Blank Checks: Unleashing the Potential of People and Businesses

How an unusual management technique inspires business teams to envision — and achieve — breakthrough results.

strategy+business magazine
by Sanjay Khosla and Mohanbir Sawhney

Illustration by Jack Unruh

English: (Photo credit: Wikipedia)

In 2007, Kraft Foods Inc. was facing a major challenge with Tang — the powdered breakfast drink that had long been one of its iconic brands, made famous in the 1960s when the National Aeronautics and Space Administration included the drink in the rations for U.S. astronauts. The brand was caught in a cycle of underperformance … In 2007, the leadership team of Kraft’s developing markets identified Tang as one of their top 10 focus brands, and came up with an unusual strategy for boosting the brand’s sales …: Tang leaders in key countries such as Brazil were given a “blank check,” essentially urging them to dream big and not worry about resources. The results have been astounding. In the last five years, Tang has doubled sales outside the U.S. and become a profitable, US$1 billion brand there (in comparison, it had taken Tang 50 years to reach the $500 million revenue mark). …

IN SPACE - JULY 15: In this handout image provided by the National Aeronautics and Space Administration (NASA), Expedition 28 crew and the STS-135 Atlantis astronauts (L-R, front) NASA astronaut Mike Fossum, NASA astronaut Chris Ferguson, Russian cosmonaut Andrey Borisenko and NASA astronaut Ron Garan; (L-R, middle) NASA astronaut Sandy Magnus and Russian cosmonaut Alexander Samokutyaev; (L-R, back) NASA astronaut Doug Hurley, NASA astronaut Rex Walheim, Russian cosmonaut Sergei Volkov and JAXA astronaut Satoshi Furukawa pose for a portrait aboard the orbiting complex's Kibo laboratory of the Japan Aerospace Exploration Agency on the International Space Station July 15, 2011 in space. Space shuttle Atlantis is on the last leg of a 12-day mission to the International Space Station where it delivered the Raffaello multi-purpose logistics module packed with supplies and spare parts. This was the final mission of the space shuttle program, which began on April 12, 1981 with the launch of Colombia. (Image credit: Getty Images via @daylife)

The secret of Tang’s turnaround was to free the team from resource constraints that could limit their imagination, inspiring them to achieve unprecedented results that would create a virtuous cycle of growth. … Managers have always been taught that they have to work with the limited resources available. Unfortunately, resource constraints … also limit the creative potential of people.

…  We believe that business leaders can unleash tremendous untapped potential by unshackling their people and their businesses from resource constraints (while still, of course, holding them accountable for results). The key insight is that business leaders, … should focus on defining ambitious goals, while leaving it to their managers and their teams to ask for whatever resources they need to achieve these goals. When teams decide their own budgets, they act as owners and are inspired to achieve the impossible. At Kraft Foods (where coauthor Sanjay Khosla is president of the developing markets group), we call this idea a “blank check” initiative.

The Concept of a Blank Check

A blank check is a metaphor for the freedom a team is given to determine for themselves the financial resources they need to achieve a set of agreed-upon goals within a defined time frame. … However, blank checks are not a license to spend without limits, without guidelines, or without consequences. Teams have to define the resources they need — they must fill in the amount of the blank check. Every blank check initiative needs to be consistent with the company’s overall business strategy. And it needs to have the potential to produce sustained, profitable growth. (See “Driving the Virtuous Cycle of Growth.”) Blank checks are not meant to produce “one-hit wonders” ... The idea of the blank check is to empower big ideas that drive a virtuous cycle and change the business’s trajectory for the long term.

Moreover, teams that sign up for blank checks are held strictly accountable for quantifiable results. Blank checks represent freedom within a framework ... For example, the framework might include a set of company priorities or areas of focus, innovation platforms, big bets, or even an acquisition strategy that guides the company’s overall strategy or vision. At Kraft Foods, for example, the company’s developing markets business has a focused growth strategy that concentrates on five key categories (e.g., biscuits and chocolate), 10 power brands (e.g., Oreo, Tang, Trident, and Cadbury), and 10 priority markets (e.g., Brazil, India, and China); the strategy is called 5-10-10. (See “Growth through Focus: A Blueprint for Driving Profitable Expansion,” by Sanjay Khosla and Mohanbir Sawhney, s+b, Autumn 2010.) The company uses this strategy as its framework, and gives freedom to select teams in the organization to drive the 5-10-10 growth agenda with blank checks.


Tang’s localized flavors are boosting sales. Photographs courtesy of Kraft Foods Inc.

How Blank Checks Work

To put the blank check idea to work, business leaders need to go through a systematic process of picking the best bets, selecting the team, defining goals and plans, kicking off the initiative, and monitoring the results. Here’s what happens at each of these five steps.

1. Picking the best bets. The first step …is … to choose the business domains that should be targeted for growth. … Business domains can be defined in different ways or viewed through different lenses — a geographic market (China, for example), a brand (Tang), a channel (food service), a category (beverages), or a consumer segment (teenagers). …We recommend selecting two or three definitions for the domain, at most, and using these definitions to shape the larger strategic context within which to look for blank check projects. The objective is for the initiative to be performance-driven and values-led ...

As the business leaders choose the domains for the blank check initiatives, they need to keep three criteria in mind …“the three Ms.” First, the business should ideally have significant Momentum. It is always easier to build on a business domain that is working well than to fix a domain that is broken. ... A second key success factor for driving a virtuous cycle of growth is Margin potential in the business. ... Third, the business initiative should be Material — something that produces high impact with the least possible effort. …

2. Selecting the team. Blank checks are ultimately bets on people, ...
Team leaders selected for blank check initiatives need not be the most senior or the most experienced — more important is for them to be the people with the most potential. …

The business leaders must ask themselves a series of questions about the blank check candidate. Is this person a natural choice for the challenge based on his or her current responsibilities and span of control? Will this person be willing to take on the responsibility and not be frozen by fear? Is this person capable of being stretched to think in new ways? Does this person have the capacity to inspire others to do things differently? Does this person have a track record of delivering results? … And if one cannot be identified, leaders may determine that the area of the business they were targeting is not appropriate for a blank check.

3. Defining goals and plans. … Targets need to be quantified, aggressive, and time-bound. Quantified targets are unambiguous, so everyone clearly understands the nature and goals of the game. Targets should be measurable on well-defined metrics like revenues, gross margins, and cash flow from the business.

Targets also need to be aggressive, to the point that they should not be achievable simply by making incremental improvements. Teams should be forced to question all their assumptions about their business and to confront orthodoxies that have been blindly accepted by the company. Blank check initiatives also need to have a short time frame, limited to a few years at most. It is absolutely essential to have a clearly defined set of goals for the first 12 months. The short time frame forces the team members to produce results quickly. …
At this stage, the team leaders are asked to submit a short business proposal … that reflects the three Ms.

The time given to the team to develop the proposal is relatively short. This prevents the team from becoming paralyzed by overanalysis. …In a few cases, the team will decide to turn down the blank check. This is fine, because undertaking a blank check initiative must always be voluntary.

The business proposal needs to define the initiative and the key steps that the team will take to produce the agreed-upon results. This includes … steps detailing how the plan will be executed, key milestones and deliverables, and financial projections. At the early proposal stage, the initial execution steps may be outlined, but the full project need not be fully fleshed out.

Along with the proposal, the team also must fill in the amount of the blank check — the financial outlay that they are asking for. … The amount should be more than enough for the team to carry out the initiative without worrying about running out of money to invest.

4. Kicking off the initiative. Once the business plan has been agreed upon, business leaders need to formally “issue the check” by approving the amount the team has asked for and transferring it into an account that can be accessed by the team leaders.

The typical first reaction to a blank check challenge is skepticism. … Once the team realizes that their business leaders are serious, skepticism can easily give way to fear — fear of failure and fear of being in the spotlight. Fear is often followed by frenetic activity, when the team tends to focus on doing more of the same or doing the same things better. But the team quickly realizes that this linear and extrapolative thinking will not produce the breakthrough results that they need to achieve. This, in turn, leads the team to powerful insights because they are forced to focus on the essence of the business, the brands, and the market.

5. Monitoring results. As the blank check initiative begins, it is important to set milestones for key deliverables, and then to monitor them closely as the initiative proceeds. … As is true of a company’s startup phase, blank check initiatives rarely go according to plan. The team will run experiments and take risks, and some of these experiments will inevitably fail. Failing is part of the learning process. What is important is to fail early, fail cheaply, and learn fast from the failures. Metrics for blank check initiatives should be kept simple enough so that progress can be measured on a single-page report. …

Dealing with Failures

Blank checks produce spectacular results when they work. However, … a certain percentage of them will be unsuccessful. Business leaders need to be prepared for some of these initiatives to fail. There are two important lessons in dealing with failures — learn from the failures and overcome the fear of failure.

Kraft’s Royal affordable nutrition program in Latin America is an example of how to deal with a blank check initiative that doesn’t work out. Kraft believed that there was a large opportunity to drive growth at the “bottom of the pyramid” by developing nutritious yet affordable products for low-income Latin American consumers. … However, the products failed to sell well, and the gross margins were lower than expected. Kraft decided to pull the plug on this initiative.

The team learned many important lessons from this failure. The product involved changing consumers’ attitudes and behavior — a difficult and lengthy process. … And the business model was not sustainable: Costs were too high, and the company could not meet the affordability target it had set while still earning an acceptable gross margin. Importantly, the team leading the initiative was not penalized; the team leader was promoted to head the snacks business in Brazil despite the failure, because he took a risk and then learned from his mistakes.

Tips for Managing Blank Checks

Through our experience with several blank check initiatives in different product categories and markets, we have identified some important principles for improving the odds of success.

Focus on what matters. … In the case of Kraft Foods, blank checks are linked to the company’s “winning through focus” strategy, which allocates resources in line with its 5-10-10 strategy.

Create a virtuous cycle of growth. …Business leaders should be careful that teams don’t undertake initiatives that can boost revenues in the short term but that will hurt the business in the longer term. To ensure sustainable profitable growth that drives a virtuous cycle, blank check initiatives need to be gross-margin accretive. Margin expansion can come from increased revenues, from cost reduction, or from productivity improvement.

Innovate broadly. To harness the full potential of their business, teams need to take a broad view of innovation that goes well beyond creating new products. They need to innovate with packaging, promotions, advertising, distribution, and partnerships.

Simplify everything. … Complexity adds cost and slows down decision making. … Simplification can be achieved in the product (for example, by reducing performance or features to “just enough” levels desired by consumers), in the process (manufacturing, distribution, sales), in the organization (removing layers and moving decision making closer to local markets), and in administration (faster decision making and fewer meetings).

Don’t overdo it. … Blank checks are powerful tools, but they are very demanding in terms of both financial resources and leadership bandwidth. They will produce revenue and profit increases in the long run, but they require significant investments in the short term. They also require a lot of personal attention from business leaders. Just as venture capitalists limit the number of startup investments they make and the number of company boards they serve on, business leaders need to limit the number of blank checks they issue simultaneously.

Create a family spirit. Blank check initiatives require every team member to put the collective good of the team above his or her ego and personal point of view. … This attitude can be fostered by adjusting incentives so that team members win when the team wins as a whole. It also helps to host “family dinners” before every major leadership team meeting. Each dinner has a clear agenda focused on two or three business issues that need input from the family. At the end of the dinner, the team arrives at a consensus on the business issues. This practice gives the team clarity on what they need to do and also promotes a sense of shared ownership of the outcomes.

Driving Organic Growth

It is not easy to find profitable organic growth. Faced with stagnant demand, intensifying competition, and greater pricing pressures, business leaders feel that their growth is constrained by the environment in which they find themselves. However, the constraints are sometimes of their own making. Even seemingly sleepy businesses hold tremendous untapped potential. If business leaders can liberate their people from the limitations of budgets and resources, they will find that their people will surprise both leaders and themselves with what they can achieve. This is the power of blank checks.

Driving the Virtuous Cycle of Growth

Although blank checks are designed to create a step change in the growth of a business, it is important that the growth in revenues and profits is lasting. … [True] shareholder value is created when the profitable growth is sustained over the long term.

To ensure that blank checks produce durable profit and revenue growth, it is important to embed the blank check initiatives within a well-defined process that ensures checks and balances on the initiatives. We call this the Virtuous Cycle of Growth. The virtuous cycle is based on a seemingly simple insight — the more you grow revenues and cut costs, the more resources you have available to invest in future growth. The essence of the virtuous cycle is that growth generates resources that drive more growth. The virtuous cycle consists of five steps; each step emphasizes an outcome and the means to achieve the outcome. These steps need to be followed rigorously to ensure that blank check initiatives remain on track.
— S.K. and M.S.

Author Profiles:

• Sanjay Khosla is president of developing markets at Kraft Foods Inc.
• Mohanbir Sawhney is the Robert R. McCormick Tribune Foundation Clinical Professor of Technology and director of the Center for Research in Technology & Innovation at the Kellogg School of Management at Northwestern University.

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The 10 Biggest Mistakes Entrepreneurs Make

Growing Your Empire Newsletter

By Paul Lemberg

It's hard to avoid certain mistakes, especially when you face a situation for the first time. In fact, many of the following mistakes are hard to avoid even if you're an old hand. Of course, these are not the only mistakes CEOs make, but they sure are common enough. …

1. Big Customer Syndrome
If more than 50 percent of your revenues come from any one customer you may be headed for a meltdown. … [You] are so busy servicing that one big account that you fail to develop additional customers and revenue streams. Then suddenly, for one reason or another, that customer goes away and your business borders on collapse.

Use that burgeoning account as both a cause for celebration and a danger signal. Always look for new business. And always seek to diversify your revenue sources.

2. Creating products in a vacuum.

Image by ronploof via FlickrYou and your team have a great idea. … When you finally bring it to market, no one is interested. Unfortunately you were so in love with your idea you never took the time to find out if anyone else cared enough to pay money for it. …

… Do the market research up front. … Talk to potential customers, at least a dozen of them. … If enough people say "yes" go ahead and build it. Better yet, sell the product at pre-release prices. Fund it in advance. If you don't get a good response, go on to the next idea.

3. Equal partnerships
Suppose you are the world's greatest salesman, but you need an operations guy to run things back at the office. Or you are a technical genius, but you need someone to find the customers. Or maybe you and a friend start the company together.

In each case, you and your new partner split the company 50/50. That seems fine and fair right now, but as your personal and professional interests diverge, it is a sure recipe for disaster. Either party's veto power can stall the growth and development of your company, and neither holds enough votes to change the situation.
Almost as bad is ownership split evenly among a larger number of partners, or worse, friends. … No one has the final say, every little decision becomes a debate, and things bog down quickly.

Image via WikipediaTo paraphrase Harry Truman, the buck has to stop somewhere. Someone has to be in charge. Make that person CEO and give them the largest ownership stake, even if it's only a little more. 51/49 works much better than 50/50. If you and your partner must have total equality, give a one percent share to an outside advisor who becomes your tie-breaker.

4. Low prices
Some entrepreneurs think they can be the low price player in their market and make huge profits on the volume. Would you work for low wages? Why do you want to sell at low prices? … Remember, low margins = no profits = no future. So the grosser the better.

Set your prices as high as your market will bear. Even if you can sell more units and generate greater dollar volume at the lower price (which is not always the case) you may not be better off. … Figure all your incremental costs. Figure in the extra stress as well. For service companies, low price is almost never a good idea. How do you decide how high? Raise prices. Then raise them again. When customers or clients stop buying, you've gone too far.

5. Not enough capital
… Regardless of the cause, many businesses are simply undercapitalized. Even mature companies often do not have the cash reserves to weather a downturn.

Be conservative in all your projections. Make sure you have at least as much capital as you need to make it through the sales cycle, or until the next planned round of funding. Or lower your burn rate so that you do.

6. Out of Focus
… [Many] entrepreneurs - hungry for cash and thinking more is always better - feel the need to seize every piece of business dangled in front of them, instead of focusing on their core product, service, market, distribution channel. Spreading yourself too thin results in sub-par performance.

Concentrating your attention in a limited area leads to better-than-average results, almost always surpassing the profits generated from diversification. …

… Don't spread yourself thin. Get known in your niche for the thing you do best, and do that exceedingly well.

Image via Wikipedia7. First class and infrastructure crazy

Many a startup dies an untimely death from excessive overhead. … Your management team should earn the bulk of their compensation when the profits roll in, not before.

… Spend all the money really necessary to achieve your objectives. Ask the question, will there be a sufficient return on this expenditure? Everything else is overhead.

8. Perfectionitis
… Finishing the last 20 percent of the last 20 percent could cost you more than you spent on the rest of the project. When it comes to product development, Zeno's paradox rules. Perfection is unattainable and very costly at that.

Plus, while you're getting it right, the market is changing right out from under you. On top of that, your customers put off purchasing your existing products waiting for the next new thing to roll out your doors.

… Focus on creating a market-beating product within the allotted time. … Know when you have to stop development to make a delivery date. When your time's up, it's up. Release your product.

Image via Wikipedia9. No clear return on investment

Can you articulate the return which comes from purchasing your product or service? … You say it's too hard to quantify? … If it's too difficult for you to figure, what do you expect your prospect to do?

… Talk to your customers, create case studies. Come up with ways to quantify the benefits. … If you can demonstrate the great return on investment your product provides, sales are a slam dunk.

10. Not admitting your mistakes.
… At some point you realize the awful truth: you have made a mistake. Admit it quick. Redress the situation. … Sometimes this is hard, but, believe me, bankruptcy is harder.


Assume your costs are sunk. Your money is lost. There is good news: your basis is zero. From this perspective, would you invest fresh money in this idea? If the answer is no, walk away. Change course. Whatever. But do not throw any more good money after bad.
OK, everybody makes mistakes. Just try to catch them quickly, before they kill your company.

***
Paul Lemberg helps small business owners become wealthy. Since 1995, Paul has helped hundreds of small business owners achieve outstanding success. He has written three books, including Faster Than the Speed of Change, Earn Twice As Much with Half The Stress (co-authored with Tom Matzen), and his latest, the business best seller, Be Unreasonable. On television, Paul has appeared on Good Morning America, CNN, Financial News Network, and dozens of national radio programs. His work has been featured in over eighty magazines and publications including the New York Times and the Los Angeles Times, as well as the world's largest circulation newsletter, Bottom Line Personal. You can learn more about Paul at http://www.paullemberg.com/.

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Richard Branson on How to Avoid Common Startup Mistakes

Image via CrunchBase

Entrepreneur.com
BY Richard Branson

Editor's Note: Entrepreneur Richard Branson regularly shares his business experience and advice with readers. What follows is the latest edited round of insightful responses. …

Q: What are some of the most common mistakes entrepreneurs make when starting out? -- John Gachiri

A: Making mistakes is part of the process of building a company; quickly recovering from them is what's most important. …

But your way forward is not entirely uncharted: When you notice an opportunity that has never occurred to anyone else, there are certain steps to turning your vision into reality. You must formulate an innovative business plan, find funding, hire the right people to carry out the plan, and then step back from your role in the business at exactly the right moment.

Step 1: Stay on Target
A mistake often associated with the first step is signaled by an entrepreneur's inability to clearly and concisely convey his idea. You have to be able to generate buy-in from investors, partners and potential employees, so nail down your "elevator speech" -- what you would say if you ran into an important potential investor in an elevator. Try using a Twitter-like template to refine the essence of your concept into just 140 characters. Once you've done that, expand your message to a maximum of 500 characters. Remember, the shorter your pitch is, the clearer it will be.

An associated error is lack of focus. ... Clearly define your goals and strategies, then establish a timeline. Don't let the other possibilities or hazy dreams distract you from achieving your goal.
Getting too far ahead of yourself is also dangerous. If your product or service is still on the drawing board, don't get sidetracked by plans for future versions. As a general guideline, looking two or three years ahead is best, but the nature of your business and feedback from your investors will help you determine just how far ahead you should plan.

Be flexible, because just as lack of planning can be a problem, adhering blindly to your plan is a surefire way to steer your company off a cliff. A successful entrepreneur will constantly adjust course without losing sight of the final destination.

Step 2: Be Realistic About Costs
Don't shortchange your start-up when estimating the funds you will require -- you'll just diminish your chances of success. Keeping your expenses under control is vital, but don't confuse capitalization with costs. …

Step 3: Hire the People You Need, Not the People You Like
As tempting as it may be to staff your new business with friends and relatives, this is likely to be a serious mistake. If they don't work out, asking them to leave will be very tough.

When Virgin starts any new business, we always hire a core team of smart people who already know the industry and its inherent risks. … One of your goals should be to find a manager who truly shares your vision, and to whom you can someday confidently hand the reins so that you can carry out the next step.

Step 4: Know When to Say Goodbye
A great entrepreneur knows when the time has come to leave the CEO role. It's seldom easy, but it has to be done: few entrepreneurs make great managers. …

Stepping back doesn't mean turning your back on your business. …

Image via CrunchBaseImage via CrunchBaseFounders shouldn't hesitate to re-insert themselves into their businesses when necessary -- look at Larry Page, who temporarily returned to the CEO role at Google in April. That said, I had to laugh when I heard this news, wondering how many managers at Virgin businesses had thought, "Wow, I hope this doesn't give Richard any ideas."

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10 Mistakes Growing Companies Routinely Make

 Forbes
Martin Zwilling, Contributor
I provide pragmatic advice and services to entrepreneurs and startups.
+ Follow

9/28/2011 @ 2:04PM |1,936 views

I’ve been advising and mentoring startups and growth companies for years, … for the sake of growth and survival.  When you try new things, you make mistakes, ... Smart companies learn from their own mistakes, but some don’t pay enough attention to other people’s mistakes.  …[Here] are some common mistakes that seem to happen routinely:

1. Wait until your company is up and growing before you formalize it. …The simple answer is to do something, and start simple. In almost every state, you can incorporate as an LLC with a minimal effort, and a cost in the hundred dollar range. This step shows everyone you are serious, and limits your liability on any mistakes. It also forces you to pick a name for your company and put other intellectual property stakes in the ground.  It’s not that hard to change later to a C-Corp.

Image via WikipediaCompany and product naming may also seem simple, but should be a key early effort, because mistakes can be very costly. You may recall the Chevy Nova, a compact car from GM. Pundits in Latino countries quickly pointed out that the name, ‘no va’ means ‘does not go’ in Spanish. Professional advice in this area is highly advised. Cultural and religious implications must be very carefully considered.

2. Rely on informal agreements with partners. You may all be friends, or spouses, today, but things do change quickly in the stress of a growing company. The same principles apply to strategic partners. …

3. Quick to hire and slow to fire. … The message here is that if you don’t know exactly what help you need, you probably won’t get it. … On the other end of the process, don’t hesitate to pull the trigger fast when a new hire isn’t working, but don’t forget to be human and follow all the steps. Carrying a non-performing employee probably triples the costs, since you are paying two people to do the job, and at least one other is de-motivated by the inequity.

4. Only hire people who like you or think like you. …  Look for the thoughtful challenge to your ideas, and practice active listening, when you are selling your vision. … Make it a rule to not fraternize with your employees, and choose your partners wisely.

Image via Wikipedia5. Be super-conservative on your cash needs. Double-check both the money you need before funding, and the size of investor funding requests.  …You should buffer the first by 50%, and the second by 25%. Severe cash flow problems are a big mistake, and may not be recoverable. When you have people and their families depending on you for their paychecks, and you are strapped for money, there certainly won’t be any money for growth. Even if you can find someone willing to help, it may be a very expensive proposition.  Cash is more important than profit.

6. Let your accountants manage the expenses. … In reality, the most important task of a every small company CEO is to review every expense with a miserly hand before the money flows out. Do not delegate this task. … The result of budget and expense overruns is not only lost growth opportunities, but lost credibility and lost support from investors and vendors.

7. Make all the decisions yourself.  …  For a company to grow, the team has to grow, and decisions must be delegated.  …Even early in the startup process, you need someone like-minded but complementary in skills to help you with the startup plans. … Lastly, make good use of your Board Members. One or two “experts” who have “been there and done that” can head off many mistakes and suggest a calm recovery plan for the ones you make.  …

8. Defining the strategy is a one-time process. Assume your initial strategy will be wrong. … Plan for strategy changes by scheduling an adjustment review every month. … Be sure to communicate changes to the team effectively and often, so it doesn’t look like you are making random changes.

9. Let the daily crisis keep you from the “most important” issues. It takes practice and effort to focus on the most important things first. In business, “most important” means time to market, customer service, low cost, and beating your competitors. It also means knowing when to delegate, when to rest, and reserving time for effective communication with your team. If you allow yourself to be driven by the crisis of the moment, you will lose the ability to set priorities and focus on goals. …

10. Ignore the mistakes of others. The biggest mistake of growing companies is failing to learn from the mistakes of others, or even from your own mistakes. … Wise people admit their mistakes easily, and move the focus away from blame management and towards learning. The …reality is that making mistakes is part of every successful growth effort.  … But the one unforgivable mistake you should never make is to repeat a previous mistake. …

I am the Founder and CEO of Startup Professionals, a company that provides services to startup founders around the world. My background includes a 30-year track record as an executive in general management, computer software development, product management, and marketing. I'm now in "give-back mode" as a mentor to startup founders, and an Angel investor. My experience with investors includes roles on the selection committee of two local Angel groups, and working from the other side of the table with several VCs in Silicon Valley. In addition to blogging, I recently released my first book titled “Do You Have What It Takes To Be An Entrepreneur?” You can contact me directly at marty@startupprofessionals.com .
The author is a Forbes contributor. The opinions expressed are those of the writer.

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The No. 1 Predictor of Startup Failure: Premature Scaling

 PEHub
Posted on: September 5th, 2011
Joanna Glasner

…The Startup Genome Project … published last week, crunches data from a set of more than 3,200 companies, seeking to identify the qualities that make startups most likely to either succeed or fail.
… The most consistent predictor of failure, …was a startup’s propensity to engage in premature scaling.

What is premature scaling? The authors define it as “focusing on one dimension of the business and advancing it out of sync with the rest of the operation.” For example, a startup may overspend too early on customer acquisition, hire too many employees, or focus too much on engineering at the expense of customer development. …

Researchers at the Startup Genome project, an eight-month-old effort supported by a collection of startup industry insiders and academics, also churned out some other interesting findings related to startup success. Insights include:

Pivoters do better: Switching a core facet of one’s business model, or pivoting, is sometimes the only way a startup can stay competitive in a fast-changing market. …

Image via Wikipedia… Researchers found startups that pivot once or twice raise 2.5 times more money, have 3.6 times better user growth, and are 52% less likely to scale prematurely than startups that pivot more than two times or not at all.

Co-founders scale faster: Researchers found solo founders take 3.6 times longer to reach scale stage compared to a founding team of two, and they are 2.3 times less likely to pivot.

Business and Technical Partners Outperform: Teams with one business and one technical founder raise 30% more money, have 2.9 times more user growth, and are 19% less likely to scale prematurely than technical or business-heavy founding teams.

Founders are ridiculously over-optimistic: Researchers found that startups need two to three times longer to validate their [market] than most founders expect. Startups that haven’t raised money, meanwhile, tend to over-estimate their prospective market size as 100 times bigger than it actually is.

Interestingly, while premature scaling is quite common, its opposite, which the authors call dysfunctional scaling, is quite rare. … Curious to see if you’re committing any of these startup sins? The Startup Genome Project has a tool for companies to test whether they are scaling prematurely.

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The 18 Mistakes That Kill Startups

Paul Graham's web page

Image via CrunchBase

October 2006

In the Q & A period after a recent talk, someone asked what made startups fail.

… If you have a list of all the things you shouldn't do, you can turn that into a recipe for succeeding just by negating. … It's easier to catch yourself doing something you shouldn't than always to remember to do something you should. [1]

In a sense there's just one mistake that kills startups: not making something users want. … So really this is a list of 18 things that cause startups not to make something users want. …

1. Single Founder
…What's wrong with having one founder? To start with, it's a vote of no confidence. It probably means the founder couldn't talk any of his friends into starting the company with him. That's pretty alarming, because his friends are the ones who know him best.

… Starting a startup is too hard for one person. …[You] need colleagues to brainstorm with, to talk you out of stupid decisions, and to cheer you up when things go wrong.

The last one might be the most important. The low points in a startup are so low that few could bear them alone. When you have multiple founders, esprit de corps binds them together in a way that seems to violate conservation laws. Each thinks "I can't let my friends down." This is one of the most powerful forces in human nature, and it's missing when there's just one founder.

2. Bad Location
Startups prosper in some places and not others. Silicon Valley dominates, then Boston, then Seattle, Austin, Denver, and New York. After that there's not much. …

It's an interesting question why cities become startup hubs, but the reason startups prosper in them is probably …: that's where the experts are. Standards are higher; people are more sympathetic to what you're doing; the kind of people you want to hire want to live there; supporting industries are there; the people you run into in chance meetings are in the same business. …

3. Marginal Niche
… If you make anything good, you're going to have competitors, so you may as well face that. You can only avoid competition by avoiding good ideas.

I think this shrinking from big problems is mostly unconscious. …Your unconscious won't even let you think of grand ideas. So the solution may be to think about ideas without involving yourself. What would be a great idea for someone else to do as a startup?

4. Derivative Idea
… If you look at the origins of successful startups, few were started in imitation of some other startup. Where did they get their ideas? Usually from some specific, unsolved problem the founders identified.
…

It seems like the best problems to solve are ones that affect you personally. …

…Instead of starting from companies and working back to the problems they solved, look for problems and imagine the company that might solve them. [2] What do people complain about? What do you wish there was?

5. Obstinacy
In some fields the way to succeed is to have a vision of what you want to achieve, and to hold true to it no matter what setbacks you encounter. Starting startups is not one of them. … Startups are more like science, where you need to follow the trail wherever it leads.

So don't get too attached to your original plan, because it's probably wrong. Most successful startups end up doing something different than they originally intended—often so different that it doesn't even seem like the same company. …

… Switching to a new idea every week will be equally fatal. … If in each new idea you're able to re-use most of what you built for the previous ones, then you're probably in a process that converges. Whereas if you keep restarting from scratch, that's a bad sign.

Fortunately there's someone you can ask for advice: your users. If you're thinking about turning in some new direction and your users seem excited about it, it's probably a good bet.


6. Hiring Bad Programmers
…So how do you pick good programmers if you're not a programmer? I don't think there's an answer. I was about to say you'd have to find a good programmer to help you hire people. But if you can't recognize good programmers, how would you even do that?

7. Choosing the Wrong Platform
A related problem (since it tends to be done by bad programmers) is choosing the wrong platform. …

Platform is a vague word. It could mean an operating system, or a programming language, or a "framework" built on top of a programming language. It implies something that both supports and limits, like the foundation of a house. …

How do you pick the right platforms? The usual way is to hire good programmers and let them choose. But there is a trick you could use if you're not a programmer: visit a top computer science department and see what they use in research projects.

8. Slowness in Launching
… It takes an effort of will to push through this and get something released to users. [3]

Startups make all kinds of excuses for delaying their launch. Most are equivalent to the ones people use for procrastinating in everyday life. …

One reason to launch quickly is that it forces you to actually finish some quantum of work. Nothing is truly finished till it's released; you can see that from the rush of work that's always involved in releasing anything, no matter how finished you thought it was. The other reason you need to launch is that it's only by bouncing your idea off users that you fully understand it.

Several distinct problems manifest themselves as delays in launching: working too slowly; not truly understanding the problem; fear of having to deal with users; fear of being judged; working on too many different things; excessive perfectionism. Fortunately you can combat all of them by the simple expedient of forcing yourself to launch something fairly quickly.


9. Launching Too Early
Launching too slowly has probably killed a hundred times more startups than launching too fast, but it is possible to launch too fast. The danger here is that you ruin your reputation. You launch something, the early adopters try it out, and if it's no good they may never come back.

… We suggest startups think about what they plan to do, identify a core that's both (a) useful on its own and (b) something that can be incrementally expanded into the whole project, and then get that done as soon as possible. …

The early adopters you need to impress are fairly tolerant. They don't expect a newly launched product to do everything; it just has to do something.


10. Having No Specific User in Mind
You can't build things users like without understanding them. I mentioned earlier that the most successful startups seem to have begun by trying to solve a problem their founders had. Perhaps … the problems you understand best are your own. [4]

That's just a theory. What's not a theory is the converse: if you're trying to solve problems you don't understand, you're hosed.

And yet a surprising number of founders seem willing to assume that someone, they're not sure exactly who, will want what they're building. Do the founders want it? No, they're not the target market. Who is? Teenagers. … Or "business" users. What business users? Gas stations? Movie studios? Defense contractors?

You can of course build something for users other than yourself. … But you should realize you're stepping into dangerous territory. …

… When designing for other people you have to be empirical. You can no longer guess what will work; you have to find users and measure their responses. …

Image via Wikipedia11. Raising Too Little Money
Most successful startups take funding at some point. Like having more than one founder, it seems a good bet statistically. How much should you take, though?

Startup funding is measured in time. Every startup that isn't profitable (meaning nearly all of them, initially) has a certain amount of time left before the money runs out and they have to stop. …

Too little money means not enough to get airborne. What airborne means depends on the situation. Usually you have to advance to a visibly higher level: …It depends on investors, because until you're profitable that's who you have to convince.

So if you take money from investors, you have to take enough to get to the next step, whatever that is. [5] Fortunately you have some control over both how much you spend and what the next step is. We advise startups to set both low, initially: spend practically nothing, and make your initial goal simply to build a solid prototype. This gives you maximum flexibility.


12. Spending Too Much
It's hard to distinguish spending too much from raising too little. … The only way to decide which to call it is by comparison with other startups. …

… The classic way to burn through cash is by hiring a lot of people. This bites you twice: in addition to increasing your costs, it slows you down—so money that's getting consumed faster has to last longer. …
We have three general suggestions about hiring: (a) don't do it if you can avoid it, (b) pay people with equity rather than salary, not just to save money, but because you want the kind of people who are committed enough to prefer that, and (c) only hire people who are either going to write code or go out and get users, because those are the only things you need at first.


13. Raising Too Much Money
…  The problem is not so much the money itself as what comes with it. … If VCs fund you, they're not going to let you just put the money in the bank and keep operating as two guys living on ramen. They want that money to go to work. [6] At the very least you'll move into proper office space and hire more people. That will change the atmosphere, and not entirely for the better. Now most of your people will be employees rather than founders. They won't be as committed; they'll need to be told what to do; they'll start to engage in office politics.
…
Perhaps more dangerously, once you take a lot of money it gets harder to change direction. … After taking VC money you hire … The more people you have, the more you stay pointed in the same direction.

Another drawback of large investments is the time they take. The time required to raise money grows with the amount. [7] … VCs never quite say yes or no; they just engage you in an apparently endless conversation. Raising VC scale investments is thus a huge time sink—more work, probably, than the startup itself. And you don't want to be spending all your time talking to investors while your competitors are spending theirs building things.

We advise founders who go on to seek VC money to take the first reasonable deal they get. If you get an offer from a reputable firm at a reasonable valuation with no unusually onerous terms, just take it and get on with building the company. [8] …

14. Poor Investor Management
As a founder, you have to manage your investors. You shouldn't ignore them, because they may have useful insights. But neither should you let them run the company. …

Pissing off investors by ignoring them is probably less dangerous than caving in to them. … If the founders know what they're doing, it's better to have half their attention focused on the product than the full attention of investors who don't.

How hard you have to work on managing investors usually depends on how much money you've taken. …
If things go well, this shouldn't matter. So long as you seem to be advancing rapidly, most investors will leave you alone. But things don't always go smoothly in startups. Investors have made trouble even for the most successful companies. One of the most famous examples is Apple, whose board made a nearly fatal blunder in firing Steve Jobs. Apparently even Google got a lot of grief from their investors early on.

Image via Wikipedia15. Sacrificing Users to (Supposed) Profit
… Because making something people want is so much harder than making money from it, you should leave business models for later, just as you'd leave some trivial but messy feature for version 2. In version 1, solve the core problem. And the core problem in a startup is how to create wealth (= how much people want something x the number who want it), not how to convert that wealth into money.

The companies that win are the ones that put users first. …

It is irresponsible not to think about business models. It's just ten times more irresponsible not to think about the product.


16. Not Wanting to Get Your Hands Dirty
Nearly all programmers would rather spend their time writing code and have someone else handle the messy business of extracting money from it. …

There's nothing like users for convincing acquirers. It's not just that the risk is decreased. The acquirers are human, and they have a hard time paying a bunch of young guys millions of dollars just for being clever. When the idea is embodied in a company with a lot of users, they can tell themselves they're buying the users rather than the cleverness, and this is easier for them to swallow. [9]

If you're going to attract users, you'll probably have to get up from your computer and go find some. It's unpleasant work, but if you can make yourself do it you have a much greater chance of succeeding. …[10] …

If you want to start a startup, you have to face the fact that you can't just hack. At least one hacker will have to spend some of the time doing business stuff.


17. Fights Between Founders
Fights between founders are surprisingly common. …

A founder leaving doesn't necessarily kill a startup, though. Plenty of successful startups have had that happen. [11] Fortunately it's usually the least committed founder who leaves. …

Most of the disputes I've seen between founders could have been avoided if they'd been more careful about who they started a company with. Most disputes are not due to the situation but the people. … And most founders who've been burned by such disputes probably had misgivings, which they suppressed, when they started the company. Don't suppress misgivings. …The people are the most important ingredient in a startup, so don't compromise there.


18. A Half-Hearted Effort
… Statistically, if you want to avoid failure, it would seem like the most important thing is to quit your day job. Most founders of failed startups don't quit their day jobs, and most founders of successful ones do. …

Does that mean you should quit your day job? Not necessarily. I'm guessing here, but I'd guess that many of these would-be founders may not have the kind of determination it takes to start a company, and that in the back of their minds, they know it. The reason they don't invest more time in their startup is that they know it's a bad investment. [12]

I'd also guess there's some band of people who could have succeeded if they'd taken the leap and done it full-time, but didn't. I have no idea how wide this band is, but if the winner/borderline/hopeless progression has the sort of distribution you'd expect, the number of people who could have made it, if they'd quit their day job, is probably an order of magnitude larger than the number who do make it. [13]

… Most startups fail because they don't make something people want, and the reason most don't is that they don't try hard enough.

In other words, starting startups is just like everything else. The biggest mistake you can make is not to try hard enough. To the extent there's a secret to success, it's not to be in denial about that.


Notes
[1] This is not a complete list of the causes of failure, just those you can control. There are also several you can't, notably ineptitude and bad luck.

[2] Ironically, one variant of the Facebook that might work is a facebook exclusively for college students.

[3] Steve Jobs tried to motivate people by saying "Real artists ship." This is a fine sentence, but unfortunately not true. Many famous works of art are unfinished. It's true in fields that have hard deadlines, like architecture and filmmaking, but even there people tend to be tweaking stuff till it's yanked out of their hands.

[4] There's probably also a second factor: startup founders tend to be at the leading edge of technology, so problems they face are probably especially valuable.

[5] You should take more than you think you'll need, maybe 50% to 100% more, because software takes longer to write and deals longer to close than you expect.

[6] Since people sometimes call us VCs, I should add that we're not. VCs invest large amounts of other people's money. We invest small amounts of our own, like angel investors.

[7] Not linearly of course, or it would take forever to raise five million dollars. In practice it just feels like it takes forever.
Though if you include the cases where VCs don't invest, it would literally take forever in the median case. And maybe we should, because the danger of chasing large investments is not just that they take a long time. That's the best case. The real danger is that you'll expend a lot of time and get nothing.

[8] Some VCs will offer you an artificially low valuation to see if you have the balls to ask for more. It's lame that VCs play such games, but some do. If you're dealing with one of those you should push back on the valuation a bit.

[9] Suppose YouTube's founders had gone to Google in 2005 and told them "Google Video is badly designed. Give us $10 million and we'll tell you all the mistakes you made." They would have gotten the royal raspberry. Eighteen months later Google paid $1.6 billion for the same lesson, partly because they could then tell themselves that they were buying a phenomenon, or a community, or some vague thing like that.
I don't mean to be hard on Google. They did better than their competitors, who may have now missed the video boat entirely.

[10] Yes, actually: dealing with the government. But phone companies are up there.

[11] Many more than most people realize, because companies don't advertise this. Did you know Apple originally had three founders?

[12] I'm not dissing these people. I don't have the determination myself. I've twice come close to starting startups since Viaweb, and both times I bailed because I realized that without the spur of poverty I just wasn't willing to endure the stress of a startup.

[13] So how do you know whether you're in the category of people who should quit their day job, or the presumably larger one who shouldn't? I got to the point of saying that this was hard to judge for yourself and that you should seek outside advice, before realizing that that's what we do. We think of ourselves as investors, but viewed from the other direction Y Combinator is a service for advising people whether or not to quit their day job. We could be mistaken, and no doubt often are, but we do at least bet money on our conclusions.

Thanks to Sam Altman, Jessica Livingston, Greg McAdoo, and Robert Morris for reading drafts of this.

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Valuation in emerging markets

Procedures for estimating a company’s future cash flows discounted at a rate that reflects risk are the same everywhere. But in emerging markets, the risks are much greater.

McKinsey Quarterly
DECEMBER 2000 • Mimi James and Timothy M. Koller
As the economies of the world globalize and capital becomes more mobile, valuation is gaining importance in emerging markets—for privatization, joint ventures, mergers and acquisitions, restructuring, and just for the basic task of running businesses to create value. Yet valuation is much more difficult in these environments because buyers and sellers face greater risks and obstacles than they do in developed markets.
In recent years, nowhere have those risks and obstacles been more serious than in the emerging markets of East Asia. … In Indonesia, Malaysia, the Philippines, South Korea, and Thailand—the hardest-hit Asian economies—cross-border majority-owned M&A reached an annual average value of $12 billion in both 1998 and 1999, compared with $1 billion annually from 1994 to 1996.¹

Image via WikipediaYet little agreement has emerged among academics, investment bankers, and industry practitioners about how to conduct valuations in emerging markets. … Our preferred approach is to use discounted cash flows (DCFs) together with probability-weighted scenarios that model the risks a business faces.²

The basics of estimating a DCF value—that is, the future cash flows of a company discounted at a rate that reflects potential risk—are the same everyplace. We will therefore focus on how to incorporate into a valuation the extra level of risk that characterizes many emerging markets. …
Macroeconomic volatility is another minefield in Asia, where the financial collapse and subsequent recession generated a mountain of nonperforming bank loans. …

A simple risk premium isn’t enough

Image via WikipediaIn valuations based on discounted cash flows, two options are available for incorporating the additional risks of emerging markets. Those risks can be included either in the assessment of the actual cash flow (the numerator in a DCF calculation) or in an extra risk premium added to the discount rate (the denominator)—the rate used to calculate the present value of future cash flows. We believe that accounting for these risks in the cash flows through probability-weighted scenarios provides both a more solid analytical foundation and a more robust understanding of how value might (or might not) be created. Three practical arguments support our point of view.

First, investors can diversify most of the risks peculiar to emerging markets, such as expropriation, devaluation, and war—though not entirely, as the recent East Asian economic crisis demonstrated. Since finance theory is clear that the cost of capital—the discount rate—should reflect only nondiversifiable risk, diversifiable risk is better handled in the cash flows.³ Nonetheless, a recent survey showed that managers generally adjust for these risks by adding a risk premium to the discount rate.⁴ Unfortunately, this approach may result in a misleading valuation.
Second, many risks in a country are idiosyncratic: they don’t apply equally to all industries or even to all companies within an industry. The common approach to building additional risk into the discount rate involves adding to it a country risk premium equal to the difference between the interest rate on a local bond denominated in US dollars and a US government bond of similar maturity. But this method clearly doesn’t take into account the different risks that different industries face; …
Third, using the credit risk of a country as a proxy for the risk faced by corporations overlooks the fact that equity investments in a company can often be less risky than investments in government bonds. …
In principle, equity markets might be expected to factor in a sizable country risk measure when automatically valuing companies in emerging markets. But equity markets don’t really do so—at least not consistently. …
…(Exhibit 1). Although not definitive proof that no country risk premium is factored into the stock market valuations of companies in emerging markets, this finding clearly suggests that market prices for equities don’t take account of the commonly expected country risk premium. If these premiums were included in the cost of capital, the valuations would be 50 to 90 percent lower than the market values.

Incorporating risks in cash flows

Overall, our approach to valuation helps managers achieve a much better understanding of explicit risks and their effect on cash flows than does the simple country-risk-premium method.
Analyzing specific risks and their impact on value helps managers make better plans to mitigate them. …
To incorporate risks into cash flows properly, start by using macroeconomic factors to construct scenarios, because such factors affect the performance of industries and companies in emerging markets. Then align specific scenarios for companies and industries with those macroeconomic scenarios. … Since values in emerging markets are often more volatile, we recommend developing several scenarios.

Image via WikipediaThe major macroeconomic variables that have to be forecast are inflation rates, growth in the gross domestic product, foreign-exchange rates, and, often, interest rates. … When constructing a high-inflation scenario, be sure that foreign-exchange rates reflect inflation in the long run, because of purchasing-power parity.⁵ Next, determine how changes in macroeconomic variables drive each component of the cash flow. Cash flow items likely to be affected are revenue, expenses, working capital, capital spending, and debt instruments. These should then be linked in the model to the macroeconomic variables so that when the macroeconomic scenario changes, cash flow items adjust automatically.

…When constructing the model, make sure that the industry scenarios take the macroeconomic environment into consideration.
We used this approach in a 1998 outside-in valuation of Pão de Açúcar, a Brazilian retail-grocery chain. The forecasts were developed with the help of three macroeconomic scenarios published by an investment bank, Merrill Lynch (Exhibit 2). Our first scenario, or base case, assumed that Brazil would enact fiscal reforms and enjoy continued international support and that the country’s economy could therefore recover fairly quickly from the shock waves of the Asian economic crisis. … The second scenario assumed that Brazil’s economy would remain in recession for two years, with high interest rates and low GDP growth and inflation. The third scenario assumed a dramatic devaluation—which is what actually happened. In this third scenario, inflation would rise to 30 percent and the economy would shrink by 5 percent.

These three macroeconomic scenarios were then incorporated into the company’s cash flows and discounted at an industry-specific cost of capital. The cost of capital also had to be adjusted for Pão de Açúcar’s capital structure and for the difference between the Brazilian and US inflation rates. Next, each outcome was weighted for probability. Exhibit 3 shows the results of the three scenarios and the probability-weighted values. The base case received a probability of between 33 percent and 50 percent; the others were assigned lower probabilities based on our internal assessments. The DCF value range—a large one because of the uncertainties of the times—was about 223 percent to 135 percent of the base case.

The resulting value was $1.026 billion to $1.094 billion, which was within 10 percent of the company’s market value at the time. If we employ the alternative valuation method, using base-case cash flows but adjusting for additional risk by adding Brazil’s country risk premium to the discount rate, we find a value of $221 million—far below the market value.⁶
Using probability-weighted scenarios brings us much closer to market values and, we believe, to a more accurate view of a company’s true value. Moreover, these scenarios don’t just confirm the market’s valuation of companies; by pinpointing specific risks, they also help managers make the right decisions for those companies.

About the Authors

Mimi James is an alumnus of McKinsey’s New York office, where Tim Koller is a principal. This article is adapted from Tom Copeland, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the Value of Companies, third edition, New York: John Wiley & Sons, 2000 (updated to a 5th edition in July 2010, by Marc Goedhart, Tim Koller, and David Wessels).
The authors acknowledge the contributions of Cuong Do, Keiko Honda, Takeshi Ishiga, Jean-Marc Poullet, and Duncan Woods to this article.

Notes

¹Asian Development Outlook 2000, Asian Development Bank and Oxford University Press, p. 32.
²The use of probability-weighted scenarios constitutes an acknowledgment that forecasts of financial performance are at best educated guesses and that the forecaster can do no more than narrow the range of likely future performance levels. Developing scenarios involves creating a comprehensive set of assumptions about how the future may evolve and how it is likely to affect an industry’s profitability and financial performance. Each scenario then receives a weight reflecting the likelihood that it will actually occur. Managers base these estimates on both knowledge and instinct.
³Diversifiable risks are those that could potentially be eliminated by diversification because they are peculiar to a company. Nondiversifiable risks can’t be avoided, because they are derived from broader economic trends. Many practitioners use the capital asset-pricing model (CAPM), developed in the mid-1960s by John Lintner, William Sharpe, and Jack Treynor, to determine the cost of capital. In CAPM, only nondiversifiable risks are relevant. Diversifiable risks would not affect the expected rate of return.
⁴Tom Keck, Eric Levengood, and Al Longfield, "Using discounted cash flow analysis in an international setting: a survey of issues in modeling the cost of capital," Journal of Applied Corporate Finance, Volume 11, Number 3, fall 1998.
⁵The theory of purchasing-power parity states that exchange rates should adjust over time so that the prices of goods in any two countries are roughly equal. A Big Mac at McDonald’s, for instance, should cost roughly the same amount in both. In reality, purchasing-power parity holds true over long periods of time, but exchange rates can deviate from it by up to 20 or 30 percent for five to ten years.
⁶The country risk premium typically used at the time of the valuation (September 1998) was about 8 percent.

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