that leap successfully. After all it’s not rocket surgery. Lot’s of people dumber than you have done it. One day she gets tired of working at home. Doesn’t want to do paperwork at night. Hates taking calls on her cell phone when she’s on a job. She want’s to grow large enough to afford an office with a receptionist/bookkeeper. Can she afford it with just two trucks on the road? Will it take three? Five? Undoubtedly she’ll enter another canyon before she reaches that plateau. How deep is that canyon?

Build a Model not a Business Plan
To answer those questions you need a business model. By now you’ve realized that I’ve been pulling these numbers out of my butt – for illustrative purposes of course. But if you used real numbers – actual cost of vans, labor, advertising, rent, salaries plus realistic sales figures you’d have a model of how money flows through our plumbing company. The most critical feature to put in your model is capacity – the amount of work each person can reasonably be expected to do. The model shows the interrelationship between sales and the various costs required to sell and service that much business. Your model will show you how deep the canyons of negative cash flow are, what level sales have to be to reach the next plateau of profitability and by including capacity your model will show you how many crews it will take to reach that level.

A model is different from a business plan in two ways: 1. It explicitly includes capacity. 2. It’s not time based. Everyone knows that the monthly numbers for most business plans are fiction. What a model allows you to do is state your assumptions (It will take 6 months to increase sales by 50%) and then adjust as reality hits the fan.

What a model does is take the experience, wisdom and gut feel that most entrepreneurs live by and quantify them in a way that you can monitor the progress of your team. That way the changes and tweaks needed to make any vision a reality don’t depend on your immediate involvement. This gives you the space to be the CEO and do the strategic directing of the company.

Takeaways:

• If you expect to build a team that can handle the day to day without you, and allow you to be the CEO – a detailed model is a must.
• This is harder than it looks because it requires you to make guesses and assumptions before hand rather than just make decisions when stuff comes up.
• A well-built model has a place to note your guesses and adjust them as they get tempered by actual accomplishments.
• The model is always a work in progress – but it allows you to see on a daily basis if you need to, how changes will affect your most critical resources: Cash, and staff capacity.

[tags]Business Model, Small Business, Entrepreneur, Management, How to be CEO,CEO Skills, Profitability[/tags]