The Rule of 2

–> Take a startup’s business projections and multiply by 2, multiply by 2, and divide by 2. Successful businesses often require 2x projected capital needs, take 2x as long to reach the investment goal, and attain 1/2x of projected revenue.

This is my back of the envelope calculation whenever considering an investment in a startup. Let’s look at Company X:

COMPANY X

• Funding Request = $1,000,000
• Goal = Cash flow neutral in 18 months
• Annual Revenue 3 Years from Today = $16,000,000

Here’s what I do:

Apply the Rule of 2

• Money Company X will actually need = $2,000,000
• Goal = Cash flow neutral in 3 years
• Annual Revenue 3 Years from Today = $8,000,000

Keep in mind that this is often the result of a successful business and not every business. Successful means you are some small % of the 1% of business ideas that get to a point where there is a paying customer and real revenue. This is obviously not an exact science. The Rule of 2 is a good starting point, a good sketch. Given the Rule of 2, does the business still get to a point where a venture capital investment return is realistic?

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.

_______________________

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.

_______________________

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 Ari Gold Rule

The Ari Gold Rule:

–> Beware of a venture deal where you have a VC agent shopping the deal unless there is s a good reason that entity is involved

We see “Ari Gold” in many industries today. A large majority of professional athletes hire an agent or middleman that acts on behalf of the player, helping the athlete secure the most lucrative contract from a number of potential suitors. Another example is the real estate industry where most home buyers hire an agent that assists in the home buying process. These “middlemen” typically make 2-6% of the total transaction (depending on the industry).

There are times when I am approached by an Ari Gold to invest in the next hot startup. This leaves an instant bad taste in my mouth. When I am approach by a VC agent I instantly assume 3 things:

1. The company has previously been unsuccessful with raising money on their own

2. The business is being shopped to dozens of VC’s simultaneously so it is either being rejected by every other firm (more likely scenario) or will be a highly competitive deal (less likely scenario)

3. The middleman will take ~3% off the top of our total investment before our newest portfolio company will spend a penny