July 23, 2024 – Ben Yoskovitz – Founding Partner at Highline Beta | Author of FocusedChaos.co

I’m a huge Lean Startup fan. The concept of Build -> Measure -> Learn makes a ton of sense to me. A simple, elegant loop where you figure out what to build, measure the results, and learn. You iterate as quickly & frequently as possible to increase the odds of “figuring it all out”.
Unfortunately like most frameworks, it’s oversimplified. When Alistair Croll and I wrote Lean Analytics, we decided to expand on the concept w/ The Lean Analytics Cycle

1. Pick the One Metric That Matters and Draw a Line
   1. Decide on the biggest problem you’re facing. Be honest. Focus wins. In my experience most founders KNOW what it is, they just don’t want to admit it or don’t know how to fix it. They mess around on the edges hoping for a miracle.
   2. Once you know what the biggest problem is you can identify the right metric to track (OMTM).
2. Find a Potential Improvement & Write a Hypothesis
   1. Bring the whole team together for an ideation session. I’ll share how to do this in the comments. The top problem at your company is EVERYONE’s problem. So get ’em aligned.
   2. You can also look at data. What are your best users doing compared to those that churn? What commonalities exist amongst your best users? Data can drive hypotheses.
   3. Quickly prioritize the top 1-3 ideas based on value vs effort. Then write assumptions. Literally. Write them down. So many startups skip this step & do not get the team aligned or forget what they’re focusing on and why.

3. Design a Test
   1. Now run a test. Could be small. Maybe it’s not even adding a new feature. Try taking a feature out! Or changing a process. Deploy something to half your users. Run a fake door test. Or f**k it ship it and build something new and launch.
   2. No test should take longer than 2 weeks to develop. If it does, your team should immediately question whether things can be done faster/better. Some things take longer, but recognize the risk in a longer cycle/learning time.
   3. Analysis paralysis is the enemy. Doing something is better (most of the time) than nothing. In the absence of data, use your gut.
4. Measure the Results
   1. Did your test move the needle?
   2. Maybe the test failed. You can give up, try again, or pivot. A failed test is still LEARNING.
   3. Chances are the test worked, but maybe not well enough. In that case, test again and again. You’re probably running multiple simultaneous tests; this makes it tougher to know what worked, but startups aren’t built in labs.
   4. Eventually, tests drive diminishing returns. Going from 10% to 7% churn might be easy, 7% to 6% is tougher, 6% to 5% harder still. If you get to 5.5%, maybe you stop and draw a new line. Focus on something else. Going from 5.5% to 5% may be too costly and not worth it for the stage you’re at.

➡ Whenever you focus on one thing, it generally tells you where to focus next. If you reduce churn enough, it’s time to go to the top of the funnel and get more leads. It’s a fairly logical process in an insanely chaotic one (building a startup).

Friends in the startup world, please consider advice from the Fremont Group below and then return here.

If you run a fast-growth startup with a national or global potential as one of only a slice of “small businesses” that the Fremont Group addresses below, are they addressing you in relation to your business in startup or early-stage development?

In truth, the Fremont Group probably has a book of established lifestyle business clients. It would also be hard to argue with their advice to these clients. This seems to be to be not only sound advice but advice that is rather fundamental. Yet, I know from having been a consultant for over 20 years with a book of clients like theirs, that they are right in saying most don’t budget or manage to budget well at all. I’ll throw you another statistic. Fewer than 10% of lifestyle businesses make any entity profit, and a chunk of those profits are less than what the owner could earn selling the same skill set as an employee in a large company.

But, you are not a lifestyle biz, you are a “fast-growth” innovation startup. You are pre- or early revenue. You are not “established” yet. Heck, your sub-industry might not even be established yet as it exists in such an innovative, developing capacity.

So, does the advice apply to you? Yes, it does, and here is how….

Change the word “budget” to “capital-plan(-to-exit)” and “small business owner” to “startup”, then re-read Fremont Group’s advice.

Still every bit as true, isn’t it? If you don’t agree, you shouldn’t run a startup. Sorry, but this is simply a core truth.

And equally true as your lifestyle management counterparts, most innovation startup managers don’t have a thorough, robust, bottom-up-built capital-plan-to-exit to which they manage. This is why you (even more of you than lifestyle starts) fail.

Some will argue that there are all kinds of reasons for failure, and that’s fair. But I recall a survey done some years ago by a global research firm. Of 100 reasons, the #2 reason listed by founders that they failed was this: they ran out of cash!

<Duh moment.>

A business as an entity exists when it has cash in the bank, and ceases when it doesn’t (for 30-ish days typically). Looking over the list of their other 99 reasons for failure, it’s simple logic to argue that all 99 other reasons caused the out-of-cash condition. 99 reasons for running out of cash lead to really the one reason for going out of business – it’s a universal dependency chain. Cash is king. Cash measures all other results!

Therefore, if you are going to manage to keep a business from going out of business – you must manage the cash first, right? All other decisions are made in light of present and future impact on cash. Try to argue your way around this, if that’s how you learn, or accept the root premise and read the conclusion below.

A “capital plan to exit” is the plan for all cash coming in (investors, debt, from sales, etc.) and all cash to go out on the way to a liquidity event for you and your investors. If the balance ever dips below zero, you’re out. If it ever dips anywhere within sight of near zero, you’re margin of error probably means you’re out.

OK, so what? Well, the very activity of making the plan forces rational thought into how every assumed number gets conceived and added up. It puts you on the hook for your assumptions, and defending those assumptions to yourself, your colleagues, and your investors. It grounds you to manage in keeping to the plan to reach milestones or else explain deviations from the plan while you continuously adjust it.

Thus, when you don’t do this, as probably a top-3 primary ongoing activity of running a startup, you’re just shooting at ducks on a moonless night. You might be able to make out a few shadowy lines for what is in front of you, but you’re mostly just hunting blindly for success and your risk of failure is “magnifold” (my silly mash-up of “magnified” and “hundred-fold”.

The last generation of seed investors has been too gracious to startups for various wide-ranging reasons better left for a sociologist to blog about (OK, Boomers?). The incoming generation of more data-reared seed investors, who are fewer to-boot, aren’t going to invest so subjectively or emotionally. We will be less emotive in our investment decision-making and expect anyone asking us for money to show more rationality in their business execution plans than perhaps you are prepared for, or even the entrepreneurial educational ecosystem prepared you for.

But change is coming, in expectations, for everyone. Some who see it ahead will adjust and thrive (founders and investors alike), but many more will be blindsided, and complaining about it after the fact will only be confirmation that your project isn’t a risk worth taking.

Just shooting you straight.

Early-stage founders frequently struggle to put a price tag on their company when still early in development and commercialization.

The ‘why this is’ is revealed by identifying the solution.

First, we need to understand that capital markets are competitive. Interest rate “spreads” are the easiest way to understand risk vs. financial reward. When a U.S. Treasury bond (considered “safe”) pays 5%, then how much more needs to be paid for a riskier investment? For example, a home mortgage, inventory loan, or an investment in a pre-clinical oncology company?!

The more risk taken, the more that should be paid to take that risk. The spread between 5% and whatever the return is represents the size of the risk of failure and loss.

In today’s dollars, the valuation that a company applies to its business when making an investment offering must be defined to ensure a fair return to the investor at the exit, relative to the risks of failure ahead for the company and the price being paid today for both similar and different levels of risk available elsewhere.

The solution, therefore, necessarily depends on forecasting an estimated ROI to a new investor today. This subsequently depends on actually doing the planning to conceive of how much money the company will need to raise, at various points and terms, to reach each milestone that leads to the exit.

So many early-stage companies try to raise money after the initial self- and F&F investment without actually having done this level of planning. They get stuck focusing only on what it’s going to cost to reach the next set of milestones and then trying to raise that amount of money on looser concepts of what they think their solution idea is worth to the world, instead of what investing in it ought to be worth to serious and professional investors.

But the plan-as-you-go style of setting up a startup mostly always fails for this simple reason: planning all the way to exit reveals hidden risks the founders weren’t aware of until they had to quantify the costs and potential setbacks of the company’s entire lifecycle to the hoped-for exit. But when not planned for, if they get far enough to encounter those unexpected risks and setbacks with no pre-conceived backup plans, the first setback often becomes the failure point as investors flee the struggling enterprise.

In effect, when a founder sets a valuation without a fully conceptualized birth-to-exit financial and dependent capital plan of their company, it is the same as doing a top-down revenue forecast.

A well-done revenue model is built bottom-up from bits by counting reachable customers, available capacity, and costs of executing a plan that produces at capacity and acquires those customers. (This itself is only a very summarized explanation. Revenue planning is a detailed exercise that takes a lot of time and research to construct.) But when you create a bottom-up revenue plan, you discover the assumptions you need to make about details you weren’t thinking about and inevitably “don’t add up” or seem realistic. In the discovery of those problematic assumptions, you have the opportunity to work out alternative business and operational methods to overcome those unrealistic assumptions.

Similarly, a bottom-up valuation is built from the company exit – backward, not from the present point forward. In the same way, then, a company forces itself to make a set of assumptions which, in the conceiving of them, sometimes will shout out degrees of unrealism at the founders that force rethinking and replanning.

Therefore, a company should first define what it thinks the final milestone is to be achieved from scaling, and what it believes will make the enterprise worth it to the acquirer (or at IPO, etc.). This involves various methods of comparative and parallel analysis of acquisitions of revenue streams from similar types of solutions sold in the marketplace. (Yes, some solutions are new, without direct comparables. Parallel analysis is the study of what other things were worth, in inflation-adjusted dollars, when those solutions were new.

Next, a company should build a timeline backward from there of each major milestone it should achieve, leading up to the final one, which should represent a significant value inflection for the company, until it arrives back at where it presently stands.

Then, a company can do the requisite and traditional operational financial planning to determine how much it’s going to cost to reach each inflection point (inputs like material & labor, administrative and overhead costs, marketing & costs of sales, etc.) (It should buffer this for risks of costing more or taking longer than anticipated!)

The company can proceed then to overlay a fundraising plan that raises sufficient capital well ahead of the necessary use of funds along the way, balancing when money will be needed against when milestones that add value have been achieved that build ongoing investor confidence.

Finally, bell curve norms of the amount of the company (%) that should be sold at each round, including set-asides for incentive options, can be applied that add the last element needed to construct a mathematical capital model. A model allows one to run multiple scenarios to test assumptions at each point and make a judgment about the exit outcome and the return to new investors in the next round. When a scenario is found that estimates a worthwhile return for investors at each round relative to the risks remaining after that round, the company has achieved a logic-based, defensible plan that impresses investors at every stage! A capital model is also a vitally valuable living tool that can continue to be refined as the company progresses, adding to the founders’ intuition in their continued planning.

In summary, with a fully conceptualized capital plan, a company can calculate the estimated ROI to new investors now, THEN ask whether that seems fair relative to the execution risks ahead for the company, and then trial-and-error various valuations until they settle on one that seems attractive and investable.

When talking about this level of planning, the not-so-clearly stated pushback often received boils down to ‘that’s a lot (or more) planning work than I anticipated doing by this point, or that I even know how to do at this point’. It’s true, this is more planning work than most founders anticipate and goes beyond the education in strategic financial planning that anyone has taught them or asked them to do, especially among a deep well of educational and coaching resources that don’t necessarily have deeply bought-into methods of teaching strategic finance themselves. I continue to believe that Finance is the resource in least supply when it comes to building businesses of any type (from mom & pop to Fortune 500 companies.)

But, does ‘it’s hard’ or ‘I don’t know how’ defeat the need to do the planning to succeed, to succeed? The obvious if the uncomfortable answer is ‘no’. It must be done, or else a very large layer of unmitigated and unforced risk of not having done it is being added on top of all the other risks a startup faces, and investors investing anyway really are just engaging in a slightly more refined gambling night out in Vegas. The analogy is appropriate because remember that in Vegas, not knowing your odds is part of the fun. It’s illegal to count the cards or be a human supercomputer – that’s not fair to the house!! But we shouldn’t be applying house rules to startups. We should know the odds, and we should be paying appropriately and knowledgeably for quantified risks.

Glossary of Deal Terms

People often accuse lawyers of using too many words. One recently received summarization of the primary terms of a venture capital investment deal in 100 words or less was submitted as follows. 

“$200,000 10% bridge loan with 25% warrant coverage. 20% of the company on a fully diluted basis for $2 million. $8 million pre-money valuation and $10 million post-money. Redeemable participating preferred stock with a 5% cumulative dividend. Convertible into Common Stock. Qualified IPO triggers mandatory conversion. Weighted average price antidilution protection with a 15% option pool. Investors receive first refusal and come along rights with overallotment options, drag along, and visitation rights, as well as one demand and unlimited piggybacks (cut-backs pro rata) and S-3 registration rights.“

Obviously, this is simple and concise. But “What does it mean?”

Let’s take a look at the definition of the key elements of the terms of this deal.

• “Antidilution Protection” is a provision that increases the number of shares of Common Stock issuable upon conversion of a convertible security or upon exercise of a warrant or option upon the occurrence of specified events, usually the issuance of more shares for a low price.
• “Bridge Financing” is a loan that is used to provide the company with operating capital while the investors conduct due diligence and negotiate the terms of the investment. The bridge loan is usually converted into equity at the next equity financing of the company.
• “Come Along Rights” is also sometimes called Tag Along Rights. The right of an investor to sell shares, if a founder or other key employee sells shares. This right is designed to protect the investors against being trapped in an investment after the founders have cashed out.
• “Conversion Rate or Ratio” means the number of shares of Common Stock into which each share of Preferred Stock is convertible.
• “Convertible” indicates the right of the investor to convert shares of Preferred Stock into shares of Common Stock at the Conversion Rate stated in the corporate charter. Conversion is usually automatic upon the occurrence of a Qualified IPO. Mandatory conversion is necessary because companies sell Common Stock in their IPOs and new investors are not likely to purchase Common Stock if earlier investors retain Preferred Stock with superior rights.
• “Covenant” is the obligation in a contract to do something. An obligation to refrain from doing something is called a Negative Covenant. For example, the obligation to obtain life insurance on key employees is a covenant and the obligation to not deviate from the budget approved by investors is a negative covenant.
• “Cumulative Dividend” occurs when the dividend is not declared during the period stated in the corporate charter, the dividend accrues and is payable in a later period. If a dividend right isn’t cumulative, the dividend would be lost forever if it’s not declared during the period stated in the corporate charter. Accrued but unpaid dividends are sometimes convertible into shares of Common Stock.
• “Cutback Rights” occur when shareholders exercise piggyback registration rights, but there are too many shares for the underwriters to sell in the public offering without adversely affecting the price, cutback rights determine whose shares are left out of the offering and whose shares are included in the offering.
• “Demand Registration Rights” is the right of investors to require the company to register the investors’ shares for sale to the public even if the company was not otherwise planning to conduct a public offering. Usually, an investor or group of investors receives one or two Demand Registration Rights. Typically, the right isn’t exercisable until after the company’s initial public offering or after a stated period of time.
• “Drag Along Rights” is the right of the owners of a specified percentage of the shares of the company to require other shareholders to sell their shares or to vote their shares to approve the sale of the company. This prevents one group of shareholders from blocking the sale of the company to someone only interested in purchasing 100% ownership of the company.
• “Fiduciary” is someone who owes special duties to another person and who has liability for not performing that duty.
• “First Refusal Rights” are the right(s) to purchase stock in future offerings by the company on the same terms as other investors. Usually, the right is designed to enable investors to maintain their percentage ownership of the company by purchasing a pro-rata share of all new stock sold by the company. Investors also often require company founders to grant first-refusal rights on shares the founders own. Also sometimes called Preemptive Rights.
• “Full Ratchet” is a type of Antidilution Protection that adjusts the Conversion Ratio so that each share of Preferred Stock will be convertible into a number of shares of Common Stock equal to the number of shares the investor would have received if the investor had purchased the shares at the lowest subsequent price at which the company later sells its stock. The number of shares sold at the lower price doesn’t matter. Only the lower price matters. For example, if the company sells Preferred Stock with a one-for-one Conversion Ratio for $10 per share and later sells Common Stock for $1 per share, each share of Preferred Stock would become convertible into ten shares of Common Stock, even if only one share is sold at the lower price.
• “Fully Diluted” Fully diluted means the total number of shares of Common Stock the company has issued, plus all shares of Common Stock issuable if all outstanding options, warrants, convertible preferred stock, and convertible debt were to be exercised or converted. Fully diluted calculations are used to compare the percentage
  ownership of a company of different classes of securities by reducing each class to its Common Stock equivalent.
• “Information Rights” is the right of investors to have the company provide financial information annually, quarterly, or monthly and other information as requested by investors.
• “Key Man Insurance” is insurance on the life of key employees which investors require the company to obtain.
• “Lead Investor” is the investor who takes on most of the work in negotiating the investment terms, doing due diligence, and monitoring the company after the closing. The lead investor usually invests more than other investors who participate in the round. The lead investor is often located near the company or specializes in the company’s industry.
• “Milestone” is an event that triggers another investment by the investors in the venture.
• “Option Pool” is a number of shares of Common Stock specified in the corporate charter that can be sold to employees, officers, and directors at low prices without triggering the Price Antidilution Protection of the Preferred Stock. 15% of the fully diluted shares is fairly typical, although the size of the Option Pool usually depends on the number of shares estimated to be necessary to grant to employees to attract a team capable of achieving the goals of the company’s business plan. This varies from one company to another. Option Pool shares are usually considered to be outstanding shares when calculating the company’s valuation.
• “Overallotment Option” is the right of investors to exercise the First Refusal Rights and Come Along Rights of other investors who don’t exercise their own rights.
• “Participating Preferred Stock” is a class of stock with a Liquidation Preference, whereby on liquidation, sale, or merger of the company, the owner has the right to share on an equal basis with holders of Common Stock any money or other assets that remain for distribution after payment of the Liquidation Preference of the Preferred Stock. With Nonparticipating Preferred Stock, the holders of Preferred Stock must choose either to receive their Liquidation Preference or to receive the same distribution holders of Common Stock receive. A holder of Participating Preferred Stock doesn’t have to choose and receive both.
• “Piggyback Registration Rights” is the right of investors to have shares included in a public offering the company plans to conduct for itself or another shareholder. Usually, this applies to an unlimited number of offerings until the registration rights terminate.
• “Post-Money Valuation” is calculated by adding the dollar amount invested in the transaction to the Pre-Money Valuation.
• “Preemptive Rights” are similar to rights of first refusal.
• “Preferred Stock” is a class of stock with a Liquidation Preference; that is, the right to receive distributions of money or assets before one or more other classes of stock if the company is sold, merged, or liquidated. This protects investors by ensuring the investors get their money back (and sometimes a fixed return on the investment) before holders of Common Stock receive any money or assets.
• “Pre-money valuation” is the theoretical value of the company before the investment agreed upon by the company and the investors. Pre-money valuation is calculated by multiplying the number of Fully Diluted shares of the company before the investment transaction by the purchase price per share in the investment transaction.
• “Price Antidilution Protection” protects investors from overpaying for stock by adjusting the Conversion Ratio if the company later issues shares for a price less than the price the investors paid. Adjustment of the Conversion Ratio results in more shares of Common Stock becoming issuable upon conversion of each share of  Preferred Stock than was agreed at the time of the investment. There are two basic types of Price Antidilution Protection; Full Ratchet and Weighted Average.  Weighted Average can be either Broad-Based or Narrow-Based.
• “Protective Provisions” is the right of an investor or group of investors to veto certain transactions by the company. This is usually achieved by prohibiting certain transactions unless they are approved by a class vote of the Preferred Stock.
• “Qualified IPO” means an initial public offering by the company of a size and price specified in the corporate charter. An IPO with $20 million in gross proceeds to the company and a price per share three times the price the investor paid for its stock is fairly typical for a Qualified IPO, but this varies from one deal to another.
• “Play or Pay” is a provision that penalizes investors who fail to purchase their pro rata share of securities in a later investment round.
• “Redeemable” is the right of the investor to require the company to repurchase the investor’s stock for a price specified in the corporate charter. Redemption rights usually are not exercisable until five years or longer after the investment. Redemption rights are rarely exercised, but they give investors leverage to ensure their investment will eventually become liquid through the sale of the company if an IPO hasn’t occurred by a specified date.
• “Registration Rights” is the right of investors in a public offering to require the company to include shares owned by the investors in a registration statement filed with the Securities and Exchange Commission under Section 5 of the Securities Act of 1933. There are three general types of registration rights (i) Demand; (ii) Piggybacks; and (iii) S-3.
• “S-3 Registration Rights” is the right of investors to require the company to file a short form registration statement on Form S-3. S-3 Registration Rights are similar to Demand Registration Rights, but usually one or two registrations each year are permitted, because the short Form S-3 is less burdensome to the company.
• “Syndicate” is a group of venture investors who participate in the investment round.
• “Visitation Rights” are also called Observer Rights. The right of investors to have a nonvoting representative attend meetings of the Board of Directors of the company and committees of the Board.
• “Warrant” is the right to purchase stock at a later date at a fixed price. Similar to stock options, but usually given to investors, not employees.
• “Warrant Coverage”  are Warrants issued to reward bridge loan lenders, guarantors, or other lenders for incurring the risk of lending. The number of shares issuable upon exercise of the warrants is based on a percentage of the debt.
• “Weighted Average” is a form of Antidilution Protection that adjusts the Conversion Ratio according to a formula that takes into account both the lower price and the number of shares issued at the lower price. This is more favorable to the company than a Full Ratchet. Narrow-Based Weighted Average uses only the number of outstanding shares of Preferred Stock in the formula used to adjust the conversion price. This is more favorable to the investor than Broad-Based Weighted Average,
  which includes all fully diluted shares in its formula.