The Zugzwang Rule

–> Most startups fail. Before failure, the company is often in zugzwang. Unlike in the game of chess, entrepreneurs can choose to “not move” and return the remaining portion of the investment to investors.

First of all, what is “zugzwang”? It is a German word for “compulsion to move” and is most often used in reference to chess. A chess player whose turn it is to move has no move that does not worsen his position is said to be in zugzwang. Every move will make his position in the game worse, and he would be better off if he could pass and not move.

The concept is best described through an illustration. In the picture below, Black is in zugzwang because he would rather not move. Unfortunately, it is his turn so he must make a move. A king move (currently on f4) would lose the knight (currently on g5) while a knight move would allow the white pawn to advance.

In this game, the black knight moved to f3, white moved to h6, black knight went back to g5, and the white king followed with a move to g6. Black is again in zugzwang. The Fischer game ended shortly because the pawn would eventually slip through and “promote” (become a queen).

I’m not a chess fan, but I love the concept of zugzwang and recently discovered the term in a Marketing class at Tepper School of Business. I instantly began to think how this concept relates to venture funded startups. I have seen this play out a few times but will illustrate with a fictional example.

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Cougar Enterprises successfully raises $1m from a prominent VC. Cougar is a dating website that aims to connect women in their 40’s to men in their 20’s. After 6 months in the market, Cougar fails to catch on in the marketplace. They have only 500 registered users and website metrics are worsening. A new competitor has emerged, Puma Enterprises, which is the same idea and has significant early traction (1 million users and exponential growth). Puma just raised $30M in financing and no one (including current investors) is interested in an investment in Cougar. Cougar has $500k left in the bank and is in zugzwang.

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Here’s are Cougar’s choices:

1. Stay in business, make your next move, waste a bunch of time, eventually you will fail and kill a relationship with an investor as they will make a $0 return
2. Realize you are in zugzwang, return the $500k to investors and start over with a new idea. A smart investor will respect this decision and may even be willing to work with this entrepreneur on his next venture

I have heard of  a few examples where entrepreneurs go with choice 1. This is VERY RARE. Startups will often take the business down to its last penny or enter “hibernation” before calling it quits. Investors typically have no legal right to recall a venture investment, so admitting zugzwang is up to the entrepreneur. Sometimes the best move is no move – return the money to investors and move on to your next venture.

Side note —> This can be a very contentious issue with investors and entrepreneurs so would love to get your thoughts/feedback.

The High Tide Rule

–> A rising tide raises all boats

A crucial element for venture capitalists in evaluating a potential investment opportunity involves determining total addressable market and the compound annual growth rate for the company in consideration.

In this analogy the tide = the market or growth and the boats = all the companies in the given market. Most investors have market size constraints (the business must address a market size of $xxx before considering an investment). But even more important, if the market (tide) is increasing at a rapid rate, all the boats (you and your competitors) benefit. Investors like big, growing markets.

There are many great ideas that go after smaller markets, and I’m not saying these are bad businesses. If you are looking for VC funding, however, make sure the market you are targeting is big and rising.

The 1st Dollar Rule

–> Most successful early stage businesses have an anchor paying customer and have built a trust relationship with this customer. Getting to a trust relationship with an initial sponsor is key.

Ever been to a restaurant, dry cleaner, etc. and seen a plaque with a $1 bill inside signifying the 1st dollar of revenue that the business received? At first glance this can seem rather ridiculous, but just think how much work went into earning this first dollar.

It would be interesting to chart out the evolution of a business idea and what percentage of ideas transform into a business plan, the % of business plans that result a built product, and what % of these products get to a point where a customer is willing to pay for the product.

I bet it would look something like this.

Most ideas are forgotten or fail before any sort of business plan is developed – this is obvious. The less obvious point here is that many businesses build products and fail before they achieve $1 in revenue. They often give the product away for free with the hope that these free users evolve into paid users. I am not saying that this “free for now” strategy is always wrong, but the key point here is that most successful businesses have developed a key relationship with a customer that is willing to pay for the product.

This customer helps the startup in many ways. Since what the customer needs is not usually what the entrepreneur thinks the customer needs, this initial sponsor can help develop the key value drivers that future customers will desire. This sponsor can evangelize the business to other potential customers in the industry, help with reference calls for prospective customers, and provide real revenue to the business. A business with some revenue traction also looks much more credible to an investor and will often result in a premium valuation relative to a pre-revenue company.

The General Hosptial Rule

I will try to reserve Fridays for lighter venture rules, and I hope they are somewhat comical. Keep in mind, all of these “rules” come from real interactions. I have to credit my colleague Alan Veeck @aveeck for this one.

–> If, in your first phone interaction with an entrepreneur, you hear loud daytime drama TV shows in the background, and the entrepreneur crunchily eating chips in your ear, the chances for successful investment are low.

In addition, I’m told this entrepreneur was not eating your everyday light crunching potato chip, this was of the twice baked,  kettle cooked, extra crunch variety.

The obvious rule here is refrain from eating and cancel all background noise when talking to an investor. The implicit rule here is to pick a quiet location for important investor calls. I have noticed that investment calls when entrepreneurs are “on the road” – calling from an airport, hotel lobby, car, etc. are typically less productive interactions. Schedule important calls during times when you know that you will be in a quiet, private, comfortable location.

The Valuation Rule – Not Your Typical MBA Approach

–> Early on, a company valuation is a function of excitement and hope. Later on, a company valuation is a function of execution and performance

At Meakem Becker Venture Capital we invest mainly in early stage businesses. Early stage for our Firm = a team that is working full-time on the business, has built an impressive early version of the product, and has some early customer (revenue) traction. I am often asked how we value these early stage businesses since we have no historical revenue to make future assumptions, and projected revenue is, more often than not, nothing more than a cool spreadsheet filled with wild predictions.

People with heavy finance or business school backgrounds seem to be the most perplexed by the “excitement and hope” answer since these folks have been trained to value a business through strict quantitative methods (discounting cash flows to determine if the given project is a positive net present value project, etc.). Early stage venture investing is unique. While early stage VCs may do some financial modeling to determine the valuation of a pure early stage startup, a large part of the decision is based on the excitement surrounding the product, the founders, the market and the hope that the business will deliver.

After making an investment, we often work with our companies to develop a set of milestones. The valuation of a company in a future financing round depends largely on the execution and performance of these milestones which will vary depending on the industry. Execution and performance largely revolves around revenue targets, but other performance metrics are often equally as important (e.g. # of new customers, # of users, website growth, etc, etc).

After taking an investment from an excited and hopeful investor, be prepared to be given a set of company milestones…..be laser focused on achieving these milestones.

The Lead Investor Rule

–> Entrepreneurs, beware of an investment deal where the “lead investor” agrees to commit less than half of a total venture round but leaves it to the founders to find and fill out the rest of the round, even if this investor helps fill out the round. A lead investor “leads”.

I have seen this many times. I will be approached by the founder of an exciting startup who has received a term sheet(!!) from a venture firm. The total round is, let’s say for simplicity sake, a $1M raise and the “lead” investor has committed $100k to the round. The “lead VC” has left it to the founder to fill out the rest of the round. Even better, I have seen instances where the “lead” investor has agreed to tour the town and visit other VCs/angels with the company founders to help fill the round.

There are a few reasons why this is a problem for the entrepreneur and all other investors:

1) Unaligned incentives – The “lead” investor in this scenario has taken on 1/10th of the investment risk but will require equal rights with other  investors in the round. The investor is 10% committed while the Founders are always 100% committed.

2) Board seat – The “lead” investor will typically require a board seat (or 2!!) for this minority investment because they found the deal, set the terms of the deal, will negotiate the deal, etc. Unless this investor will add a great level of strategic value (more than $$$) this is a bad move for the company.

3) Downstream investment risk – Let’s say this round is a Series A and in 18 months the company has hit all their milestones and is hitting the market for a Series B. Often times the lead Series A investor will reserve the right to approve all future investment or, at the least, have a “right of first refusal” in all downstream investment rounds. If the “lead” investor feels the next round is not advantageous for him, the investor can severely slow down or kill the next round. Worth the risk?