investment

Make it or break it! Pricing and the Business Model

Start-ups often wrestle with critical decisions on their pricing and business model;  since I’ve consulted on these subjects for hundreds of companies of all sizes, entrepreneurs often ask me for recommendations.

It is hard to give general advice since each company faces different challenges depending on at least the product offering, the competitive landscape and the types of customer. 

There are a few factors that are always relevant:

1. Value Based Pricing

Cost is obviously a consideration when setting prices, since no company can afford to sell below their cost for very long.

As long as you are selling above your cost, put thoughts of them aside and ask yourself how much your product is worth to your customers. Try to capture a fraction of the customer value in your pricing model.

Finding out the customer value is often difficult, depending on the situation. 

In many B2B settings, you can calculate the customer’s return on investment from adopting your offer. 

You’ll need to compare the benefits of your offer to your competitors’ offers and their pricing. If your offer improves something customers care about, you should be able to get a significant price premium.

Here is a Harvard Business Review article with a little more detail on value based pricing.


2. Customer Segmentation

 

Customer segmentation is widely talked about, but often misunderstood. 

Correctly applied, it is about identifying groups of customers with different needs, seeking different combinations of benefits and having different willingness-to-pay.  Identifying these customer groups and their needs is, of course, essential when packaging your offer into different bundles for those different customer groups.

Customer differences in needs seldom follow simple characteristics such as sex, age, type of industry or geographic location. To find your segments, you must do market research. Market research is quantitative stuff; you engineers ought to be comfortable with it. Since many companies don’t do market research, they go for a simple scheme, like selling different product bundles to different age groups. Those simple schemes do not capture real need differences between groups, and this approach therefore often fails.

 

3. The Business Model

Prices come in many shapes and forms. Most people think in terms of price level - “How much”. The way you price, the business model, is at least as important as the price level for commercial success.

There are many ways to sell and price products or services, including:

  1. Give it away and make money on advertising or some other indirect source of         revenue. Prominent examples are Facebook and Twitter.
  2. Free (or almost free) Product bundled with paid services.  

    Companies can charge for installation, maintenance, training, customization, and         consulting services. This model is often used by companies distributing Open Source Software, like Red Hat Linux.
  3. A Freemium Model. Software companies like LinkedIn and Dropbox offer a free,         limited-functionality version of their product, hoping that enough users will pay for a     premium version with more advanced features. 
  4. Razor and blade Model. Sell a necessary base component cheaply and make money     on consumables and maintenance or some other life-cycle dependent factor.
  5. Subscription Model. Instead of selling a product, offer it as a subscription including     maintenance, service etc. This model may be used in a wide range of situations. Rolls Royce famously decided to supply jet engines at a cost per running hour, including service and maintenance, rather than sell engines outright as they and all their competitors had done before.

There is no recipe for which business model is best for your company but selecting the most appropriate one will definitely have a major impact on your commercial success and the future value of your company.

Startup Killer: Customer Acquisition Cost

Two of our current companies are thinking about maybe needing follow on investments during next year.

So, of course, we're thinking about what we'll need to show potential A-series investors to get them interested. We have time to get those numbers and get them right. 

One of the key metrics we need to show is that the cost of customer acquisition is much less than the value of that customer. 

So I found this excellent blog post, which puts all my old rules of thumb about sales channel strategies, costs of customer acquisition into a logical framework.

Use those simple spreadsheets they give you, people! Of course, the costs etc are for the USA, not for Sweden. The thinking is exactly the same. 

Over the years, I've had a few rules of thumb - for Lensway, the profit from three orders had to be more than the cost of customer acquisition. It was :) Three orders was about nine months worth of contact lenses, back then. Customers did generally buy contact lenses from Lensway far more than three times. That fits the model in the excellent blog post. 

When doing direct international sales, with all the salaries, travel etc. I've thought that a software deal had to give more than 1MSEK to be profitable, plus follow on revenue of 150KSEK/year. This is not about the first reference customers; they're likely to be more expensive than that by far. Not the deals you dream of when your brand name is well known, either. This is about the normal early stage deals, the ones you'll be doing in a year or so. Given Swedish salary levels, that just about fits the model as well. 

So I haven't been wrong, but experience has given me rules of thumb rather than a logical framework. And HERE IS the missing logical framework. Hallelujah. 

 

 

When to sell the company or at least some shares:

Trade Sale:

  • The market window for your product is getting measurably shorter, your kind of product is getting hyped, and you don't have the sales channels to take advantage of your opportunity.

    Sell to someone who does have the sales channels and complementary products. 

Your first alternative as a purchaser is probably someone you're already working with; you know and like each other, the trust is already there, and a deal can be rather quick and painless. They're also often willing to pay a bit more than others, since your products are already integrated in their business, and if you're sold to a competitor, they'll have to replace you in their product portfolio.  

Since a trade sale is often plan B in most techie startups, you'll want to develop those relationships with possible purchasers (OEM deals, co-marketing, what have you) so that they're ready to purchase you and make a fast decision if and when the time is ripe. 

  • Your targeted customers do NOT want to purchase your kind of product from a startup; it's too key to their business. A startup is too likely to fail or the good people disappear. Buying from you is not unlikely to damage the decision makers career. 

In this situation, you'll want to close a very few sales (they're tough to close!) to demonstrate customer pull, and then arrange bidding among the companies who have the right sales channels and whose product portfolios have a hole where you are. 

  • Your company cannot close enough sales to sustain itself and the trend is not your friend. Consider an Acquihire, or an acquisition which is focused mostly on getting the technical group to join a new company. The technology is interesting, but not that valuable. In 2016, acquihires often give *shareholders* up to 1MUSD/excellent engineer. The engineers themselves are often given further incentives to stay in the purchasing company. This is not a great exit, but it certainly beats bankruptcy.

 

  • If you are stronger than these scenarios, and still want or need to sell in a trade sale, then get several companies to compete to buy you. Figure out which companies are likely to want you, and get help to arrange bidding, a data room, etc. There are specialists; ask around. 


Shareholder liquidity


Shareholders who want to sell parts of their holdings are often employees or former employees and really need the cash. 

In order to avoid being pressured into listing the company while it's small, make sure that employee shares are vested over a fair amount of time, like maybe 4 or even 5 years. Then, perhaps, arrange for an investor to buy all the available former employee shares in one transaction every now and then.

The pressure from shareholders can be intense, and will distract you from actually doing your job and growing the company.  

Alternatives: 

Make sure that the company documents and the shareholders agreement allow share sales. You  probably have signed restrictions on share sales like tag along, drag along and right of first refusal. Follow those rules. 

  • Share placement:

If you have a reasonable sized chunk of shares to sell, or a group of you together has a reasonable sized chunk of shares to sell, then there are people in the financial industry who specialise in selling those shares to their large and well tended contact net of investors. They take something like 6-7% of the money.

  • Sell to a bigger investor who wants in: 

Sometimes, it's possible to circumvent those share placement people and their fee by finding investors who want shares in your company, possibly because they've made the fact that they recently bought shares public. You can offer them more shares for the same price they recently paid. They will generally not want to do the paperwork for less than a decent sized chunk of the company, so you may have to get several shareholders together and sell a chunk. 

  • Share markets:

Please do check any and all alternatives. Once you're listed and small, very few investors will notice you, you will not have analysts following the stock and you're still bound by all the rules and regulations around listed companies. Been there, done that. Avoid it.

On the positive side, there is a well known procedure to get more money from new investors. It's still not easy, mind you, but possible. You issue new shares into the stock market.
 
In order of increasing size: 

  • There are markets for shares in promising startups and small companies; for instance Aktietorget in Sweden. There, you can get your shares unofficially "listed" and the stock becomes at least somewhat liquid. Prices are often volatile and not many shares are traded daily. But still, it works. 
     
  • If you fit the requirements for First North, then there is more capital available, your company has a better stamp of approval, and the rules are somewhat more onerous to follow.
     
  • If you fit the requirements for NASDAQ, why the HELL are you reading this blog post?

If you're listed and big, then you will get the necessary analyst attention to tend your stock.

Nowadays companies can grow very large indeed before listing. Facebook was HUGE before it listed.  

To Patent or not to Patent

If your invention is at least reasonably valuable and has some newness to it, you ought to think about patenting it. 

If it: 

  • CANNOT be copied by a competent group when they've seen what you've done: DON'T PATENT, keep it a secret. Coca Cola kept its recipe secret for a hundred years. Of "our" companies, at least Ellen AB and Midsummer AB keep secrets. 
     
  • CAN be copied by a competent group when they've seen what you've done: PATENT IT

When you patent something, you publish exactly how to reproduce your idea, and in return for publishing, you get to use your idea without copying for 20 years. That is supposedly the deal between society and the inventor.  

It doesn't actually work entirely that way, unfortunately. 

  • If the invention may or may not be worth very much, and is in the area where your company is active, it is probably a good idea to patent. If and when you sell your company, your patents can justify a higher price for the company than standard valuation models would suggest. Patents also impress potential customers and scare off potential small competitors. Patenting does take time and effort from exactly the people who have the most to do otherwise, so there is a definite cost. It is generally well worth the effort. 
     
  • If your invention is extremely valuable, like Håkan Lans' invention of color screens for computers, then you have to have money enough to defend it BEFORE it is attacked. Your investor must have very deep pockets indeed, deep enough so the attacking large companies think twice about just using your invention. Go to a BIG institution. We're not that well off, so we're not the right investors for you.

The email below is from Håkan Lans. It's in Swedish.

If you want the .pdf file he refers to, email us. It features famous inventors whose inventions have been stolen, and asks the Swedish state to help guarantee patents.

---

Hej Jane,

Innan man söker patent skall man först fundera på några saker.

När ett patent publiceras får alla reda på hur uppfinningen fungerar och kan reproducera den (om inte så är patentet inte giltigt). Det innebär att det uppstår en stor risk för informationsläckage och därmed kopiering. För att ett patent skall skydda måste innehavaren ha tillgång till ekonomiska resurser för att kunna försvara patentet i en rättstvist. Om man inte har dessa resurser måste man finna någon som har resurserna när de behövs. När man fått en tvist är det försent att söka efter resurser eftersom man befinner sig i en tvångssituation där man tvingas acceptera vad som bjuds.

Jag bifogar en PDF fil med uttalanden från ett antal internationellt namnkunniga personer som klargör vad som gäller (se bifogade "Patent986-131110a.pdf "). Det är inte roligt att inneha ett patent som man inte har råd att försvara eftersom patentet då gör mer skada än nytta.

Innan vi försöker finna en tid att träffas föreslår jag att ni funderar på dessa frågor.

Bästa hälsningar,

Håkan

Håkan Lans
PhD, Engineering Sciences

Startup Exits

We often get worried questions from entrepreneurs about exits.

This description is meant to give a rough idea about what happens in an exit. We've exited a number of times, most recently selling Teclo Networks to Sandvine in March 2016. 

Another company decides they want your product, your employees (or most of them), and your customers as part of their company. They buy your intellectual property, your customer contracts, and contract the employees they want to stay so that those employees will themselves want to stay through the sometimes bumpy integration process. 

You decide to sell the company. Either the shares of the company ("share deal"), or "just" what is in the company: employees, intellectual property, customer contracts, etc. but not the shares of the company itself ("asset deal"). The difference is mostly in the taxation effects.  

The following section pretty much holds for both share and asset deals:   

THE CONTRACT AND PAYMENT:
You promise: ( "warrant")

  • you had the right to sell it
  • you owned the shares you said you owned
  • you haven't violated anyone else's intellectual property
  • you aren't in serious breach of contract
  • the company is not in legal trouble


You get money and shares in the purchasing company. 

  • proportions of money and shares vary
  • sometimes, the amount of money paid is partly dependent on the purchasing company's sales of the product ("earn out"). The more of your former product they sell, the more money the company sellers get, up to some limit. 
  • the purchasing price is deposited with a third party ("in escrow"), and is released over time as the contract terms are fulfilled. 
    • so the purchasing company can be sure your promises are true
    • so key employees stay employed by the purchasing company

TAXATION EFFECTS: 

This very complex subject changes often, is a subject for heated debate, and is just too much detail to cover in this blog post. Taxation of entrepreneurial companies is scheduled to change again next year. 

Just make %&/&%€!!! sure you talk to a tax lawyer before you sign that Letter of Intent.  

EMPLOYEES WHO STAY: 

  • will sign an employment contract with the purchasing company. Sometimes these contracts are onerous, including draconic non-poaching and non-compete clauses not commonly seen in Sweden. 
  • will get payment of their part of the purchase price over time, often four years nowadays. At least two years ("vesting"). This period of working in the purchasing company in order to get the full value of your sales price is also known as "Golden Handcuffs".
  • will sometimes get extra money/options/ earn out for staying with the purchasing company, over and above the payment to shareholders.


EMPLOYEES WHO LEAVE:

  • Their employment contracts will be terminated if legally possible, often on the closing date.  
  • Employment contracts that can't be legally terminated on the closing date will be handled by the purchasing company. 


EXISTING CUSTOMER AND SUPPLIER CONTRACTS: 

  • Mostly, the purchasing company wants to keep your contracts.  They'll do what's necessary formally to transfer them, either sending notices of contract transfer or waiting for a passive accept. Passive accept means a customer doesn't object when the usual service is delivered by the purchasing company. 
  • Key contacts with suppliers, customers, prospects ... are "handed over". 
  • One of the old employees visits the key contact together with the new company representatives, if they're really very important. Or you can teleconference, call, or write... 

To make sure that the hand over is smooth and the purchasing company can continue to sell  and supply your product.  

LIFE AFTER EXIT:

It's not bad, not bad at all. 
You usually continue to work with the people and technology you know and love for a few years ("vesting period", at least), you have many new customers and many new colleagues, the bigger scale of the purchasing company is exhilarating, and things do get a bit bumpy. 

Have some patience, the purchasing company does want you and your technology. 
Plus you have money and a salary you can depend on.  

INTEGRATION CAN BE A BUMPY RIDE

Nowadays, it seems that companies do what they can to keep people happy and motivated and working, but...not always.

A good integration will designate a head office "fixer" who makes integration problems go away. When your company credit card suddenly doesn't work, or the new sales person stands you and the customer up, or prospects call about products you were once planning to make but no longer, or whatever, this is the person to call.

You'll be expected to get your contact network working in the new company, as fast as possible. Work on it, that contact net is key to a happy life in the new constellation.  

A good integration will have made clear to the employees who are staying that they will have jobs and be very welcome to contribute to the company, who they report to, who they work with, a road map going forward, and have regular integration meetings. The purchasing company will do everything reasonable to make people comfortable. 

You will sometimes report to managers who are jealous of your successful exit and can make life pretty miserable for you, just because they can. 

I once had a manager, based in California, nine hours ahead of us, who scheduled direct report meetings four days a week from 14 to 16 in the afternoon. I called in, my time 23 to 1AM. FOUR DAYS A WEEK. I started coming in to work a bit late, and soon realised that wasn't a good idea; the others at the office started coming in late as well. I was short on sleep for years.

 

Investment philosophy: Time Money Exit

Time

We join your team, build the company with you and don't take over. We spend about a day a week with you and are around when you need us. We're useful people to have around: we're experienced entrepreneurs and up to date, since we're currently facing the same problems you are in other companies. When your company is no longer a startup or in early expansion, we will stop spending so much time with you. You won't need us then! 

 

Money 

We work on building trust, so our investment terms are as easy and simple as we can make them.  We want common shares, just like the entrepreneurs have. The entrepreneurs should own the lion's share of the company. We use standard, fair contracts from Startupdocs.se, take a seat on the board and invest up to 10Million SEK.

 

Exit

We don't have to sell; we are a family. 

We don't have a fund with an end date, where all investments must be sold by the end date and the money returned to the investors. Those end dates can force exits when the timing isn't right for the companies.  

We sell our shares when it is best for the company. Some examples: 

Klarna

  1. We let several early key employees take some of our subscription rights in a new financing round, so they became Klarna owners as well.

  2. When a crucial new investor demanded a certain proportion of the company, we sold some of our shares.

  3. When there was a secondary market in Klarna shares and Klarna had too big a weight in our portfolio, we sold some of our shares. 

Libego

When the company didn't look like it would grow quickly, we sold all our shares to the entrepreneur for 10SEK.

Lensway

We sold our shares when the company was sold, at the same terms as all the other shareholders.