9. Mistakes Aren’t Just for Big Companies—Small Company Chains

One of the best-known business stories in the world is how a very talented and visionary college dropout founded a software company and in 20 years, became the richest man in the world. For every huge success like Bill Gates and Microsoft, there are millions of hopeful entrepreneurs who would be happy if they could achieve even a more modest level of success.

We have focused on large enterprises in this book and, we hear about them in the news daily, but much of the world’s economy is driven by small businesses. In the United States, the impact of small business on the economy is dramatic:

• Nearly 90 percent of all U.S. businesses have fewer than 20 employees, employing about 18 percent of the nongovernment workforce.⁹²

• Over 99 percent of all U.S. firms have fewer than 500 employees,^* employ 50 percent of the workforce, and produce approximately 50 percent of GDP.⁹³

^* U.S. government, Small Business Administration definition of a small business.

• However, less than 5 percent of businesses generate revenue in excess of $1 million annually.⁹⁴

The U.S. economy would not be as strong as it is, domestically or globally, without the relatively small number of large firms that represent a large share of GDP and are part of a smooth system of global commerce. But the number of small businesses and their importance and impact on the overall economy is much greater than the average person realizes.

Small business is very different than large business, but small business owners and mangers find themselves in mistake chains in much the same way as larger company managers and executives. They miss signals, ignore or do not seek data and information, bypass systems, or allow short-term thinking to obscure their longer-term vision. These are classic drivers of mistake scenarios for all businesses, but there are some other situations that are unique to startup or smaller businesses that should be examined separately.

Most small company owners and entrepreneurs measure their success on the basis of profit but express it openly in terms of employees and/or revenue. From the preceding data, we might conclude that a very large number of small companies and proprietorships generate a middle-class living for their owners and employees, but very few generate substantial wealth. But the ability for anyone to build a business that earns them independence and the possibility of a good living, or perhaps wealth, is what drives entrepreneurs to start and operate small businesses. It is the dream that has been realized millions of times and has driven America for most of the last century.

The odds of success as an entrepreneur are not as small as they are for making it to the big leagues as an athlete playing a major sport, but the road to business success is littered with those who were not able to complete the journey for one reason or another. But the probabilities are high enough to make this ability to achieve independence and wealth the reason that many around the world admire the United States and seek to come here.

Governments around the world have initiated efforts to improve the environment for new business creation and foster a culture of entrepreneurship to stimulate economic growth. The systems that support and foster such efforts are both straightforward and very complex. There are many requirements to make such a complex system work smoothly, most importantly the rule of law and protection for intellectual property. One part of the equation that we take for granted in the United States, because we are so used to it, is the ability to easily incorporate and raise risk capital from unrelated parties whose liability is limited to their capital invested.

Most of the beneficiaries and would-be beneficiaries of this system do not realize that the legal underpinning of the ability for anyone to have an idea, start a company, raise capital, and succeed is only about 150 years old. There were large trading empires earlier than this, but business beyond what an individual could accomplish, as a sole proprietor, was somewhat unusual unless the business had government or sovereign sponsorship. The need for structures to accommodate growth was present in early society. Some assert that at least one example of a venture-capital partnership goes back to the Assyrians around 1800 BC.⁹⁵

The structure was more formalized by the 1600s when the English East India Company began trading missions, but to form a company one had to seek permission from the crown for a charter to operate. Investors could then be sought, but these were most often investments targeted to a specific short-term objective, in this case funding a trip to the Indian Ocean to retrieve spices for sale through London markets. Loose agreements often led to misunderstandings about when and how funds would be returned. In 1603, some investors in the company thought their money should be returned after one voyage, albeit one that met with only modest success because of a temporary oversupply of pepper. But the controlling investors voted to reinvest the funds for other voyages.⁹⁶ The illiquidity of pre-IPO venture investing is not new.

What is relatively new is a simple legal structure that provides the ability to incorporate easily and raise money from investors for long-term purposes, with accountability to shareholders. This has not come easily. By the mid-1600s in England, joint stock companies were permitted but fell out of favor after the excesses and scandals of the “South Sea Bubble” in the early 1700s caused investors to lose a great deal of money and faith in the structure.

Industrialization and the need for massive amounts of capital brought the realization that a stock ownership system was necessary for growth, with controls to deal with the “agency problem.”^*

^* The idea that professional managers were agents of the owners (shareholders) and that safeguards had to be put in place to protect owners from agents’ conflict of interest.

One of the most significant challenges that drove change in the systems of capital formation was the building of the railroads in the United Kingdom and United States in the mid-1800s. The new technology had obvious public benefit but made business people and politicians realize that the massive need for capital required to build and operate large-scale operations was making extant business models obsolete. At the time, the predominate business forms were still sole proprietorships or partnerships, which made it very difficult to raise the required capital for large projects that were not funded by government.

The United Kingdom enacted the Joint Stock Companies Act in 1844. Corporations were permitted in Connecticut as early as 1837, and over the next century, corporate law evolved differently in the individual states as they realized that having corporations locate, or at least incorporate, in their states was advantageous.

The system is still not perfect, and the “agency problem” still has weaknesses, as we have seen so visibly in corporate scandals at least a few times each century for the last 300 years. But for all its weaknesses, this is the system that allowed General Electric, Ford, Kodak, Wal-Mart, McDonalds, Microsoft, and thousands of other successful companies to grow from an idea to prosperity over the last century.

Not all companies go from an idea to dramatic success in a decade or two. In fact, over the lifetime of businesses, some estimate that 39 percent are profitable, 30 percent break even, and 30 percent lose money.⁹⁷ Many of those that break even are likely to be S-corporations, limited liability companies or partnerships designed to distribute all income to the owners so that the corporate tax return, from which this kind of data is drawn, shows no income or loss. This means that roughly two-thirds of all companies are at least providing a living (or more) for the owners.

We will examine many common mistakes that I have observed personally in working with and investing in small companies over the last 25 years. While these mistakes are described in small company terms, I can also say that I have seen variants of these mistakes in larger companies as well—they just look more sophisticated and are on a larger scale.

The mistakes and potential mistakes described in the following sections are often independent. They are not always a chain of mistakes where the next mistake is somehow related to the previous one. The mistakes can be made individually or in concert; it is simply a question of how many mistakes are made before there is damage and how rapidly it all plays out.

The consequences may be smaller scale, but they are no less challenging for small businesses than for large. There are some entrepreneurs who seem to have nine lives, an amazing ability to repeatedly slide to the precipice, hang on by their fingernails, and find a way to recover. This survival instinct and ability to always find a way out of a jam is unique to the most talented entrepreneurs, probably the upper quartile or less. There are many others who find themselves in situations where a few mistakes that would not damage a larger business significantly will kill a small business very quickly.

Choose the Right Idea—Then Change It

To paraphrase Will Rogers’ quote about the stock market, “Starting a company is easy: get a good idea, raise money from some investors, make the business very profitable, then sell it and retire—if it’s not profitable, don’t start it.” This is easier said than done.

I was teaching an entrepreneurship course many years ago and was discussing the mindset of entrepreneurs with a more experienced colleague. A real entrepreneur, he said, “Starts a company because he or she has a vision for how to create a business to meet a need that they can feel viscerally. They’re entrepreneurs of the heart—it makes them physically excited when they describe their vision to you.”

He went on to explain that too many students wanted to start companies because they are “intellectual entrepreneurs—they know how the process will get them the success they want if it goes well, but they don’t have a passion for any particular market or product.” The passionate entrepreneur of the heart does not always win, but he or she is more likely to win in my experience because he or she is more deeply committed.

I have seen some of these “intellectual entrepreneurs.” The Wharton Innovation Center offered market research services to entrepreneurs considering new ventures. MBA students who wanted to learn how to evaluate new ventures did most of the research work. An entrepreneur came to visit one day with some technology-based ideas for improving HVAC (heating, ventilation, and air-conditioning) systems’ efficiency.

We pulled together a team, and the group got to work doing a market and competitive technology review. A couple of weeks later, the students came to give me an update and were clearly troubled by their findings. Their concern was that more sophisticated and proven solutions were already in the market for the purpose our entrepreneur envisioned; he just did not know about them. The students thought the entrepreneur would be crushed but decided that the only thing to do was to call the guy in and tell him the competitive facts of life.

The entrepreneur came in, and the students very tactfully got around to the fact that the market was not as big as he thought and that competitive technologies already had a significant lead on his concept. After sitting quietly for about 30 seconds, our entrepreneur said “You know, I never did think that was much of an idea anyway. I’ll call you when I get a better one.”

We had two reactions. The first was that we were pleased that he realized the idea was not good and that he had saved himself a lot of anguish by not trying to start a business around a weak idea. The second reaction was that we realized he had never been particularly committed to it in the first place. He lacked the emotional attachment and excitement that is necessary to carry you through the tough times in a new business, usually in the face of competition where one must figure out how to be better. He had avoided a mistake, but his first mistake was that his level of commitment was simply not deep enough to start a new business.

I can honestly say that the most stressful time over my entire career was not associated with nuclear submarine operations, running mid-size organizations, or being a member of a board in a tough situation. It was the first year of a startup that I co-founded. You do not understand stress until you have been in a situation where you realize that, if you do not have enough receipts this week, you will not pay yourself so that you will be able to pay your programmers. Worse, this may go on for some time, and you may have to remortgage your home to lend your company money. This is what separates the entrepreneurs of the heart from the intellectual entrepreneurs. Those with passion find a way to succeed—often over and over again in the first few rough years. This does not mean, however, that if you just hang in there you can pull a bad idea to market successfully.

What do you do if you go forward with an idea and six months or a year later you find out that the market is not what you thought? You get a sick feeling in your stomach as you realize that what you just knew was a great idea is not receiving the acceptance you thought it would—or a competitor with much greater resources has beat you to market and is picking up customers fast. Is it time to stick it out, hunker down, and work harder, or is it time for a new plan?

Very often a small company will go down the drain, sticking dogmatically with the entrepreneur’s original idea, rather than shift to an area that will keep the business alive. This is the difference between idealism and pragmatism. There is no easy answer here because there have been cases of those who stuck with something and made it successful, often creating markets where no one initially saw a need (such as Apple, Xerox, Polaroid). But the big mistake is to fail to reevaluate where you are and come up with a concrete plan of some sort. Here are two specific examples:

• “The finest image on a CRT” was the subject of a new venture named Innovative Solutions & Support (IS&S) in 1988. The entrepreneur, Geoffrey Hedrick, was a serial inventor who had more than 40 patents issued in his name. He was an electrical engineer who had already built and sold a very successful company in the avionics business and had developed a technology that would make the standard cathode ray tube (CRT) capable of producing a much brighter, better-focused image while reducing power consumption.

• His reputation was good, and he quickly raised $500,000 in an “angel round”^* of financing from friends and acquaintances. He predicted in 1988 (later proven to be correct) that the monitor would become the most expensive part of the PC, not because it would go up in price but because there was no way the price of the monitor could fall as fast as the components of the PC going forward.^†

^† This has happened recently with advances in LCD display technologies, but he was correct for 12 to 14 years.

^* Typically, the earliest outside funding for a venture is from those who believe in a person and his or her ideas enough to invest when plans and organization are still in the formative stages.

• The market for monitors in 1988 was big and growing, and certain high-end applications (such as CAD/CAM) where high resolution was important had customers willing to pay more. But the company was not in the monitor business, nor was it feasible to enter that business on a small scale, so the technology would have to be licensed.

This presented a major problem: “other people’s timetables.” This is one of the greatest challenges that an entrepreneur or small company faces. When you have only one product or service with which to generate revenue, it is your lifeblood. When you have few customers, you need to generate the business quickly. Your larger customer or partner marches to a different drummer and takes longer to get your project on the agenda, much less make a decision.

While the technology was very good, the companies that were potential partners, such as Sony, saw the new technology as a minor improvement that, while valuable, did not have value for their entire customer base. Reluctantly, the entrepreneur decided to return to his roots and compete again in the avionics market where he knew he could generate revenue in a reasonable time frame.

He rapidly reoriented the company toward avionics, and over the years, IS&S grew, went public in 2000, and continues to do well.^* The original investors still own the CRT patent, but it has not been commercialized. Now, 16 years later, LCD and plasma displays have improved quality at lower prices and are beginning to replace CRTs even in higher-resolution applications. In this case, the decision to change directions was a wise one. Had the CRT business been pursued as the primary product line, it would likely have consumed a great deal of time and capital in a market that was not ready for the innovation. The specific technology opportunity was lost, but the thought process led the entrepreneur to other display applications using newer LCD technology in innovative ways. In really successful smaller companies, ideas are not always lost; they often hibernate until the world catches up with the innovator.

^* In the interest of full disclosure, the author was one of the angel investors and remains a director of IS&S.

• Improving medical office and clinic management was the objective when two partners, a physician and I, formed Intellego, Inc. to develop a medical office management system in 1985 as PCs became capable enough to do real work. Many saw the potential for PCs to replace more expensive mini-computer systems or mainframe time-share services. Vertical industry applications began to crop up as entrepreneurs all over the world saw the potential to utilize PCs to run applications developed by those who knew the details of each industry very well.

My physician partner and I shared a vision for medical practices and hospital clinics that would be able to instantly access patient information to improve clinical practice and to handle the burdensome financial tasks associated with the complex reimbursement system in the United States. We raised money from angel investors, got enthusiastic initial customer interest, obtained pilot contracts from two large and respected institutions, and hired staff to start writing code.

Typical of most software operations, we began looking for “beta customers”^* and also started selling to other potential clients for full installation while software was still being written and debugged. This “beta” stage is crucial in the software business. You hope to find out if the product is really ready from a feature and error standpoint, but you also hope to build credibility with clients who will become enthusiastic references as you go into full sales mode. Two things soon became obvious.

^* Customers who receive a discount or other consideration in exchange for helping to test and evaluate software as it is readied for full deployment.

First, we had a lot more to do on the features side. The programming job was bigger than anyone ever imagined, both for the clinical and financial applications. The second, and most surprising, thing we learned was that there was little overlap in the customers who were interested in clinical and financial applications. Those interested in clinical applications tended to be larger organizations (medical schools or large hospitals) that had automated billing systems that were working well. Those interested in the financial systems had no automated billing (smaller individual medical practices) and saw billing and receivables management as the first priority if they were going to computerize at all.

It soon became clear that neither the people nor the financial resources were there to continue work on both the clinical and financial applications. A philosophical rift developed between my partner and myself right along the lines of our training and experience—medicine versus business. Each of us thought our area was the way to business success. Following a few months of arguing about how to make progress on both fronts, the debate reached a head, and a “divorce” was in order.

The physician became a silent partner, retaining his ownership but no longer active in the business. All resources were redirected toward the financial systems side. The business grew, merged with a service bureau to expand the offerings, and was acquired by a larger company after four years.

The reality was that the clinical system was literally ten years ahead of its time and was a precursor to those used in managed care organizations today. It was seen as valuable to those with a vision of the future but was of no value at the time to those customers worried about the present. The product that will sell today is what smaller companies must pay attention to unless they have access to sufficient capital to fund the needs of tomorrow for a long time. This does not mean you never invest in the future, but when you are small, the first priority is staying alive with today’s markets, and the second priority is creating future markets. As you grow, that priority will shift.

Both of these examples illustrate a principle that for many years I have called the “conditioned market.” A market is “conditioned” when a potential customer sees your product or service offering and instantly knows how it would be used, the value it could add, and has at least a preliminary interest in knowing more about the offering.

If a market is not conditioned, the converse will be true. The potential customer does not understand what the product or service is, what value it will add, and why he or she should even be interested. It is a market that requires education and orientation, something that is always more expensive and time consuming than any entrepreneur can imagine and few can afford.

Unconditioned markets are sometimes associated with regulatory requirements, where a customer may understand the regulation requiring installation of a scrubber on his smokestack to reduce emissions but does not want to and has no incentive, other than regulation, to do so. This is not a good place to expect a quick and effortless sale to an enthusiastic purchaser.

An unconditioned market, regardless of the reason, should be a red flag waving with a warning to revisit the business plan.

Planning Your Mistakes—The Business Plan

Every book, pamphlet, course, and self-help guru will tell you that you have to have a business plan before you start your business. Contradicting this advice are many successes in which there was a business plan, but it never got out of the head of the entrepreneur and onto paper. Compaq Computer’s famous “sketch on a napkin” of a portable computer as a business plan was actually better conceived than it sounds. Very experienced engineers saw a need in a rapidly developing market and pounced, but they were not the first there. (Osborne was earlier.) They were the first with a design that worked, was physically tough, had demonstrable software compatibility (Lotus 123), and had an initial marketing partner that was the nucleus of a distribution network (Sears).

A very experienced entrepreneur, an obviously great technology, a hot venture market, or an excess supply of venture money can all lead to funding a business without a detailed plan. This does not mean that mistakes will not be made; it’s just that these folks had an easier time raising money.

On the other hand, there are many situations in which writing a business plan causes an entrepreneur or small business owner to engage in a structured thought process that helps to identify some potential mistakes that can be avoided. It is this discipline that is the most valuable part of putting the plan together, not the fact that you have a roadmap—because that will change as the market evolves and the team learns more. The best products do not always win in the startup world. It is usually the organization with the most discipline around product development, timetables, quality control, marketing focus, financial management, talent recruitment, and a range of other issues. A good idea and a disciplined approach will get you to market and success faster than a great idea and little discipline.

These are some of the major business planning mistakes that I have witnessed dozens of times:

• “Nobody else is doing what we are doing...” except for about a thousand other entrepreneurs. Even in very complex scientific endeavors that take years, we see research teams that have not collaborated reaching similar conclusions in similar time frames. This happens in most businesses. So much of business and especially technology builds on past experience and supporting discoveries by others that it is logical that many will see opportunities in similar time frames. This, of course, means you need to do as much investigation as possible to find out who competitors really are or might be in the future. It does not mean you stop when you find that you are not the first to think of the idea. It does mean that you should make an informed judgment about how you will get to market and in what time frame. In some ways, it is encouraging to know that others are in the market, helping to educate and condition it.

• “If we only get one percent of the market...” We have all seen this kind of projection somewhere in our business lives, and it was made easier by the advent of spreadsheets. It is too easy to back into the market share you need to reach breakeven and then rationalize that it will be easy to get there because it seems like a small number. What is usually missed here is the question, “Does anyone want this product, are they willing to pay a price that we find attractive, and how many highly likely customers are there in the first six months?”

• “We don’t need much capital.” This is something that can be said in error in large or small organizations, but the well is always deeper if you need to go back a second time in larger companies. The best time to raise capital is before you start making any sales in a startup or when things are going well in an established small company. The worst time to raise money is when things are going badly, but many small company executives are so paranoid about giving up equity that they reduce their chances of success by believing they can get by with less money. In my experience, this usually leads to more pain and distraction because capital has to be raised again under less-than-favorable conditions. The real reason that most startups take twice as much money and time as originally planned is a series of bad estimates: time for development, time for marketing and acceptance, and time to get payment from customers. Bad estimates of capital required are rarely because the unit costs of components or activities are not known. They usually result from bad estimates of the time it takes to accomplish important milestones, especially building market acceptance. Experienced people should know the difference between hope and reality. Inexperienced individuals should seek help from experienced business and technical people, especially with their time estimates.

• “We already have our first customer.” I have made this mistake personally. My first customer pushed me to start the systems business previously described. I was a trusted consultant to a large company on issues only loosely related to the new business idea. I had discussed our concept with some of the senior executives on a number of occasions for over a year. One day a senior VP handed me a company check for $50,000 and said:

This is heady stuff—your customer forces you into business—and you make the assumption that everyone else is just as eager to get started. We were eventually successful, but the rest of the world was not as forward thinking as the VP who handed me the check. It took longer than we thought to develop the product and the market to a point where we could make sales, but at least he had pushed us over the precipice, and we started trying to save ourselves. The lesson is to make sure that the customers who are eager are not simply early adopters because, if they are not representative of the larger population, it may be a longer road to success than you realize.

• “Customer growth will be exponential.” This is a mindset that is close to the “If we only get one percent...” thought. We all want to believe that demand will snowball once we get a few influencers to buy and like the product or service. Webvan believed that and even with $1 billion in investment never got to breakeven. Lots of people believed this about the application service provider (ASP)^* market in the late 1990s and have been disappointed.

^* The “application service provider” concept is essentially “renting” software on the basis of usage.

It rarely turns out as well as expected. Most small businesses, whether established or startup, underestimate the amount of selling that has to occur continuously. Look at large company financial statements and try to understand what goes into SG&A^† (selling, general, and administrative expenses) on their income statements. Pure selling expense is not always broken out cleanly, but it is usually a big number and is required. Small companies usually get the bottom of the barrel in terms of sales staff because they are not willing to pay reasonable commissions, cannot afford to pay a retainer plus commission, or hire the sales force before the product is ready to be sold and then lose them when they become unhappy.

^† Selling, general, and administrative expenses are usually one of the headings in an income statement.

• “Our competitors are big and slow to react.” This is something you should never say out loud and should try to avoid even thinking. That big, slow competitor just may not know you are there yet. When it finds out you are there, it will decide whether it is worth the time to squash you, and there are many legal and ethical ways to do that (and some that are both illegal and unethical but will be seen in competitive markets).

I am aware of a technology-based company that brought an extraordinary new product to market. The entrepreneur found a customer, a Fortune 100 company that liked the product and wanted to order many of them for internal use. A good and well-entrenched competitor offered to give the customer a similar product made by them at no cost as part of a package deal on a wider range of equipment. The customer refused the “free” offer on the basis that the small company offering was better technically and would mean lower life cycle repair costs—and also because they thought it was an unethical offer. This customer was the one who made the entrepreneur’s company successful because they were large and well respected in their industry and provided nice sales volume for some time. These situations happen all the time, and you are lucky if you find a customer who believes your product is good enough to do something like this—but you cannot bank on it happening.

• “Our product is superior.” This is nothing more than an opening line for the small company. There are few customers that will take the chance previously described on a new company that does not have a track record or on even a small, well-established company. Large company purchasing and technical people want security from making mistakes, and do not want to be questioned about why they took a chance on something when there were more established alternatives available. What this usually means is that you have to be able to make a proposition where the value added is so high that it is almost impossible to reject. For technical products or services, this means you have to design to sell at a price where your competitor will lose money. This must be part of the economic business visioning (EBV) process described in the previous chapter. You will get the customer’s attention when you have found ways to improve productivity, engineer new designs, reduce maintenance costs, or add so much value in products or services that the customer cannot deny the economic returns. As a small company or new entrant, an undifferentiated entry into a market is the kiss of death.

There are many other ways to build mistakes into the assumptions you make and document in a business plan, but these are some of the most important to avoid. But once you have convinced yourself that you have a plan of sorts, you will naturally be thinking about financing.

Financing—Choose Your Poison

The good news is that lots of startups and small companies raise money every year. The bad news is that the ease or difficulty of raising money from any source is highly cyclical. In case you haven’t heard, banks do not take much risk. They like collateral such as receivables, your house, your trucks, or your relatives’ signatures backed by assets. They do not lend against patents (unless already generating an income stream), copyrights, or what walks around with you in your head. Obviously, macroeconomic variables affect the picture as well in terms of interest rates and willingness to lend, regardless of risk or collateral.

Other potential funding sources, such as family and friends, angel investors, venture capital, leasing companies, and a variety of high-risk lenders, are available on different terms for different situations.

• “Friends and family are a great source of startup capital,” if you really like both pressure to produce for investors and the guilt of worrying about putting your mother in the poorhouse. This is where most small businesses get started though, with a combination of personal savings and family loans or investments. I was pleased to have friends as investors in my company some years ago, but the pressure was worse than if I had taken money from a professional venture capitalist. At least that would have been an arm’s length transaction. I valued the friendship of those who invested, which made it harder during the rough times in the business. It also meant that when we sold the company some years later, I sold some of my stock back to my original investors at a discount because I realized that it had been overpriced when we raised the first round of money from them. I would not have felt such compunction with a professional investor at arm’s length.

I have now invested in my son’s business, but I told him that it would provide him with more guilt than he deserves. I also told him I would invest only what I could afford to lose without caring (not the objective, just a calibration) because that gives him the freedom of doing the right thing without worrying about liquidity or his relationship with me. Money from friends and relatives can be a godsend, but it should be done with care because it is an added source of pressure and guilt.

• “I don’t want to be diluted.” This is the most common reason that business owners wait too long to raise money, and they often pay for it because things have gotten worse. Not only is Bill Gates the richest man in the world, but he and his co-founder, Paul Allen, managed to retain an amazing amount of ownership in Microsoft, even to this day, despite giving away vast sums philanthropically. I do know of another entrepreneur in a technology company who retained about 25 percent of his firm post-IPO, but this is not typical. My philosophy has always been that I would rather own 1 percent of a large company than 100 percent of a hot dog stand. There is no reason to go looking for dilution, but if more money will accelerate growth or bring a product to market a year earlier, it may be worth it in terms of higher market capitalization sooner rather than later.

• “The VCs have the same objectives we do”—up to a point. They want to help you make money so that they can make money for their partners, but there are differences. Their objectives and time frames are straightforward: 5 to 10 times their money in 5 to 7 years. They will not hit those numbers on every deal, but those are the objectives. It means that the expectations are high, and there has to be a liquidity event in a reasonable time frame. These expectations limit the deals they will do to a small number of businesses relative to the hundreds of thousands that start each year. Venture capital is a required piece of the infrastructure for growth in a region or a nation, but it is not for every business. They are more likely to choose you than the other way around, but if you have the choice, make sure the objectives and expectations are consistent and achievable. If you have a business that will produce a nice living but is not likely to produce high growth and high profitability fairly rapidly, venture capital is a mistake.

• “I refuse to do a ‘down round,’” meaning you have not done as well as you expected and need to sell equity, or debt with a conversion privilege, at a price that is lower than a previous round of financing. This can happen to companies at any stage of their existence, but it is most common for newer companies within the first three years or so. As previously described, it is fairly common to have missed development objectives, have slower-than-planned market adoption, more competition, more pricing pressure, and a variety of other unanticipated events. The firm may not be cash positive and yet still requires more capital. Whether you go back to existing investors or bring in new investors, a “down round” is rarely a pleasant experience. It usually involves loans with warrants to purchase more stock, meaning that if you are successful, you will pay back the debt with interest, and the investors will get a chance to buy more stock at an attractive price for up to ten years. I have seen entrepreneurs fight to avoid this until there was no other choice and then later succeed, with everyone being much happier for the result. I have also seen an entrepreneur lose his company in such a deal, but the controlling group could not turn it around either because of industry conditions.

• “We’re short of cash; I’ll pay the taxes in a couple of weeks.” This is the greatest single mistake a company of any size can make. It is tempting to borrow from the government, but they just are not an understanding creditor. As a board member for a number of smaller companies over the years, I have always required attestation from management that all required taxes have been paid each quarter because directors and officers can be held personally liable for unpaid payroll taxes. Skip paying the management before you skip paying Uncle Sam.

• “I can’t agree to those terms,” but while you wait the market may pass you by. This mistake applies to terms that customers demand for sales as well as raising capital. The most common problems have to do with customer payment terms (45 to 60 days when you need it yesterday) and security related to guaranteed performance, delivery, or ability for ongoing service. There are no simple answers here except to remember that once you have lawyers talking to lawyers, you have lost control, and the probability of a happy outcome goes down dramatically. The best way to avoid this problem is to keep looking for the champion inside your customer company that wants you to succeed and try to get him or her to get the legal department to deviate from the standard terms.

Small companies do not want to turn over source code for software in the event of a default and do not want to turn over proprietary designs for technology, but large customers will ask for these kinds of things. If you are producing a physical product, agreeing to license and qualify a second source may provide some satisfaction. Even if you are willing to do things that could potentially shift intellectual or proprietary property to a customer in order to get the business, be very careful about defining what constitutes a default under the agreement. You do not want to lose your company over a nonsubstantive technical default.

• “An IPO will solve all our problems”—not in the post Sarbanes-Oxley world of corporate governance. The costs and hassles are extraordinary, and going public might be a mistake if it is just for the ego trip of being able to talk to the analysts and track your stock price each day. Many fairly small public companies are spending $500,000 or more in annual audit and compliance fees. These fees have tripled or quadrupled with the newer, tougher audit and compliance standards of recent years. There are ways other than going public to provide for liquidity, and many smaller companies are looking at sales to larger firms or buyout funds with more interest.

The availability of risk capital is one of the great competitive advantages of the U.S. economy, but there are some great risks for smaller companies who take outside equity capital. You should not take equity capital, other than in the very early stages, if you can only keep the business alive without growth because this is rarely productive. If you do not believe the business has substantial growth prospects, then forms of capital that are more tied to operations (such as SBA guaranteed bank loans) may be more appropriate than equity investment where a liquidity event will be required at some point in the future. Capital formation and operations are not as separate as some think. They are inextricably linked because the type of capital and associated requirements or expectations for return should be linked to the plans for and expected results of operations. While most businesses need capital to start, once successful, the ability to generate free cash flow can make financing issues irrelevant. Just look at Microsoft’s balance sheet.

Operations—Implementation Is the Difference

There are many things that have to go well from an execution standpoint to make a business successful, and we have highlighted some of them in looking at mistakes in larger enterprises. There are some operational issues that are somewhat unique to smaller firms, however.

• “Just a few more tweaks and it will be ready for release.” This is particularly true of anything having to do with software, but it can affect any physical product. Whether it is bugs or adding new features because you have been talking to customers who want more even before there has been a product release, this is a tough problem. The tradeoff with what is called “scope creep” is time to market versus added features or stability. These can be difficult judgments calls, but they have to be made explicitly rather than just letting the development or engineering process drag on. I believe that if the product is stable and breaks new ground with features and capabilities that will excite people, you may lose more by waiting than by freezing development and getting the marketing and deployment started. The challenge is very visible with large, visible companies in which software, a new airplane, or a new auto model are known to be moving along in development but encounter delays. Large companies have sales of other products that produce revenue, and while the delay may be costly, it is rarely life threatening. In small companies, these delays may threaten survival because there is no other revenue.

In the last couple of years, there have been a number of announcements about new, small (six-passenger) business jets for about $1 million to $1.5 million. This is a barrier not broken before, and it depends on much new development. New companies with names like Eclipse, Saffire, and Adam Aircraft are pushing forward along with established companies like Cessna. First prototypes have begun to fly, though it is clear that development is not done, and a number of companies are going back to change engines or other major design issues that have not turned out as expected. These things happen, but once an idea, category, or concept goes past the tipping point and a market gets excited, the market will not wait for those new entrants who cannot execute. In this case, Cessna has decades of experience in making small jets and, even though higher priced, will find customers to wait for their entry in the new category. For the new entrants, timing and performance are both critical, but the first new entrant to market and then Cessna, as the established player, will set the time frame for everyone else.

Disciplined processes around product development and review, plans for getting into production, procedures for delivering services—whatever the discipline required, small companies have to work more quickly to develop a culture of performance because they will be judged that way by the markets and with less room for error than the established players.

• “Nobody around can do anything right except me.” Many small companies are small for a reason, and that reason is often that no one can get along with the entrepreneur. The challenge is that, in the early stages, the entrepreneur may be the most talented person in the firm. Small firms have difficulty attracting employees who need more pay, more security, or better benefit packages than are typical. So in the early stages, for financial and recruiting reasons, the founder may be the jack-of-all-trades. If this persists and the company cannot afford to hire capable people or if the founder or owner is a control freak who cannot let go, then a culture develops that becomes self-fulfilling mediocrity. Sometimes the entrepreneur figures this out and fixes it by hiring sharp people, and sometimes he does not, in which case advisors, venture capitalists, and others will be happy to point it out. The shift from entrepreneurial micromanagement to professional management quality and standards is traumatic for many companies and failure to make this transition is one of the most common obstacles to growth for small companies.

• “This guy has been with us from day one.” This is a classic loyalty/performance problem. Companies that have grown rapidly but are still fairly young usually have someone who was critical in the early days but whose skills or aptitude are no longer as important, or even relevant, as the company has grown much larger. The person may even be overpaid, have too much responsibility, and have more stock options than others who were hired later at a similar level.

The problem is loyalty. How can you fire or demote someone who has been with you from the week you started and who stood by you through thick and thin? Most managers eventually realize that they need to make sure that even the most loyal early employees are in appropriate jobs for their skills and personalities. This is a difficult adjustment, but demotion, lateral transfers, or invention of special status jobs with little supervision are often called for in the interest of organizational performance. Ignoring the problem rarely leads to a positive outcome and often drives off better-performing staff.

Stopping the Mistake Sequence in Smaller Companies

Many of the principles we have discussed for larger situations apply to smaller companies, including looking for signals, developing standard procedures, evaluating scenarios and risk factors, and developing an economic business visioning process. But there are a number of specific smaller-company approaches that should be considered as well:

• An advisory board. Even a small enterprise needs advisors. A company that is so small that the board is just a technicality with a couple of family members may still want to have an advisory board. The advisory board should be the best you can assemble and should be a mix of individuals who bring relevant experience from a range of skills and backgrounds. A good advisory board will often help see blind spots, push you to do the things you have been avoiding, and generally provide a perspective that is above the minutiae where the average small company leader spends his or her time.

I watched one successful entrepreneur I know in an advisory board meeting for another company as he listened to the plans for a sales campaign that was going to be launched in about three months. The advisor shifted around in his seat and was clearly uneasy with what he was hearing. He finally blurted out, “What’s wrong with selling more tomorrow? Why wait until you refine the plan for another month? Let’s simplify the plan, refine it this afternoon, and tell the sales team what they will be held responsible for each week over the next three months. If they miss the target two weeks in a row, they don’t get less commission, they get fired. What’s wrong with that?” The group sat stunned for a moment, then got into the discussion. The small company launched the program that week and had increased sales by 30 percent within four months, with a dramatic increase in profit. Sometimes an advisor can give you the whack on the head you knew you needed but just had not given yourself.

Customer advisory boards are also important to continue to calibrate your product or service offerings and to test new ideas. Some shy away from brining customers together, fearing they may learn “too much,” but if you select customers that you know like you enough to want to be helpful, this is usually time well spent.

• Get “bigger than life.” Customers may like personalized attention and a friendly relationship with staff, but they do not want to know that you are so small that there is a danger of them not getting service if someone is sick or of you going out of business. The “bigger than life” list is important to help fix this perception. Most of the things that will help are small but contribute to an important perception of size and stability. The list includes:

• Use different last names if multiple family members are in the business. My wife and I did this for a number of years, and after a few years, when the business was larger, there were even employees who did not know we were married.

• Spend the money necessary for professional-looking calling cards, stationery, and a logo.

• Develop a Web presence and provide some information, customer feedback, or other information that changes enough that customers will not simply see a static Web site. Utilize Web ordering if appropriate, but if you do this do it very well; otherwise, you will be swamped with support calls.

• Have a local presence at visible local charity or civic events.

• Develop a business philosophy, customer promise, or something else that is easy to remember and associated with the company.

• Develop and enforce dress codes and/or a code of conduct for those who interface with customers in person or via phone or e-mail.

• Find ways to seek feedback and information from customers on a regular basis via surveys, interviews, or customer-appreciation events.

There are many other “bigger than life” approaches that will work for specific types of businesses or geographies, but the point is that unless the team thinks about these sorts of things as a priority, they will not happen, and you may not control the way you look to your customers.

• Listen, continue to evaluate the EBV, and change the business plan as you get new information, advice, input, customer feedback, and response data regarding your offerings. When in the software business, I always told the team that our customers gave us all the answers to what the product needed to do in the future; they just did not know when they were doing it. Develop a disciplined approach to sit down periodically with everyone who touches customers and ask them what they are seeing and hearing. Find ways to synthesize this information and try to figure out what it all means. You will find that a lot of information from different customers and sources often points with some alignment in a direction that helps shape the business.

• Be open to changing your role. The most difficult thing a small business person ever does is to ask the question, “Is it time to replace me?” Succession is not just for large companies, and in small companies, it should not be just because you reach retirement age. There are some small business people who grow with businesses that become very large, continue to manage them well, and enjoy the transition. There are others who are terrible at managing a larger organization and hate it. Especially for founders, there is nothing dishonorable about taking on a chairman or vice chairman role and becoming a trusted advisor to those who have learned to run the business for you.^*

^* I should point out that, as a general corporate governance philosophy, I am opposed to former CEOs staying on their board after retiring or assuming a chairman role. The exception to that is a founder of a company who often has a great deal to add as an ongoing member of the board—if he or she can stay out of micromanaging the new CEO.

• Seek professional advice—and take it. I have watched small company CEOs grudgingly pay auditors, lawyers, and business advisors and generally hate the requirement to have them so much that good advice is ignored. You have to have some of them and probably want to have others. Choose them on the basis of their proven ability to help other companies your size, listen to what they have to say, and think seriously about whether it makes sense and can be applied in your situation. Many men and women in small businesses tell me they do not have enough colleagues with whom to discuss important issues. The advice is often free in CEO affinity groups, chambers of commerce, or other organizations, but you have to make the involvement and exchange a priority.

Small company mistake chains look similar to those in larger companies, and despite all the literature and experience in the market, the learning process for avoiding mistakes is no better. In fact, because entrepreneurs tend to be relatively young and do not have good internal mentoring and support networks, it is more difficult for them to see patters and learn from others’ experience. On the positive side, once mistakes are discovered, small business can often react and change more rapidly.

Insight #36: Startups and small businesses make mistakes in the same ways that larger organizations make mistakes. However, they usually have fewer resources to avoid or recover and less flexibility to survive mistakes with alternate plans or products. While the patterns are similar, some mistakes or sequences are unique to small business. These have to do with fundraising and the mechanics of getting things done in the early stages, but many others look similar to what occurs in larger, more established entities.