VI

It’s been said many times that accepting an investment from a VC is like getting married to them.  In general that’s a reference to the fact that you’ll be “courting” each other, getting hitched, and then spending a lot of time together.  All of this is true, but, unlike VC’s and investments, few love-struck couples think about divorce when they’re thinking about marrying.  Bit all VC investments come with the mother of all pre-nuptial agreement – the term-sheet.

Imagine if you were handed a pre-nuptial along with the marriage proposal!

Imagine that the pre-nuptial gave the following powers to your spouse-to-be:

1. In the event of a breakup of the marriage, they get out their CD collections, mother’s antique jewelry, the PS/3 and all the Twilight posters before you. (Liquidation Preferences).
2. And then you share what’s left, but since they had a tougher job, they get the lion’s share of your previous matrimonial home and joint bank balance. (Participating Preferred).
3. Or that they could get their friends to agree that you’re not a good spouse and, without your say, declare that you’re getting divorced (Voting Rights).

Of course it not exactly analogous, but interesting to think of in that respect.  However it does bring up two very important considerations for every founder seeking investment:

• Do your due diligence of the VC as thoroughly as they will do it on you.
  • Consider how you are treated in courtship, it won’t get much better after the wedding, if at all.
  • Find out how many divorces the VC has had in their portfolio, if appropriate talk to them and ask them how they’d been treated.
  • Make sure you understand (really understand) the consequences of the terms you are agreeing to.
    • Valuation (and the games played; like Option Pool 2-Step, Double Dipping)
    • Liquidation Preferences
    • Participating Preferred
    • Voting Rights
    • ROFR

Good investment relationships, like good investment decisions, are based on mutual respect and honesty.

I’ve had to attach the PDF for this post here   ARPU — couldn’t get Word tables to paste into Wordpress.

/d

Another day another topic, or so it seems.  This time Gross Margin and SaaS.

If you’re selling a product with a one-time price, revenue is easy to determine – it’s basically the sales price.

The Gross Margin (a financial metric that is very meaningful in real products – like washing machines or routers) is defined as:

Gross Margin = ( (total revenue from product) – (total cost of product) ) / (total revenue from product)

The cost of the product is known in accounting terms as Cost of Goods Sold (COGS) and is all those expenses – both components and labor – needed to assembly the product.  Cisco, for example, has an aggregate Gross Margin of between 60% and 65%, this means that $0.35-$0.40 of every $1.00 of revenue is the cost of the product.

For software products, COGS is basically the cost of CD’s, and a CD burner and labeling equipment, the packaging and the labor costs of packing.  Obviously there is a fixed cost element of this, but in general Gross Margin for software product is in the region of 98%-99%.

For software products that are delivered via the web, i.e. downloaded, COGS is even less.  It worth noting that the cost of delivering a product, i.e. in this case the cost of a server and communications costs, are not considered as part of COGS.  So, in general Gross Margins for software products delivered digitally are in the region of 99.99%

And then there are subscription services, where a service is delivered for a monthly or annual subscription fee.

These are two interesting properties, from an accounting and financial metrics perspective.

First, revenue is accounted as the total of all subscription fees for a particular period; month, quarter or year.  This is particularly important if you have multiple price plans. 

On a side note, many it’s time interesting to calculate average revenue, for a number of reasons.

For products, it’s usually called Average Sales Price (ASP).

ASP = (total revenue from product) / (total number of sales)

I use that to get a sense of how much sales are discounted against list price.

For services, it’s usually called Average Revenue Per User (or ARPU, pronounced r-poo) and is generally regarded as a monthly average.  It’s really a vestige from telecommunications companies accounting of the monthly telephone bills they collected, but it serves well for most subscription services.

ARPU = (total subscription fees) / (total number of subscribers)

I use that to get a sense of how much upselling is being achieved.

But things get a little strange when considering the Gross Margin of a SaaS business.  At first glance, one is tempted to consider it in the same category as software products that are delivered via the web, but a very close inspection of the accounting definitions changes that.  You can’t really call it goods sold it’s more accurate to use the term Cost of Service Sold (COSS) – except the accounting world hasn’t gotten round to decide yet.   And in the case of a SaaS offering, the cost of the service includes the cost of servers and communications in order to deliver it – since the service is the product.  Whether your business buys, leases or rents servers and storage, or in-houses or out-sources the operations of those servers, its can all be consider as part of the COSS .  In my experience, and through examining P&L’s of SaaS businesses like salesforce.com, Gross Margins for software service delivered digitally are in the region of 95-97%.

 In summary:

 In conclusion.  If you are in software Gross Margin is all but meaningless, unless you are dealing with an accountant.  So just add it in with these metrics.

There have been a few questions floating around recently regarding pricing, and much of the information available on the web is either way too academic or downright stupid, so I thought it was time to answer them all at once.  I’ve never come across a methodology for pricing, rigorous or otherwise, so this is a collection of ideas that have just been picked up along the years.  As usual, big caveats for what may be generalizations.

The first / only rule of pricing?  Your business should make money!

Now at this point, most of the web material you’ll come across will dive head first in price elasticity and economics’ supply and demand curves.  All good stuff, but as much use as a chocolate teapot if you’re launching a new business or product.  The only take away from it is ‘you’ll probably sell more if the price is cheaper”.  But that, by itself, doesn’t indicate whether you’ll make more or less profit at the end of the day.  The only way you can tell is to plug in different pricing scenarios and corresponding unit sales / subscriptions and see what flows to the bottom line.  (Using Excel “What-If Analysis” really helps here.)

In general – in software and web services – reducing price and increasing volumes is emphasizing revenue and market share, and increasing price and reducing volumes is emphasizing profit – but it really depends on your underlying cost structure – all those operational costs.

Next.  Match the price to buyer price sensitivity.  We all come to our own personal threshold of price sensitivity – individually as consumers, or as buyers for businesses.  I really don’t think about buying an iPhone app at $2.99, but I do at $9.99.  Neither does $50 a bottle for a good wine cause me to think twice, but $200 would.  We all have our own concept of value, some is very subjective, and much is quantifiable.  As some stage the value proposition of your product or service can be reduce to a financial equation, e.g. how many months value from your product or service will it take to recover the cost?  The longer it take to get that ROI, the more likely your product is overpriced, or lacking function / value – you can fix either, but reducing the price can be lot easier and quicker that adding more functionality to the product.

Then there’s competition (and there’s always competition).  As with ROI, if you are pricing at the maximum of all those competitors, then there had better be hard value that can be easily demonstrated.

So, in simple terms, you need a price that makes a profit at the volumes you’ll be selling, and that clearly demonstrates adequate value over the cost to a buyer, and the competition.

The next step sometimes leave product managers frozen in the head lights … “what if I get it wrong?”  Well, you will get it wrong, everyone does.  More precisely, rather than being wrong, you’ll probably want to adjust pricing – both up and down – to test different markets, campaigns, value propositions, etc.  But it isn’t earth shattering to either get it wrong, or to recover from it.

It’s also worth a quick side trip into sales at this point.  If a product isn’t selling, the first and by far the most common reason given by sales people is “It’s too expensive.”  If you’ve never managed sales before this can be quite disconcerting, and you may be tempted to create knee-jerk price reductions.  Ask the question “Which element of the product’s value proposition did you not manage to sell?”  That’ll teach you volumes about the sales cycle, process and individual sales folks.  More on that in a bootcamp session of survival skills for sales and sales management.

But, back to the plot.  Let’s say you’ve done all of the above analysis and come to the conclusion that your product should be $599 or $10 / month subscription.  But your really don’t know.

Here are some options:

1. Launch with full price or a “launch promotion discount” that expires after 30 / 45 / 60 days.
    
2. Evaluate your pipeline and bookings against planned volumes – remember you’ll also be testing a new sales process and possible sales team / strategy.  Drill into the reasons for low sales.
   1. If you decide your price is too low. 
      Grandfather your existing customers on their price / subscription and then either step them through a price increase at the moment schedule, or leave them on that price indefinitely.
   2. If you decide your price is too high.
      Immediately reduce price for all future sales, and find some way to compensate your initial customers for being over charged.

      In either of these cases you can create a winning experience for your customers.

Finally, a couple of other points.

1. Don’t overuse discounts.  It’ll become an entitlement.

     2.    Expect to be field testing multiple price plans as any one time, so get used to price plan conversions.

I’ve been deep into looking at convertible loans and option pools, and their impact on cap tables, dilutions and valuations.  The difference between an investment round and a round with converting convertibles or anti-diluting option pools, is the equivalence of the difference between Newton’s predicts of planetary orbit and Einstein’s. 

Its FAR too complicated and anal to delve into the difference between “nominal” and “real” pre-money valuation … beyond mind-numbing.  But if anyone is involved in a round that does include converting convertibles or option pool anti-dilution, please email me and I’ll step you through it.

It seems like there’s some difficulty getting started on a “pitch” so here’s a suggestion.

Rather than suggest another “template”, think about your pitch as “telling your story”.  Every business is unique – at least in some aspect – so there’s no “one-size-fits-all” template that is the best vehicle for telling your story.  However, the story should answer all or most of the following questions:

-          What’s the idea?

-          Does it solve a problem, or create an opportunity? (BTW, to a great extent an opportunity can always be expressed as the inverse of a problem J ).

-          Who has that problem?
Can you describe a typical customer?  Organization?

-          How many people/organizations have that problem?

-          What is your solution? Can you make money from it?

-          Would they be willing to pay to have the problem fixed?

-          How much would they pay? (If the answer is $0, then where will your revenue come from?)

-          Is there anyone else offering a solution to their problem? Who? How many are buying it? What’s the price?

-          Why would they use/buy your solution instead of one of these others?

-          How are you going to identify and reach these customers?

-          How are you going to convince them to use your solution rather than someone else’s?

-          How many will you sell, and how much revenue will you generate?

-          Finally, why is this team going to be able to achieve all of the above?

I like to think of pitches as a story that answers these questions.  The order is somewhat important, but only as an aid to the telling, and the uniqueness of every business will result is a uniqueness of the order.

Market Analysis

This area of business planning is always a quagmire of terms and definitions, but it’s not difficult if you step through it slowly and deliberately.

Ultimately a market is the interception of a product with a number of buyers – and exchange of value. And ultimately a market is just the prioritization of spending in one market to another.

To put this in “business” and “economic” terms:
• Total Market is the sum of all $, £, or € spent by all buyers of a product or a class of product..
• Value Proposition is the price a buyer is willing to give in return for the value they derive from the product.
• Competition is anything that prioritizes a buyer‘s spending on something other than your product.
• Competitive Advantage is a value proposition that prioritizes a buyer’s spending on your product rather than a competitors’, usually expressed in terms of Unique Selling Points.

I’ll carefully side step Available Market and Addressable Market for the moment, and simplify things for illustrative purposes.

So then, the Total Market are all those $, £, or € that could be spent on the class of product that you are selling.

For example, if your product is a new notebook computer, the market for it will be all potential buyers of notebook computers. And your share of that market will be those buyers you convince to reprioritize their spending away from the competition, with your value proposition and completive advantage. In this scenario the market size (the “pie”) is static and you are just taking a more market share (a bigger “slice” of the “pie”) from your competitors.

Your notebook may also have some very strong features that convince buyers of more powerful laptop computers to switch to your notebook. In this scenario you, and other notebook manufacturers, are increasing the market size (a bigger “pie”) by convincing this buyer that your notebook as enough value for them to switch.

There are two ways to think about market size; as the total $, £, or € spent (e.g. $10B to be spent of netbook computers in 2014), or the total number of purchases (e.g. 50M netbook computers will be sold in 2014). Of course the relation between those numbers is the Average Sales Price (ASP). If given the choice, I always prefer dealing with the latter.

So, when considering your market size, think about the following:
• How many buyers are there for your product? How many purchases?
• How much is being spent on similar products or services.
• How much is being spent generally in the space your product or service is in – remember it’s a zero sum game, if buyers spend money on your product, that’s $, £, or € that will not be spent somewhere else.
• Remember, if your competitive advantage is lower price (ASP), then the market size (in $, £, or € terms) is shrinking.

I’m toying with the idea of putting on two “Sales Survival” seminars.  Part 1 Sales and Part 2 Sales Management.

The objective would be to give some basic structure to the selling processing (sales script, process, objectives, closing)  and managing those that sell (sales cycle, pipeline management, forecasting).  It will also need to be generic in nature, so will never be a fit for your actual business.

I’d like to hear if this is needed and there is enough interest in putting this on?  And what specific concepts need to be covered?

This has come up on three different occasions in the past two weeks, so a brief overview ….

You can raise money for your business from getting an investment (equity) or taking a loan (debt).  Each is fairly clear.

With an investment, you sell equity in your business and the investor gets his/her return when the shares are sold.  Of course there is always the risk that may never happen.

With a loan you borrow money and are expected to pay it back over a specified period (term) at a specified interest (rate).  In theory its less “risky” than equity so earns less return to the investor.

A convertible loan is a hybrid instrument, that always starts out as a loan, but may be converted – at the lenders discretion – to equity.

Let’s suppose you needed $100,000 and that was best suited to a loan.  You could look at a “straight” loan (as opposed to a convertible loan) which would come with a repayment schedule (term) and interest (rate) attached.  Let’s say, for illustrative purposes, that the terms of the straight loan were 8% APR over a five year period.

A convertible loan would give the lender the ability to “convert” any of the unpaid principal into shares in the business at an agreed share price.

Why would the borrower or lender want to do that?

First, the lender.  Perhaps he/she would like “a piece of the action” – equity – but for a number of reasons isn’t willing to jump in with a straight investment.  Those reasons could include their intolerance to risk.  By using a convertible loan, they get their cake and eat it too.  The risk is reduced (in theory) and they can jump in with equity if they decide.  That’s a good option to have.

From the borrow’s side. He/she is giving up something here, by giving the lender the right to convert.  That’s worth something.  In general the value prepresented by the right to convert on the lenders side, is matched by better loan terms for the borrower – usually reduced interest rate or more favorable general terms.  In this case, the convertible loan may look like; $100,000 borrowed at 6% over a seven year period, with the unpaid principal converting to shares at $5/share.

Et voila.

/d

1381 The tower of London is stormed by rebels who enter without resistance.
1648 The first witch is hanged in Boston.
1775 The birth of the US Army.
1777 The Stars and Stripes is adopted as the US flag.
1789 The mutiny on the Bounty survivors arrive on Timor.
1807 Napoleon defeats the Russian army.
1822 Charles Babbage propose his “difference engine” to the Royal Astronomical Society.
1846 California is proclaimed a republic.
1919 The first non-stop transatlantic flight.
1937 The House of Congress passes the Marihuana Tax Act.
1940 Paris falls to Germany.
1967 Mariner V is launched towards Venus.
1982 The end of the Falklands War.
2010 StartVI starts.