Silicon Valley's need for oblivion

Just as people slowly enter the streets after a natural disaster, the players in the start-up community--entrepreneurs, venture capitalists, and start-up executives--are slowly but surely beginning to re-engage. However, in order to achieve a truly successful recovery, the industry has a lot to unlearn.

That's right, "unlearn."

Public companies learn lessons quite quickly during a market collapse. When Wall Street analysts shift from price-revenue ratios, and start looking only at price-earnings multiples, it's easy to get the picture. Or when your stock falls to 95 percent of its former high, you can rest assured that everyone in your company is not going to become a millionaire overnight.

Because private equity markets do not have the daily feedback mechanism that exists in public markets, lessons are learned (and forgotten) much more slowly. Over the five-year period from 1996 to 2000, the Internet era trained many young executives on precisely how not to succeed with a start-up. The key to moving forward is to put these ideas behind us and to operate as if it is 1994 all over again. The trouble is that most of these lessons have been learned intrinsically and are quite difficult to forget.

One interesting place to start is to look at time-to-liquidity. Prior to 1995, the average start-up took 6.5 years to go from inception to IPO. That number then fell to 1.7 at the height of the Internet craze. Now that we are forgetting, market participants need a pulse check on their own patience. This is no longer a quick-hit game, but rather a steady slow process. The sprinter mentality that worked wonders during the past five years is a recipe for certain failure in this new-old environment. Find all those players on the fast track, and purge them from your organization.

Now let's consider the general rule of thumb that investment banks are preaching these days with regard to IPOs (initial public offerings). If a company wants to go public, the saying goes, it needs to have at least $30 million in annual revenues and show at least two consecutive quarters of profitability. Now let's see what that means from the perspective of company growth, specifically with regard to head count.

Let's assume that in six years, Company X will have $30 million in revenues, an 80 percent gross margin, and a 5 percent pretax profit. In month 72, this implies a $2.5 million revenue line, with $125,000 of pretax profit and $1.88 million left to cover operating expenses. If we assume an operating expense per employee of $15,000 (below average in Silicon Valley), you arrive at a total potential head count of 125 at the end of year six. Assume a linear growth path, and you get 21 employees at the end of year one and 42 at the end of year two.

The numbers are worse for a hardware vendor that will be saddled with a much higher variable cost line. Let's assume Company Y is the same as Company X, except that Company Y has a 50 percent gross margin. In order for this company to be profitable at $30 million in annual sales, peak head count would be 75. Bump the breakeven revenue number to $50 million, and you still have a year-six head-count number of only 125.

These head-count figures will seem shockingly low to any executive who was educated on Internet time. These executives shoot to 100 employees in their first year, because that's the way it was done when capital was freely available. The justification for such growth is typically not one of rationality, but rather a function of pointing to other companies with similar commitments and execution ramps. "That's what it requires in this market" is the phrase of the day.

Managers that are stuck on Internet time are easy to spot. They are the ones that still believe that it is OK to consume $75 million in cash on your way to profitability, and that their business does not reach profitability until it hits $250 million in sales. Businesses that exhibit these characteristics should be closely examined. Capital intensity is quite the turnoff to the 1994-style investor, as it represents dilution and simultaneously raises the bar for the level of success needed to repay each investor. Also, businesses that require huge revenue hurdles to hit scale are by their very nature less-scalable, less-interesting businesses.

On the competitive side, some companies will tell you that they have to spend at a certain level to compete with the industry leader, typically a multibillion-dollar player. Once again, this argument will be quite uninteresting in a newly skeptical venture environment. The need to spend dollar for dollar with a large industry player appears to be a blatant condemnation of the differentiation of the start-up's product. After all, product uniqueness should be its own sales pitch--especially early in a company's life.

As capital goes from free to precious, you should notice many changes in funding cycles. At the height of the craze, it was common practice for companies to raise as much capital as they possibly could, preferably sooner rather than later. The idea was to build up a war chest, but all that was built up were employee bases and infrastructure.

We are now heading back to a time when executives want to raise less money rather than more, and raise it later, rather than sooner. Why? Because raising money is dilutive to ownership, and therefore it makes sense to raise as little as possible, and to raise it after you have achieved as many milestones as possible so that the valuations will be higher. This is not the standard operating procedure, but it will be.

How close are we to such shifts? Not very. People are creatures of habit, and these lessons have been etched in the mind for more than 60 months as standard practice. Eventually, the private equity markets will deal with these issues in their own way--leaving those that resist with failure. That said, there is a much better way to approach the Internet era when it comes to start-up organizations--forget it ever happened.