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Business terms

A couple weeks ago I sent my business partner in one of my projects a list of indirect competitors.  He, a television producer without a business background, replied that they are not competitors.  That made me realize that the many terms used in business are very confusing and their subtleties are unclear.  So I put together a little glossary of some terms that are often misused/mistaken.

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Direct competition vs. Indirect competition:  Direct competition is pretty clear but what about indirect competition?  For example Netflix’s direct competitor is Hulu.  They’re both streaming video platforms.  An indirect competitor can be the simple antenna TV or something that can be a technology that is still in R&D.  Over the air TV broadcast isn’t necessarily a streaming on-demand platform but it is a substitute video entertainment/content delivery system.  So a competitor can be something that is obvious or something that is not so conspicuous.

Industry vs. Market:  Industry is what your company is in.  It is your competitors, your supply chain, and related companies.  They are essentially the parties that sell to the market.  The market is your customers.  They are the buyers of your product or service.  When industry publications write “market size” they are talking about the amount of money that can be made from the customers.

Sector vs. Segment:  Sector is a subsection of an industry.  The “telecommunications industry” for example is made up of thousands of sectors; the router sector, the ground wire/cable sector, the GPS tech sector, etc.  Industry term is only as broad as the scale of your analysis.  If you are analyzing just the GPS sector, then you can say “GPS industry” and then breakdown the relevant sectors within that industry.  Segment is a subsection of a market.  A segment of the “millennial market” is tween girls, etc. (when a segment is referencing a group of people, then it can also be called demographic).  A segment of the “restaurant market” is Mediterranean restaurants.

Revenue vs. Profit (income):  Revenue is the money that is coming in before costs, expenses, taxes, depreciation, etc. are taken out.  Once those pesky things are taken out you have profit.  There is gross profit which is revenue – expenses, and and net profit which is revenue – expenses – taxes.  Then there is retained earnings, which is another step!

There are many many more (branding, PR, etc.) so if you are unsure, please feel free to ask!

How founders equity works

A few months ago, a client was looking to expand their company by bringing in more partners.  However, his partners were unwilling to give up equity.  This is fine, however in order to grow while maintain one’s shareholding amount within the company, the shareholders needed to put more money into the company. Either by hiring more workers/consultants or purchasing more assets.  They did not want to expand through labor or capital expenditures.  So they had to bring in new equity partners that were willing to invest money or sweat equity into the company.  But, as mentioned earlier, they didn’t want to give up equity.  The founder ended up leaving the company and starting anew.  Sad but a necessary step when working with partners that could not agree on how to move forward.

In reality, founders almost always have their equity positions reduced over time.  Pretty much every founding CEO you can think of will have a lower % than what they started with.  I will explain why.

Hypothetical Scenario

Typically, when Company A is formed there are a specified number of shares.  Let’s say 100 shares (in reality it’s more like 1 million or more, but for simplicity).  Founder 1 has 40%, Founder 2 has 35% and Founder 3 has 25%.  So that means Founder 1 has 40 shares, Founder 2 has 35, and Founder 3 has 25 shares (assuming all shares are out and none are held as treasury stock).  The founders decide to grow the company by seeking $50,000 (for hiring a consultant).  They can take a loan and keep their respective positions or bring in someone that can invest or do the $50,000 worth of work.

Equity Reduction

So in the hypothetical above for Company A, the board of directors (the three founders in this case) can decide to either 1) issue more shares say 9 more to the new shareholder or 2) give some of their own shares (to keep it at 100 shares).  Either way Founder 1-3 will have a reduction in their equity positions.

  • In option 1 (109 outstanding shares):  Founder 1 will have 36.69% (40/109), Founder 2 will have 32.11% (35/109), Founder 3 will have 22.93%, and New Guy will have 8.25% (9/109).
  • In option 2:  Say each founder gives up 3 shares; Founders 1-3 will have 37% (37/100), 32%, 22% respectively, and New Guy will have 9%.

Equity Maintenance

Let’s say the Founders do not want to give up any position.  They would have to divvy up the $50,000 proportionally so that their respective positions aren’t diluted.  However, in the hypothetical they do not have an extra $50k to invest into the company.  If outside money is not brought in through a loan, then the only way they can maintain their positions while giving up equity is to have a combined ownership of anything less than 100%.  This is because mathematically it is impossible to give more if there is nothing else to give.  So, let’s adjust the hypothetical to say Founder 1 has 39%, Founder 2 has 34%, and Founder 3 has 24% (a 1% reduction for all) for a combined total of 97% and 1,000,000 shares.  That means there are 30k shares available (without having to issue new stock) for New Guy to claim.  If new shares are issued, then New Guy can be given any number of shares as long as Founders 1-3 have 97% of the total amount of shares.

Company Growth

As the company continues to grow it will have to issue new shares (unless it takes on debt, which companies frequently do both).  At some point, the Founders will not be able to or unwilling to keep pumping money into the company to maintain their position.  Hopefully, at this point they won’t have to because the dividends that they may receive will be enough to satisfy their return on investment (ROI) needs.

This is why founding members rarely have the same percentage as the company grows.

For those that like pictures, check out this great infographic from FundersandFounders.com

how-funding-works-infographic

David vs. Goliath

Over the weekend I was doing some industry analysis for a client. She had a great idea and a novel one at that. Well it turns out that there was one other company in the same niche. A direct competitor…that has the early mover advantage.

So what do you do when your the new kid on the block?  Like anything else, with lots of hard work and a great deal of luck.  Let’s look at the case of Netflix vs. Blockbuster for guidance.

In 2004, Blockbuster had about 9,000 stores globally and revenues of over $6 billion.  Netflix had started just 7 years prior.  Fortunately it had several things going for them:

1.  Hard work

  • Competitive Advantage – Netflix’s algorithm takes user ratings on movies they rented and then make (i.e. compute) recommendations for other films that they might like, including movies that the viewer may have never heard of.  This rating based recommendation is very common-place now (seen everywhere from Pandora to Amazon), but in 1997, Netflix’s algorithm was a competitive advantage.  Viewers get recommendations they really enjoy, customer retention & satisfaction increases, money comes in.
  • Constantly Improve – One of Netflix’s criticisms is that DVD delivery was often slow.  Creating a logistics and inventory management system that receives orders and quickly sends out product, in addition to receiving returns and repackaging for reshipment was key to customer retention & satisfaction.  Netflix is still staying current by moving from DVDs to streaming VOD.

2.  Lots of luck

  • Competition was Flat-footed – Blockbuster kept the same mentality of a 1985 video rental shop.  They held on dearly to their late-fee revenue source, and its high fees and strict enforcement soured customers’ views of the business.  The late-80s/early-90s business model put them behind.  All they did was copy.  In 2005, they finally did away with late fees.  In 2009, they introduce Blockbuster Express, a DVD rental kiosk designed to compete with Redbox.  By now customers are streaming videos and renting DVDs at kiosks, while Blockbuster is trying to off-load their many stores.
  • Competition Thoughtlessly Expanded – Blockbuster rapidly expanded adding its 1,200th store by June 1990 and 9,000 stores worldwide by 2004 .  They wanted to be the biggest.  And fast.  The filled their stores with not just movies, but video games, candies, and other goods.  Unfortunately, all these stores require operating expenses.  Operating expenses that where greater than the gross profit (i.e. Revenues – Cost of sales).  Also, among many stumbles (which is much too long for this post but I put some references below so you can read to your heart’s content) is they failed to anticipate how media consumption will change.  From analog to digital.

Fast forward to today, Netflix has a share price of over $400, revenues of $4.37 billion USD, and over 2,000 full-time employees.  Blockbuster is bankrupt.

netflix v blockbuster

However, like most engaging stories, the end is never the end.  Dish Network purchased Blockbuster and its remaining 1,700 stores on April 6, 2011 for $233 million and took over Blockbuster’s $87 million in debt and liabilities.  Dish now continues to license the brand name to franchise location, and keeps its “Blockbuster on Demand” video streaming service and the “Blockbuster@Home” television package for Dish subscribers.  Maybe this strategy to resuscitate a nearly-dead brand  sounds foolish.  However, so did mailing out DVDs.

For more info:

http://www.referenceforbusiness.com/history2/93/Blockbuster-Inc.html

http://www.ibtimes.com/sad-end-blockbuster-video-onetime-5-billion-company-being-liquidated-competition-online-giants

http://www.fastcompany.com/1690654/blockbuster-bankruptcy-decade-decline

http://www.getfilings.com/o0000930661-02-000951.html

http://www.lundholmandsloan.com/Case%20Materials/12.%20Netflix/BBI_10_K.pdf

Loving this site!

So you tried commercial banks for a business loan for your startup.  Well, there are other sources of funding.  Namely, Angels.  Great!  Now where to find angels?  Angel.co (without the ‘m’) is a great resource to find investors that have invested in the types of business you’re starting.

Maybe, I should back up.  What are ‘angels’?  Angels are wealthy individuals that invest relatively small amounts (below $1 million) of their own money, usually in exchange for equity, into your business.

Now that you’re all caught up, checkout Angel.co and get searching!

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Uber now valued at $40 billion

Uber’s latest funding round values the San Francisco ride-service company at $40 billion, making it one of the world’s most valuable startups.

So how is a company valued? Company valuations are more of an art than a science and there are many methods to value a company. For example, if a company has been established for a while, it is more straight-forward. You can use the enterprise value method, if the company has shares, which is market capitalization + debt, minority interest and preferred shares – total cash and cash equivalents. Another is the comparables method, which like when buying/selling a house, uses comparable businesses to gauge the value of your business.

But what if it’s a startup without established revenue streams? You see it on Shark Tank all the time, someone asking for $X amount for Y% of the company. If the entrepreneur is asking for $100k for 10% of the company, s/he valued his/er company at $1M. Is that an acceptable method of valuation? Kind of. Startups can tell the market what they are worth. If the market believes the startup, it will pay that much. If it does not, then the market believes the startup is “over-valued.” Sharks will offer a small amount for a large % of a company, effectively reducing the value (not worth) of the company. Another method is the discounted cash flow method, which uses the present value amounts of projected future revenues. Obviously, a startup generally does not have established revenues so it is difficult to project future revenues.

This is why valuation is an art and the market takes time to find a price for a business, like how share prices settle at a certain point after an IPO.

How to calculate costs when you don’t know the costs

Sometimes all you have are a few figures.  Revenue, cost of goods sold, rent.  Now what?

It certainly isn’t enough to write a business plan but there is still a lot of information you can extrapolate from that.  Industry averages of financial ratios are very helpful in determining what other companies in your industry are spending on, for example advertising.  There are many paid databases, such as Factiva and BizMinder.com that provide this information but Bizstats.com is a free site that offers information on general industries.  Also, at your local library they should have the  Almanac of business and industrial financial ratios, and Industry Norms and Key Business Ratios.  Two helpful and highly detailed reference books that I use regularly.

There’s always a will if there is a way so keep researching and gathering as much info as possible.  Like they say, it’s better to measure 10 times and cut once than vice versa.  Know as much of your costs first before taking them on.

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