The Brink of Chaos

Tom Sawyer may have been ingenious converting whitewashing fences into play, but when he is trying to help Huckleberry Finn free a slave he represents the establishment.

For those that don’t know the story, here is a quick overview: Huck and Jim are running away. Huck from his father, Jim from slavery. Eventually Jim is caught far from home and while his captors search for his owner, Huck happens to run into Tom Sawyer and the two of them set about freeing Jim.

Jim is barely watched and very loosely locked up by a farmer. Freeing him was simple, but Tom doesn’t think that’s the right way to do things. After all, the daring escapes found in books came after many long years of planning and toil. The boys go through all manner of difficulty to make the escape as difficult as possible. For example, after digging a hole under the building which Jim could easily escape out of, they bake him pies with wax to deliver teaspoons to him. Jim needs a stone to carve some messages on, so they have him leave his captivity to help them carry the stone back into his cell. Instead of simply lifting the bed to release Jim’s shackles, they cut the leg off the bed and eat the saw dust (much to the disgust of all three).

Throughout this time, both Huck and Jim question Tom about why in the world they should do all of this. Tom tells them they don’t know nuthin’. Who ever heard of someone escaping by just lifting the bed? That just ain’t the way it’s supposed to be done.

Tom is stuck trying to reenact stories as the model for the way things are supposed to be done. He dismisses any ideas to the contrary. It’s almost painful to read as the answer is so obvious and yet Tom continues to take the most difficult path. But we all do this from time-to-time. We’ve read the books. We’ve heard the stories of other successful companies. Rather than creating our own path, we want to stick to what we’ve heard, what we think is safe. In a world that is changing so quickly around us, what we’ve done before or what we’ve heard may no longer be “the right way”.

We can also be like Huck; we see the simpler solution but give in when the establishment pushes back. In fact, if we’re trying to do anything new, we’re likely to hear people tell us that it’s just not the way it’s done. But this is how new stories get written and how we can find success instead of failure. Sometimes it’s time to kill the sacred cows.

What if we have so many customers knocking down our door that we can’t support them all? What if our support is so bad, they never come back? We should build our company and technology for that day, just in case. This hypothesis keeps companies overbuilding their product for an eventuality that will probably never come. Most “overnight” successes take years to create, but this fear of too much success, persists.

The two most critical resources for a startup are time and cash. The more time you spend in building something, the less time you have for trying something else. If you spent too much time overbuilding a piece of technology, you lose out on the ability to build something of more value. Moreover, most technology development follows the 80/20 rule: The first 80% of functionality takes 20% of the time. The final 20% of polish takes 80% of the time.

Ultimately, I think this is what the mantra “Fail fast, fail often” is really about. It’s not so much about the value of failure itself, it’s about being willing to face the fear of shipping.  It means putting out incomplete work and getting some experimental results, even if it means learning that you need to do something different. Once you get confirmation that you’re on the right path, that’s when investing and executing on the remaining 20% will pay off huge.

An investor friend of mine posted on his blog this question:

This week’s sign of tech bubble: multiple seed-stage startups demanding investors buy common stock instead of preferred. Thoughts? I have strong professional opinions on this and will draft a full blog post on the topic, but thought I’d crowdsource some input first…

Every start-up business that is looking for external funding has three basic outcomes:

1. The business becomes wildly successful and is bought or goes public at a valuation that is many multiples of its original value.
2. The business runs out of cash and must be sold in a fire sale/bankruptcy
3. The business barely reaches a positive cash flow allowing it to stay in business indefinitely, but without much prospect for growth. I’ve heard this affectionately called “the walking dead” by several investors.

Investors are motivated to put their money to work. By putting their money in the hands of skilled entrepreneurs that can turn that money into more money. entrepreneurs are interested in building a successful business AND turning their time into more money. When investors and entrepreneurs partner together, the goal is to align motivations across the three various outcomes.

Preferred stock gives the investor certain additional ‘preferences’. These typically cover cases #2 or #3 in the above scenarios. For example, if an investor puts in $1M for 30% of the company and the company sells in a fire sale for $2M, the investor has the right to get his $1M back first instead of the $600K that he would receive as his pro-rata share. Better explanations of the variants on this can be found over at AVC.

The primary motivation behind preferred stock is to protect the investor in the case of an unsuccessful outcome. The reasoning typically given goes something like: employees used the money of the company to get paid their salary but were not successful in turning the business into a profitable entity, therefore the investors should be entitled to their money back in the case of fire-sale.

There are four possible flaws to this argument:

1. The argument ignores that employees are also investing their time in the enterprise. This time could be spent in other endeavors. Typical startup salaries are less than in a large enterprise, so the employee is also investing the difference in his earning potential (the difference between the money he will make, and the money he would have made elsewhere).
2. It assumes the entire responsibility for the business succeeding or failing depends on the work of the employees. Since it’s possible for unforeseen issues that are out of the control of employees to take a business down, they should not carry the full weight of that outcome.
3. It assumes the employees need investors to build the business. If investors are having a hard time finding opportunities to put their money to work, or the opportunity is so strong that the risk of outcome #2 and #3 is low enough, it doesn’t make sense to add the complexity that comes with different kinds of stock.
4. It assumes that VC’s will make judicious use of their preferences (or more accurately, are focused on aligning motivations as partners not trying to secure an aggressor/victim relationship)

In the end, the question is about negotiating incentives that cause everyone to focus on outcome #1 as the ideal while still mitigating risk for all parties in the outcomes #2 and #3.

In the case of argument #1, the problem here is whether or not the salary being paid to the employee is greater than other opportunities might provide. If that is the case, then there is a strong motivation for them to make this into a lifestyle company (outcome #3) rather than taking the risks that are needed to result in outcome #1. If the salary is significantly less than other places, then the employees are also motivated to outcome #1. (I would expect to see this kind of structure in any “everyone owns common stock” deal).

I could see entrepreneurs wanting to make argument #2 but I don’t think it’s a very strong argument for aligning motivations. If you couple this argument with an overemphasis on “fail early, fail often”, it likely leads to far more #2 outcomes, where the employees would still reap some reward for their failure.

The third argument is probably the most indicative of a tech bubble. If investors can’t find enough qualified places to put their money, then entrepreneurs can select their pick. It is obviously in their interest to own the same kind of stock as the investors. Ultimately, it is becoming easier and easier to start companies without additional capital (especially at the seed stages).

The fourth argument is probably the reason this is getting requested. Similar to the point I made on the challenge of pricing , because VC’s have a reputation of abusing entrepreneurs that don’t know better, they are now reaping the reward of this reputation. Namely, that the entrepreneurs don’t want to trust that VC’s will make judicious use of their preferences.

When you couple the reduced need for external capital with the abuses of VC’s, I can see why entrepreneurs are looking to change the motivation calculus at the onset.