Building on Bedrock

by Derek Lidow

  Angel Dreams

  There are also angel investors. Angel investors seek to invest their own money in startups. There are an estimated 300,000 angel investors in the United States. In 2015, angel investors invested $24.6 billion in 71,100 startups and small businesses, which works out to an average of about $346,000 of angel investment in each company. Because angel investors often invest in a company with other angels,[11] the actual check size for any single angel investor is usually much lower—typically closer to $50,000. On rare occasions the checks can be bigger. I know a wealthy angel with $6 million invested in just one company, but the angel’s former chief technology officer runs the company—there are always special circumstances associated with angel investors writing large checks.

  In aggregate, angel investors invest just as much money as VCs in startups, but in smaller amounts to many more companies. Angel investors fire founders infrequently, but they are often even more involved in helping the company. This extra “help” may or may not be appreciated by the entrepreneur. Just as with VCs, most angel investors do a poor job of investing their money, while a few angels do a great job and enjoy phenomenal returns on their money.

  Angel investors can therefore be problematic for bedrock entrepreneurs who want to remain independent. Angel investors want their money back, so taking an investment from an angel investor sets an expectation that the company will be sold in three to seven years, even if angel investors wind up owning much less than 50 percent of the shares.

  Angel investment can be a great source of initial capital, but high-risk entrepreneurs cannot rely on angel funding except to get started. Angel investors fill in the gap that VCs have created in not wanting to risk their money on startups that are not already established. Because angels don’t write big checks, high-risk entrepreneurs are still faced with the challenge of being one of the approximately 1,400 companies a year VCs choose to start supporting. Angel investors are not an alternate path of funding for high-risk entrepreneurs; they are a bridge.

  The same holds true for accelerators. Accelerators take a small ownership in companies started by teams (never individuals) in return for putting up to fifty teams at a time through a ten- to twelve-week program of mentorship, education, and networking. In the United States, there are about 300 accelerators, operated mostly by investors hoping to make large amounts of money from these ventures. Accelerators mentor and train over 4,000 teams, including more than 12,000 aspiring entrepreneurs, in their programs each year.

  Accelerator owners are entrepreneurs (mostly bedrock as they usually invest their own money!). Accelerators can be profitable businesses by investing small sums—often in the range of twenty-five to a hundred thousand dollars per team—in a large number of startups.[12] To show a positive return, accelerators need only a few of these companies to eventually sell for modest sums. Because accelerator owners want to get their money back quickly, they nurture teams of high-risk entrepreneurs they think have a decent chance of growing fast. All accelerators are selective, and the best ones are highly selective, choosing less than one in ten of their applicants; after all, the accelerators want to make money. Accelerators are therefore hotbeds of high-risk entrepreneurs. Since most accelerators have only been around for a few years the overwhelming majority of accelerators have not yet generated any positive cash flow.

  Interestingly, a number of large established companies recently started hosting accelerators with the objective of identifying new product ideas that they can keep track of and eventually own. Many universities also run accelerators to help teach students about entrepreneurship, and they usually do not take any ownership in their student companies. (Princeton runs a summer accelerator.) These non-quick-hit accelerators can be good deals for both aspiring bedrock and high-risk entrepreneurs, if they can get in.

  While accelerators help thousands of teams a year explore their entrepreneurial potential, these teams, when they’ve graduated, nonetheless still need to find investors in order to survive. Every accelerator invites groups of angel investors, and VCs if the accelerator is famous, to their “demo day” graduation ceremonies with the hope that some of the newly accelerated companies will get funded. A small number of accelerated companies from the top dozen most highly regarded programs (i.e., the top 2.5 percent accelerators) receive funding by VCs—Airbnb and Dropbox most famously.

  But even with the help of accelerators and angel investors, there still are only about 1,400 companies each year founded by high-risk entrepreneurs that get the funding they need to reach their full potential. While this number has not changed much in twenty years, the number of high-risk entrepreneurs has. More high-risk entrepreneurs present their ideas to a growing number of angel investors, more apply to a growing number of accelerators, more send pitch decks to VCs, and more aspiring entrepreneurs than ever read and dream about famous high-risk entrepreneurs. Our society is leading a lot of proverbial entrepreneurial lambs to slaughter.

  The implication is clear. High-risk entrepreneurs must understand how to please VCs in order to get funded and then to keep their jobs. Few entrepreneurs I meet understand this.

  Bedrock entrepreneurs can have high aspirations, too. Sam Walton built what is today the largest company on the planet using bedrock values and bedrock financing. He borrowed money to build his companies from 1945 to 1970, when Wal-Mart went public. He first borrowed money from his father-in-law, and then from banks. He paid back his first loan from his father-in-law in three years; he paid back his first bank loan (for $1,500 to buy a popcorn machine) in two. By the time Wal-Mart went public, Sam was personally responsible for millions of dollars of personal debt. Wal-Mart sold 20 percent of itself to the public when it was listed on the stock exchange, and those proceeds were enough to pay off all of Sam’s personal debts, and for Wal-Mart to raise enough money to open stores as quickly as they could find good locations.

  Sam built his retailing business with partners. His closest partner was his older brother Bud, with whom he partnered in several stores. Sam offered small percentages of ownership of each store that he opened to potential store managers in order to lure them away from other competitive retail chains. He also offered to let a store manager buy a larger ownership if he (it was still only “hes” at that time) was willing to pay for some of the store’s opening costs. To a successful store manager that worked for another variety retail chain—J.J. Newberry, for example—the chance to own a piece of their store was unheard of. The lure of ownership encouraged many successful store managers to leave their current positions so that they might work for Sam. As we’ll describe in the next chapter, Sam had already gotten to know every manager he tried to lure away, so they weren’t really strangers by the time they signed on with him. Because Sam was risk-adverse, he made it his business to know a great deal about the people he offered to partner with.

  By the time Sam started thinking about taking Wal-Mart public, he had opened twenty stores. In addition to the thirteen Ben Franklin franchises he owned that remained very profitable, he had eight more Wal-Marts being planned and constructed. Each store had been formed as a separate company with a unique set of partners. And some stores had seen their original managers retire or move away, so there were often multiple partners in a single location.[13] In order to go public, Sam had to reconcile, with unanimous consent, how several dozen partial owners of individual stores would each come to own some percentage of the original Wal-Mart shares. This was not an easy task for even the most seasoned dealmaker, and we can see from Sam’s original handwritten worksheets that he spent a large amount of time working out formulas for the allocation of ownership. It is clear from the several thousand numbers on his worksheets, with about a hundred columns itemizing store assets and initial investments, each hand calculated (long before personal computers and spreadsheets, Sam used a hand cranked adding machine for his totals—even today, a spreadsheet this detailed would takes many hours to lay out before even starting to load it with numbers) that he was
concerned that this be done fairly and correctly.

  Venture capital firms have bright young graduates with quantitative degrees from good schools to do equivalent analyses when they’re about to sell or take public one of their portfolio companies. Today, a VC-backed company of the same relative size to Wal-Mart when it went public would likely have a similar or greater number of disparate shareholders. For a contemporary VC-backed company, the disparate shareholders would be comprised of a combination of angel investors, various distinct venture capital funds (remember that each VC firm may manage several distinct ten-year limited partnerships funds, each investing as a distinct entity), and employees that held options to buy shares—not to mention the founder(s).

  In the case of Sam Walton, almost all the ownership outside the family had been given away to create closer ties with key employees, equivalent to what stock options do today. After the IPO, Sam Walton and his family owned 61 percent of the company shares, the public owned 20 percent, and the remaining 19 percent was owned by store managers and executives (4 percent of this 19 percent belonged to Sam’s brother). Ultimately, Sam gave to his key store managers individually larger ownership stakes in Walmart than all but C-level executives would expect today through stock options in their startups. Sam thought about ownership as an exercise in creating closer bonds with people he considered his partners, not about raising money, let alone from strangers.

  To get started, Stephanie DiMarco initially raised about $50,000 from a family friend who was financially savvy and therefore could legitimately be called an angel investor (whether or not he thought of himself as that). This same friend invested another $50,000 a year later to tie Stephanie over for the extra year it took for Advent’s software to get accepted. A couple of years after that, the original angel investor introduced Stephanie to another sophisticated financial investor whom she felt comfortable letting buy the shares previously belonging to her former partner Steve.

  Stephanie later raised venture capital, primarily to give her company more credibility in the anticipation of going public. She did not need the money when she raised it—Advent was already profitable and growing steadily. VCs love to invest in fast-growing companies that are profitable and do not need their money. Shares in profitable, fast-growing companies go up in value much more often than they go down, so are not as risky. The lower risk profile of Advent compared to other private companies of its age meant that the partners in the VC firm offered to invest with relatively few restrictions on their investment. Under those conditions, venture capital was an excellent proposition even for a bedrock entrepreneur, and Stephanie was savvy enough to understand that.

  To further understand whether bedrock or high-risk is the better path to entrepreneurial success and satisfaction, you need to understand how success happens, how good you need to be, and how much you need to have—the subjects of our next three chapters.

  * * *

  [7] In recent years the pitch deck with supporting information has replaced the business plan as the way entrepreneurs introduce their ideas and their teams to potential investors.

  [8] Because VCs often do not require all the money committed by their investors to be deposited immediately, actual returns can be slightly higher. For example, if a VC waited two years to call for the funds to be deposited and returned 3 times that amount 8 years later, it would equate to a modestly higher annual return of 14.7 percent.

  [9] Often to sell a mature marginally profitable firm with risky growth prospects the VC firm must agree that a large fraction of the sales price of the company depends upon future results, thereby delaying their receipt of any cash for years and making the amount of money received an unknown variable. These deals are called “earn-outs.”

  [10] Often the fired founder is offered an honorary title to save face.

  [11] Angel investors often form formal investment clubs within their local area and thereby compare notes and ideas about companies before one or more angels decide to invest together.

  [12] Hence the adage, “VCs shoot rifles, angels handguns, and accelerators shotguns.”

  [13] Since the IPO took place in 1970 and the Bentonville store opened in 1950, some Ben Franklin stores had been open for twenty years by the time of the IPO and the stores had seen multiple managers.

  CHAPTER 6:

  How To

  Advising entrepreneurs on how to succeed seems pointless on at least three levels. First, entrepreneurs differ more than they resemble each other, and what they do to make people happy is almost equally diverse. How do you extract any insight from countless unique entrepreneurial journeys? Second, a din of contradictory advice from countless self-proclaimed entrepreneurial experts comes in the form of books, blogs, and podcasts. If the “experts” cannot agree, why should aspiring or practicing entrepreneurs pay any attention?

  Third, providing “how-to” advice plunges us back into the wilderness of definitions for “entrepreneur” discussed in chapter 2. Which definition you have in your head as you contemplate starting a company influences how you go about it. If you think entrepreneurship is about starting companies that you can promptly sell, then you will pay diligent attention to how corporations are formed and how products are developed and launched as quickly as possible. If you think entrepreneurship is about successfully running the company that you start, then you’ll pay much more attention to operational issues, like how you make a ton of sausages. If you think entrepreneurship is about leveraging your disruptive state of mind, then you’ll pay special attention to how to get yourself and everyone around you psyched up to disrupt whatever industry you decide to go after.

  Unfortunately, every definition of entrepreneur, each with an implied criterion of success, leads entrepreneurs astray because each definition narrows the entrepreneur’s focus when their challenges are actually quite diverse. How an entrepreneur decides what to do—start a company, lead the company to prosperity, and then make the company capable of standing on its own, all the while being a decent person who may or may not have a family to care for—is complex, challenging, and fraught with siren-like calls to add unreasonable risks.

  How best to cut through all this confusion on who does what to whom to get what result? By looking for a single role model who succeeded using the simplest, most widely applicable entrepreneurial techniques—Sam Walton. He may be the purest entrepreneur who ever lived. As we discussed, Sam’s upbringing motivated him passionately to want to be a respected leader in a small-town community in order to have a happy family. To Sam, entrepreneurship was how you win respect while making enough money to comfortably take care of your family. Sam’s explicit motivation to make money aligned well with his implicit motivation to be different from his father by having a happy family while living the small time life. Sam Walton led Wal-Mart into becoming the greatest entrepreneurial value creator of all time. Equally important, Sam was also a great husband and father, as well as a community leader—everyone around him benefited from his entrepreneurial leadership. Only his competitors suffered. Fortunately for us, because he was an extrovert and a straight talker who craved respect, Sam was willing to openly and sincerely share his entrepreneurial experiences in his autobiography Made in America. The book is a great read, but it is not a “how-to.” Luckily, however, Walmart and the Walton family granted me access to Sam’s files and the many oral histories of early employees that had worked closely with him that illuminate how he worked. Hearing the stories while holding in my hands the documents Sam Walton used when he made such pivotal decisions provides valuable insight into his experience. In essence, we can construct his how-to.

  Virtually all entrepreneurs learn on the job. Sam’s story vividly illustrates how learning formal skills and developing new skills relate to entrepreneurial success. He first learned the basics of retailing by buying out a nearly bankrupt owner of a Ben Franklin–franchised variety store in the small town of Newport, Arkansas. To help franchise owners succeed, thereby increasing Ben Franklin’s
revenues and profits, the corporate organization trained and supervised franchisees. What Sam needed to know to run a store he learned from them. He learned how to fill out bookkeeping, ordering, and inventory forms, and he learned merchandising—where to display goods on the shelves to better sell them. Ben Franklin expected franchisees to follow their prescriptions to the letter, and the franchisees could expect to make a decent living running a store in a small town.

  The store Sam bought had been poorly run and two other variety stores stood in the same town square, though Newport had only 3,500 residents. Sam was happy to find a store he could afford with his savings, and a loan from his new father-in-law. But he was extremely naïve about the poor prospects of the business. How could he know? He had no experience and consulted no one who did. After he took over he soon realized that, like the previous owner, he faced imminent bankruptcy unless he could figure out how to lure customers from his nearby competitors. Sam quickly corrected everything the previous owner had obviously been doing wrong—for example, he didn’t let popular products go out of stock and he laid out the store differently so customers could see every product the store had to offer—and sales ticked up modestly, but not enough. He then started visiting his competitors’ stores and copying techniques that seemed to be working for them. Sam’s constant “visits” annoyed his competitors, but there was nothing they could do about it other than appeal to the loyalty of their customers. Sam soon started to visit other stores in other towns to copy their successful promotions. Sam quickly learned that letting customers know what bargains they could find at your store really made a big difference. Within a year his sales doubled, and within three years, he was outselling both of his competitors.

  After four years, Sam was running the best performing Ben Franklin store in the entire region. In fact, the store was performing so well that the landlord wanted it for his son. Sam was screwed. When he had agreed to assume the previous owner’s lease, he had neglected to ask the landlord for an option to renew. Without an option to renew, Sam had no legal right to remain. Location in the town square was essential, and there was no other space available. Sam was left without a choice—he had to sell his inventory and other store assets to the landlord to recover what costs he could.