by John Toepfer
As an entrepreneur with a fairly lengthy career focused on starting and growing small businesses, I am often approached by people and asked to invest in their ideas or evaluate their business plans. The types of businesses plans that cross my desk range from brew-pubs and gyms to educational media and software development companies. In reviewing these plans and then observing what happens to the businesses that are eventually created, I’ve developed somewhat of a series of litmus test questions that can tell me pretty quickly if the idea will grow legs.
Nobody can guarantee the success or failure of any startup business.
I’m sure there are plenty of now successful businesses that I would have pronounced DOA. But let’s call this “my four questions that tell me if you stand a fighting chance.”
Question #1 – Is anyone quitting their day job to make this business go?
I hardly believe the number of times the answer to this question is “no,” and I can’t remember a single instance when this has resulted in a positive outcome. I’m still surprised at the number of plans that are formed around one, two or five people (usually they are drinking buddies), all offering to chip in some money and time but nobody is taking the big plunge.
It usually goes like this: A group decides on a good idea that shouldn’t cost too much. Each person starts imagining the stories they’ll tell of being on the ground floor of this startup when it goes big. This group-think optimism is similar to what happens when you work with a financial advisor. The advisor starts pitching this fund or that stock and gets you to envision yourself as a winner in the market game-only this time you’re selling yourselves, and you’ve got the added pressure of not wanting to disappoint your friends. A group member who asks too many detailed questions or keeps pointing out obstacles can be seen as negative and is often marginalized or even left out.
So, a few of the friends say, “What the hay, I’m in.” Then comes the fun part: Mike outlines the business plan; Beth, who is a CPA, does some financial pro-formas; Jerry starts scouting locations and Casey, who hasn’t had time because of a big case she is on, calls into the weekly meeting talking about how much she hates her client and wants to quit the rat race.
Because you’re all smart, high-functioning adults, a plan comes together and it’s time to start working on outside capital to match the $100,000 the core group has committed. Enter a soft commitment from Beth’s brother, another one from Mike’s dentist and then something from someone’s parents (we won’t name names).
This is about the point when the plan usually hits my desk, and I ask, “Who’s quitting their day job to make this happen?”
Actual answers I’ve heard include:
- “Well, Mike works for AT&T and really does nothing but surf the Web at work; he’s got time to act as the day-to-day manager.”
- “We know this guy, Eddie, who doesn’t have the money to buy in, but he’s perfect for the GM position, and we’re going to hire him as an employee with half of his compensation going into an eventual equity position.”
- “Oh, we’re all really committed and will be sharing the CEO role, we’ll be great partners.”
- “Beth got laid off last month, so she has the time to really manage this (and watch her kids because they now can’t afford their nanny).”
- “With a good website, this business should practically run itself!”
So the options include: giving the reigns to someone who is so unmotivated that he’s happy to sit in a do-nothing corporate gig, a guy who was unable to scratch together 10 or 20 grand to invest, a CPA who is doing this largely because she was unfortunate enough to lose her job, or nobody in particular.
Those are all wrong answers. Here’s the right answer:
Q: Who’s quitting their day job to make this happen?
A: Beth and I both are. I’m going to run sales and marketing, and Beth is going to take care of all the GM and finance issues. We’re going to have monthly board meetings, and Beth and I are each getting additional equity because we are taking the risk.
Whether you’re starting a brewpub, an interactive media agency or a website specializing in after-market parts for exotic cars, you need someone who wakes up in the morning and goes to bed at night thinking about the business and how to make it go. That’s a full-time gig.
Maybe if you’re looking to run that auto-parts website from your basement with only word-of-mouth advertising, and you’re highest aspiration is that the proceeds will pay for half of your annual vacation to Hilton Head Island, you can do this part-time. But if you’re looking for any form of real financial payback, and you have partners who expect real income, you’re going to have to really throw yourself into the business.
Question #2 – How are you dividing the equity?
The second most common mistake I see is in the basic partnership or shareholder agreement terms. For example, when a group of friends is going in together, everyone feels it would be crass to ask for more than equal shares. Even if it’s not a friendship-driven business, people tend to avoid throwing topics on the table that may derail the process of getting the company off the ground. This is a big mistake.
It’s basically a rule that all parties, especially if there are three or more, are not going to put the same amount of time and effort into the business. Even if you have a plan that compensates people for their time to make up for this disparity, you’re likely to wind up with problems down the road. You need to have these critical conversations early on so that you don’t end up having big arguments and calling lawyers later on.
If you’re the one with the idea, the one quitting your job, or the one fronting most of the cash, you need to establish your relative value up front. You’ll need to say something like: “This business does not go forward without me. I need you guys, but I need shares that are commensurate with my role.” This may cause an argument, but nobody is going to get sued and tied up in court if you have this conversation early on. Don’t wait until business is booming and there is real money on the table. At that point, it will be too late.
This ties closely with two related matters: arrange your corporate papers so that you do not risk a deadlock vote at the shareholder or board of directors level. I won’t pretend to give legal advice here. Ask your attorney for advice on methods, but know that a tie vote is a very, very bad thing in business.
While I’m really into egalitarian partnerships and a flat-as-possible organization, experience and observation have taught me that every business needs a CEO and a clear method to resolve contention. If no one steps up to be the CEO, you have the problem discussed in Question #1. If someone does step up, they need a pay and equity package that recognizes their leadership role. If that person is you, ask for what you deserve (or will deserve), and don’t be afraid of a measurement system to make the others comfortable that you’ll be successful. If you’re not going to be the CEO, don’t resent the person who’s putting more on the table when they ask for more of the dessert.
Question #3 – What is your marketing plan?
This one seems so obvious it may be treated as a throwaway. But it’s not. For the more bootstrapped companies, marketing is often the component that is most neglected, even though everyone knows how important it is. Developing and executing a marketing plan takes real time, effort and money. In other words, a marketing strategy isn’t something one of your partners can put together while moonlighting.
Here are some other things to consider:
- Groupon is not a marketing plan.
- A website and SEO is not a marketing plan.
- A mailing list is not a marketing plan.
- A coat-tails relationship with a partner company is, at best, half of a marketing plan.
Unless you happen to open your new dry-cleaning business in a crowded residential neighborhood on the same day your only competitor in the area decides to retire, It’s going to take some time to build up your business. A dry cleaner is a commodity trade with established demand and customer behaviors. . As long as the demand for dry cleaners exceeds the availability of dry cleaners in the area, your business will be a sure-fire success.
If your business is a new concept, you’re going to have to create demand and modify customer behaviors. If your business is an existing concept with better pricing or features, you’re going to have to get the word out…and modify customer behaviors. Both of these things take time and money.
I’ll say that again in case the point was lost. To create a successful new business, you will have to change your customers’ behavior. They will have to leave their current dry cleaner, switch from Mac to PC, stop using their internal design team, stop using Snapchat, or pull the plug on the internal development plan. You have to get your customers to decide to make a change.
Even if there are large and obvious problems with the previous tool, system or vendor, it still takes real and considerable effort to induce your customers to change their behavior] You can choose to take on this effort one client at a time through an educational sales process, or you can work to move the market using a more broad and long-term marketing plan.
The section of the business plan devoted to marketing should be one of the largest, and it should include the money to support a sustained and consistent effort.
For better or for worse, I’ve made some of the above mistakes myself. But I did so with a single-point rationale; if we don’t have the time or budget to sustain the effort, we’re better off not doing it at all. While this is true, the better approach is to make the time, and find the money. Marketing is what makes a business grow faster than a walking pace.
It’s also where outside capital and real second-party relationships come into play. For example, I helped to start a content/education company a few years ago, and developing a relationship with a known and well-targeted industry media company was a principal part of its success. For 20 percent of our revenue, we had full access to their magazine, webzine, conferences and webinar engine, in addition to a targeted mailing list of over 200,000 names. Yes, 20 percent off the top was a lot, but the access they represented to us, a no-name startup, was priceless. Once we got on our feet and had our own subscribers and mailing list, we let that relationship go. However, in the early stages, the partnership was critical to our growth.
Your marketing plan needs to describe exactly how you will gain real access to your target audience, establish brand, reputation, references and differentiators.
Question #4 – How soon will you know if the business is going to be successful?
Largely because of the optimistic spirit that comes with being an entrepreneur, most people looking to start a business underestimate several time and effort factors:
– How much marketing it will take to effectively cast your net
– How much time it will take to build momentum
– How much money it will take to support the time and effort in the first two items
My rule of thumb in higher-dollar-value businesses is: By the one-year mark, you will know whether your business plan was actually good. No less. After two years, you should be able to determine the potential for sustainability and scaling.
If you haven’t sold anything within the first year, or you haven’t sold very much, your idea or execution is missing something. If you’re not seeing your pipeline and close rate multiply by two or three times in year two and a retention rate of over 70 percent, then your growth and sustainability expectations should be more in line with that of a niche business.
Yes, if you’re selling a new iPhone app, the cycle is months or weeks, not years, but for the rest of the economy, one to two years is your likely timeline.
This means you need to plan your finances to cover two years of business expenses (plus any up-front R&D expenses), and you need commitments from all partners and backers to this timeline. People will get antsy somewhere between nine months and one year, and start re-assessing their involvement. This may seem distracting and short-sighted, but it happens. The silent partner who invested $18,000 and has been watching the original bank-roll shrink for 12 months is going to have an existential crisis every six to nine months, and you do not want to be wasting everyone’s time on partnership issues when making the business grow should be your full occupation. From the outset, you should make the timeline clear, including the available decision points.
Again, I’m not an attorney, but you should use a good attorney to form your shareholder agreement. In that document, be sure to include clear means to handle partners who quit and their desire for a return of their investment.
Starting a business takes a huge amount of foresight. You can’t just have the idea; you have to be ready to follow through and get others invested in your plan. To reiterate, there are four main issues you need to address: First, somebody needs to take control of the business if it’s ever going to get off the ground. Second, you need to have the difficult conversations about equity early. People always want to avoid talking about money, but the earlier you figure out who’s being compensated for what, the better of you’ll be. Third, you need a legitimate marketing plan with funding behind it. Finally, it’s going to take a year or more before you can accurately gauge your success.
No one can ever predict whether a business will truly be successful, but doing things right from the start can help prepare you for whatever comes.
What do you think about these 4 critical questions? Is there anything else you think needs to be considered before starting a business? Share your thoughts in the comments below: