Anatomy Of A Startup – Part II

As I mentioned in my first post in this (occasional) series: “building a startup is one (highly risky) way of making $7 million in 7 years!”

My first B2B (business to business) startup was 100% offline (a.k.a. B&M a.k.a. ‘bricks and mortar); it funded my entire investment strategy – you have to get your cashflow from somewhere, right?

Even though it made barely more than a wage in terms of profits, I was able to scrimp, save, twist, and manipulate my way into an unbeatable combination of Business + Real-Estate to make my first $7 million in 7 years … even before I sold the business!

Nowadays, my twin passions come together in this post: writing about personal finance + working on startups.

I still own one fully b&m business (a finance company, established for nearly 20 years) and own 50% of another (a startup selling a unique product to cafes), but my ‘passion within a passion’ is actually web 2.0 (or, more trendily known these days as ‘social media’) startups.

And, I have just agreed terms with my two partners on my latest 100% online project (I found these guys by joining a meetup group online … kind of like meeting your future wife on PlentyOfFish.com!) .

The question that will obsess you most at this stage (it shouldn’t!) is “how much equity” did each partner get?

There’s many ways to cut-and-dice the pie:

The simplest is when two or three founders get together at a party and come up – in a flash of drunken inspiration (which is exactly how my LAST idea came to fruition) – with The Idea. Then they all do a handshake and a business is formed with each holding equal shares.

It only gets complicated – killing the business and the friendships – when one of the partners doesn’t pull their weight, or when one needs to go full-time to take the idea to the next stage, or …

The other way is to recognize different contributions at the outset:

– Who came up with the idea? Let’s say that I came up with the idea, and have begun the patent process (for whatever that’s worth).

– When did you come on board? Let’s say that I found you, and need you for a specific job (e.g. web-marketing).

– Who needs to draw a salary? Some partners will need SOME money to live … hopefully, nobody’s stupid enough to believe that this is a real, paying job (yet/ever).

– How many hours a week will each partner work? What about after launch?

– What are the basic milestones?

These are the real questions that we had to address in the past week or two, and here’s how we dealt with them [AJC: the real numbers are close to the following cooked up example]:

We agreed a NOMINAL dollar value for everything:

– The idea was given a nominal value of $200,000 (normally in the $100,000 to $200, 000) range

– It was agreed that each partner’s time pre-launch (and, to a specific point after: see milestones, below) would be worth an identical amount (we chose $100k each for the sake of simplicity; not to be confused with a real salary i.e. nobody will actually draw $100k in salary, at least not for quite a while!)

– We also agreed to keep an extra ‘salary’ for an extra partner that we would still need to find to plug a gap in our teams’ combined skill-set

– We also agreed to keep an extra few $ (initially, we wanted this to be $100,000 … we settled for less) as an extra incentive for PAID staff who may come on board in the future, but not as partners

– We also agree that we needed an ‘advisory board’ of 3 members, who would split about $35,000 in nominal ‘salary’ (remember: they will take this in % equity, not in cash!)

– We then agreed who was going to get paid in real $$$ before we actually make any money, and agreed that would be only one of the three founding partners who needed $40k to pay the bills at home! That was easily dealt with by taking down his starting position from $100k to $60k

– Finally, somebody needed to come up with some cash to start the company off (seed money); fortunately, asking me to reach into my pocket to offer $100,000 was a relatively easy decision for the group.

Now, realize that these are not real $$$ (except for the $40k salary for one of the partners and my very real $100k cash contribution) …. nobody is going to get paid $100,000! Nobody is going to give me $100,000 or $200,000 for the idea! I’m only going to put in the $100k as and when/needed!

These are NOTIONAL dollar amounts:

What we did next was to add all of these $$$$ together to come up with a single total, in this case just under $700,000.

Then it was a relatively easy matter to calculate everybody’s share of the equity e.g.:

– the founder who was not drawing a salary would receive $100,000 / $700,000 = 14% starting equity

– the founder who was drawing a $40k starting salary would receive ($100,000 – $40,000) / $700,000 = 9% starting equity

– The advisory board would split $35,000 / $700,000 = 5% (we would eventually offer 1.5% each and keep the rest as ‘spare equity’)

… and so on.

Note: whatever equity is left over (remember the ‘spare equity’ for the extra founder and for future staff incentives, plus any left over from rounding down as we did for the advisory board?) is actually owned by the founders in equal proportion to their starting equity. Equally, though, as future rounds of funding are taken on, the founders will be diluted in the same proportion.

Oh, but how do we know that we will actually work well as a team?

Simple: we didn’t hand out the equity all in one lump, we came up with a vesting arrangement tied to key business milestones.

Here’s what we came up with (each founder had exactly the same vesting arrangement, as did the advisory board, just to make sure that it didn’t cost us too much to get rid of any ‘lemons’ in our team); 20% of the offered equity would be released to each founder / advisory board member at each of the following milestones:

Milestone 1:   Project Commencement (date of incorporation of (working name))

Milestone 2:   Market launch of first functional web site

Milestone 3:   Receipt of first substantive revenues (>$5,000 in aggregate from time of startup)

Milestone 4:   Receipt of >$150,000 in aggregate revenue from time of startup

Milestone 5:   Receipt of >$500,000 in aggregate revenue from time of startup

This way, everybody needs to pull their own weight until the business is truly firing on all cylinders before they ‘earn’ their full allocation of equity.

The complication will come if additional outside funding is required before these milestones are reached. Then again, if all founding partners are still on board, everyone will be affected equally (well, in proportion).

Now, why did a say this equity discussion is not important?

There’s no equity if the business doesn’t get off the ground: your prime focus, at this stage, is to make sure that you have an idea that the market wants and that you have the skills to bring to the party … and, that’s all about commitment and execution (as well as a little luck)!

If you have a startup, leave a comment to share your experience with horse trading starting equity 🙂

Start a new business or work 100 hours per week?

The title of this post is a little misleading, as my astute readers would know that your business will also ‘cost’ you 60 to 100+ hours a week, even as it matures.

But, Con has a real ‘business v job’ dilemma:

I’m kinda stuck in a dilemma as to what I should do after graduation in June this year.

I did my undergrad for 3 years, worked for a year and went back to school for another 2 years to get my masters.

I recently got a job at an investment bank making around A$100k after taxes. However, I will be working 100 hour weeks.

I really enjoyed my time when I was a kid going through highschool because I used to sell stuff online and amassed a small fortune about $30k out of that. I don’t think any 17 year old kid had that much money back then. However, I stopped selling stuff because of other commitments and ‘uni life’.

After so many years of formal education, I think that too much education is a hinderance to entrepreneurship. I have about $50k in capital right now, and I am thinking of starting something small.

But on the other hand, if my business doesn’t work, I will be sacrificing a ‘good’ career opportunity + time wasted. I am 23 this year, and my peers have already 2 years of work experience ahead of me.

Unfortunately, I can not give Con – or, anybody for that matter – direct personal advice, but I can tell you about my 16 y.o. son who has a very parallel life and aspirations:

– My son is still in high school and started off selling eBay stuff online and now has ‘graduated’ to a fully-functioning web-site that earns him about $100 a week … I’m sure it will make him a lot more if he knew how to promote it online.

– My son wants to be an investment banker but is not happy about the typical 100 hr work-week and, neither should Con be happy with that set of working conditions … for long!

Since I can’t give Con personal advice, what I would tell my son is:

1. Continue on the educational path that seems to make the most sense / offer the most opportunities (if he asked me if investment banking – and the double law/commerce degree required – was a good choice, I would say “it’s up to you, but I think it’s fine!”)

2. Continue to build his businesses part-time … with luck, his business (or, any future business he decides to start) will replace the time/revenue from a part-time job. Hey, nobody gets to study without working at least part-time, right?

3. At some stage he may need to make the hard decision: continue studying or continue to grow the businesses, but that’s unlikely.

Which ultimately might lead him to exactly where it sounds like Con is today:

My advice – if my son chooses to ask for it – would be to work at least 2 years at the required 100+ hours / week, then make the ‘corporate life v business ownership’ decision; he should walk away with some excellent corporate/professional experience and he should have some serious debt paid off and some big $$$ behind him … in the meantime, I would strongly advice my son not to spend a dime unnecessarily.

For anybody still going through college or starting their first job or business, I say:

Keep living like a penniless college kid, mooching off family and friends like any ‘normal’ college kid does, while you’re busy investing 99% of what you earn.

Then you’ll have the capital (and/or no debts) to do whatever it is that you like!

Make money while you sleep?

Making money while you sleep … isn’t that everybody’s dream?

Erica, my favorite small-biz-whiz, shares her success with a business that makes her money not just when she’s sleeping, but also while she’s away:

You don’t need to stay home to work. Whoosh Traffic had its 1st $1000 day, hit $10K in total revenue, & became profitable while I was gone!

But, there’s a problem, the kind of business that lets you make money while you’re asleep / away is also the type of business that tends to produce small numbers. Take a look at Erica’s results: $1k a day in sales, $10k total revenue.

Now, we know that this isn’t Erica’s only income stream – and, even this one is new and growing – but, I’m sure that Erica will be the first one to tell you that there’s a (low) ceiling to the income that a business can grow that can truly “make money while you sleep”.

In fact, I wager that in aggregate, Erica’s “make money while you sleep” businesses actually keep her pretty busy … and, she has plans to be even busier.

You see, I am willing to bet London to a brick (whatever THAT may mean) that Erica has a Number [i.e. the amount of money that you need in order to begin life after work a.k.a. retirement] that is pretty big, but most “make money while you sleep” businesses won’t be enough to help her get there:

a) The income they produce may not be enough to build up the Number on their own, and

b) They have no – or insufficient – resale value.

Of course, there’s a third alternative: if the business makes money while you sleep, and that income is enough to pay the bills, why do you even need to reach your Number?

Simply because no business lasts for ever … and, do you want to bet your financial future in the face of ever-changing technology and market conditions that you will continue to find replacements?

My businesses made money while I slept or went away – on some days. But, whenever my cell-phone rang – wherever and whenever I was in the world – I HAD to answer it because the buck ultimately stopped with me … banks and ceo’s demanded it!

But, the advantages were:

1. The businesses eventually produced enough cash to fund both my ever-growing lifestyle AND my long-term retirement investment strategy i.e. I could buy enough investments that I reached my Number by my Date, without needing to sell my businesses,

2. Even if I hadn’t already invested externally, I could (and did) sell my businesses for more than enough to reach my Number before technology and/or market conditions could change to my detriment.

Two paths to reach my Number: invest and/or sell [AJC: I did both and advise you to do the same … never rely on being able to sell your business]

Price: restless sleep!

So, is there a place for ‘Erica Style’ businesses?

Absolutely:

– You could build up a portfolio of those businesses; in doing so, you are making building these types of business your business! What?! That’s exactly what Erica is doing: she puts in 110% effort to build these types of businesses and to teach you how to do the same. I bet that she doesn’t have a ‘kick back on the sofa and let the business make money while I sleep’ attitude at all!

– More simply: you can build one or two of these types of businesses while you are sitting around at college, writing your blog, or working your ‘day job’, and use the EXTRA income that this business generates to fuel your investment strategy – or, build up the seed capital for that ‘real business’ …

… the one that WILL keep you up at night, until you sell 😉

Copying the magician …

Have you seen those acts where the magician calls a volunteer up from the floor, hands them a rope then says to “do exactly as I do”.

The magician walks the volunteer, step by step, through the process of knotting his rope, while the volunteer tries to copy him exactly.

Of course, at the end, the magician’s rope is neatly knotted and the volunteer has rope all over the place and looks a little foolish.

You see, the magician has some extra steps that the volunteer doesn’t pick up, or performs in mirror image, so the trick is doomed to failure for him.

Of course, it’s all good-natured fun …

… but, it’s not so much fun when it happens in real life 🙁

For example, in my last post, I outlined some steps that retirees can take to create a “zero withdrawal rate” strategy for their retirement to virtually guarantee that their money will last as long as they do:

Now, 0% does not mean withdrawal nothing, but it does mean having a sustainable, self-regenerating supply of income; this is not as hard to achieve as you might think.

For example, you can create an ongoing stream of income from:

1. Inflation protected annuities (albeit expensive)

2. TIPS (albeit a low return)

3. 100% owned real-estate (albeit, needs management)

4. Dividend stocks (my least preferred as they are sometimes a sub-par investment that tends to rise-fall with the markets).

Remember, when you retire, you want not only ZERO chance that your money runs out, but you don’t even want to get anywhere near to zero by a wide margin.

A great feat … if you can pull it off.

But, you have to copy my strategies exactly … and, to do that you need to use your powers of observation to do exactly as I do. No deviation.

So, let’s take a ‘volunteer’ from the audience, Evan, who commented:

My goal is to have a little bit of all those buckets…right now I am trying to build the dividend portfolio.

Right strategy, but it seems that Evan missed the magician’s “secret step”:

You only implement these steps AFTER you have retired (at least, after you have reached Your Number).

Your goal should be to:

1. Have a large enough nest-egg (i.e. Your Number) to provide enough to retire with, and

2. To then ensure that it (i) keeps up with inflation and (ii) never runs out.

These strategies (dividend stocks, TIPS, 100%-owned real-estate, etc.) only work for Step 2.

They typically don’t provide enough return (including growth of capital and income) to build up the nest-egg that you need, in the first place!

So, if you implement them too early, your nest-egg will be too small to begin with …

Instead, you need to find a class of investment where both your capital and your income grow (at least) with inflation.

Here’s an example using real-estate:

a) BEFORE retirement, build up a large real-estate portfolio with 20% down, and refinancing at regular intervals to build up a large portfolio over time. Reinvest all excess profits into buying more real-estate. Use a mixture of residential and commercial to provide higher growth. Add value by building, rehabbing, etc. etc.

b) AFTER retirement (or, as retirement approaches) sell down your portfolio (particularly the lower-return residential component) until you have sufficient cash to pay out the prime commercial properties in your portfolio. Your aim is to own the best rental properties 100%, with a buffer for vacancies, repairs and maintenance, etc.

c) WHEN you get too old or ill to manage the portfolio (even with the help of qualified Realtors and property managers), sell out (or, leave instructions to your attorneys to sell out) and purchase TIPS (or bonds, if TIPS aren’t available).

Three radically different investment approaches … one for each critical stage of your life.

The ‘No Lease’ car lease …

The wrong way to buy a car is to lease it:

You’re financing a depreciating asset: so, as the car goes DOWN in value over time, your investment in it is going UP, payment by payment.

Dumb, huh?

The frugal way is to buy a used vehicle and run it into the ground.

But, what if you like and can afford to buy a ‘certain quality of car’?

Well, I would never buy a new one, and I would usually buy one of a lesser standard than I can afford, because cars do depreciate and are simply NOT an investment (even when you think they are).

Now, this is a blog for aspiring MULTI-millionaires, so I am going to spare you the usual reasons for buying used rather than new [hint: something to do with depreciation vs future resale value curves], because you can actually afford to buy new!

No, what I have to share works on the assumption that you can afford to buy a new car, but you do have budgetary contraints: i.e. a Number that has to fund your required standard of living for life. You can’t afford (literally) to have your money run out before you do!

If you’re either too rich or too poor for that to apply then this post [AJC: actually, my whole blog] does not apply to you …

But, this post DOES apply if you have a new car budget, be it a new $250,000 Ferrari 458 Italia [yum] or a new $11,000 Chevrolet Aveo [yuk]:

No, the problem is that IF your mindset is to buy a new vehicle, then how do you feed your desires in 3 to 5 years when your ‘new’ car becomes just another ‘used’ car?

However you justified the ‘new car’ purchase – new car smell, new car warranty, new car reliability, new car status – in just 3 to 5 years, the ‘gloss’ will have well and truly worn off, and you will be in exactly the same position as you are in today:

You will want ANOTHER new car!

And, you will want another one – similar to the first one (or better!) every 3 to 5 years thereafter, until you are too old to care about cars anymore … and, take it from me, you will be pretty old when THAT happens 🙂

That’s why, when I ask people to calculate their Number, I ask them to come up with their required annual spending plan (and, multiply by 20), then add in any one-off costs: usually just houses plus your first post-retirement vehicle purchases (what’s your chances of your spouse settling for less than you?).

But, for non-annual repeat purchases (the annual ones should already be in the budget … get it?), I simply ask them to calculate a lease / finance rate for the occasional purchases they are interested in (e.g. cars, around the world trips) as though they were going to finance those purchases, and build that cost into their required annual spending plan (basically, their expected retirement living budget).

This will include your replacement vehicles … the ones that you will need to buy after the first 3 to 5 years in retirement.

How to calculate the correct amount?

It’s actually quite simple:

1. Choose the car from today’s model lists that seems to be likely to suit your purposes from a new car pricing web-site.

Right now, I drive a BMW M3, my next car is likely to be no less expensive. But, I actually want more, so I will build in the cost of a Ferrari 458 Italia (that should pretty much cover me for any other car I decide to ‘graduate’ to as I get older, e.g. top-of-the-line Mercedes). If I didn’t aspire to more in the future then I would use the current list price of a 2011 BMW M3 as my ‘base’.

2. Find the current price of a 5 year old Ferrari F430 (because the 458 Italia wasn’t around 5 years ago) from a used car pricing web-site.

3. Subtract 2. from 1.

4. Find an online auto leasing calculator and use 3. (i.e. the amount over the trade-in of your current auto that you will need to come up with every 3 to 5 years) plus the age of the vehicle that you selected in 2. (i.e. how often you expect to want to changeover cars) plus select an interest rate that is likely to reflect long-term averages for investment returns on your remaining money (6% – 8% is plenty)

5. The calculator should then spit out the monthly amount that you need to add to your required annual spending plan

Now, why should you choose “an interest rate that is likely to reflect long-term averages for investment returns on your remaining money” rather than the expected cost of FINANCING such vehicles?

Didn’t you read the opening paragraph of this post?!

You’re not financing anything, you are SAVING to replace you current auto (or, the one that you first bought when you reached your Number and stopped working), and you are building in the LOST OPPORTUNITY COST of having your cash tied up in your cars rather than sitting in your investment account working for you, and you are accounting for inflation pushing up the price of your future, future, future replacement vehicles.

What if you make a mistake with you future financial position or the price of your next car?

Well, you simply hang on to the cars that you already own for a while longer … or, ‘down-size’, if you have to …. who says that you HAVE to replace your cars every 3 to 5 years?

Now, you can apply this same strategy before you retire: it’s called saving up for your next car (and, the one after that, and the one after …) rather than financing it 😉

AJC.

PS If you run these numbers again, here’s an even better strategy:

Instead of buying a new car, buy a slightly used – but much better – make and/or model of vehicle. Because I’ve found that cars – just like radiation – have a half-life (but, different for each brand of vehicles) and some depreciate 20% as soon as you drive them off the lot, you may find that you can buy a much better car for the same money albeit 1 to 2 years old. If you choose well, you may find that you are (a) driving a better vehicle and (b) can keep this vehicle for another 4 to 6 years before replacing it (because ‘classic cars’ tend to remain classic long after your shiny new American/Japanese/Korean production-line ‘beauty’ has well and truly gone off the boil). Plug a 6 to 8 year replacement cycle into you calculator v the 4 year one that you chose for new and see what that does for your retirement plans!

The ‘No New Year’s Resolution’ Resolution!

I’ve just returned from my longest vacation-from-blogging that I’ve had in the the 3 years since I’ve been writing this blog.

Some of it had to do with poor internet access where I was traveling; it was supposed to be a ‘first world country’ but had ‘third world’ internet access. But, that was also probably a side effect of the second reason that I didn’t post: I was too damn tired/busy from touring.

I made the ‘mistake’ of agreeing to take a two week educational/discovery tour with a busload of other families from my childrens’ school: whilst educational, it was hardly a vacation! On the bus / off the bus … next historical site … on the bus / off the bus … three to four times each day. Crawl into bed each night exhausted, on the bus again by 8am the next day.

And, being a group tour, the hotels were set at the lowest common denominator: around 3 stars, hence the poor internet access.

Now, this probably sounds like fun to my main readership base (sub-30’s singles or young couples / no kids) … the rest of you are nodding in silent agreement: there comes a point where Hilton-hopping is REALLY what you need in a vacation!

Anyhow, we’re back and enjoying Resort Cartwood (i.e. home) with it’s huge landscaped and tiled 5-star surroundings, pool, tennis court, home theater, and so on … who needs a holiday away from home!

We celebrated New Year whilst away … which really means that we did nothing but had a wonderful view of the fireworks from our hotel window.

But, it did get me thinking:

Why make resolutions on New Year?

Does that mean that you wait – on average – 6 months to finally build up the courage to ‘resolve’ to do something that you already know is important for you to start doing / quit doing?

Does that mean that you put off for an average of 6 months that which you ALREADY know you must change?

Does that mean that New Year Resolutions are yet another means of justifying procrastination?

Does that mean that you build up the change to such a crescendo that by the time New Year comes and you – for some reason – fail to succeed in making the change, you’ll be too ashamed to try again (at least until 10-12 months later when the next New Year comes around and you build up the courage to ‘try’ again)?

So, why not have a New Day’s Resolution?

If you have something that you need to change, don’t wait until a New Year to resolve to change it, wait until the next day?

Well, I even have an issue with that!

You see, why delay – even a tiny bit – by RESOLVING to do anything?

Why not just DO? Now!

And, don’t even fool yourself into ‘trying’; do as Yoda says:

Try Not. Do or Do not. There is no try.

That’s why I’ve just resolved to never again make another New Year Resolution … at least, not until next year 😉

The 0% ‘safe’ withdrawal rate …

What % of your retirement ‘nest egg’ can you safely withdraw each year, to make sure that you money lasts as long as you do?

Many would say that this is a question best answered by highly educated practitioners of the highly specialized field of Retirement Economics, who will give you an answer – or, more likely, a range of answers – accurate to many decimal places.

But, I can give you a single answer …

… one that is accurate to at least 17 decimal places, yet I am not an economist of any kind.

You see, Retirement Economics is an oxymoron.

Why?

First, let me give you an excellent example of what retirement economics is …

In his blog dedicated to pensions, retirement plans, and economics, Wade Pfau provides the following chart:

It superimposes two charts:

– one shows descending survival rates for men, women and couples who retire at age 65.

For example, if you retire at 65, there’s only a roughly 18% chance that at least one of you will live past the age of 95. Reduce that to 90, and there’s a 40% chance that one of you will survive.

– The other is an increasing probability that your money will run out before you do the larger the % you withdraw from your retirement portfolio.

For example, if you only withdraw 3% from your portfolio (if invested in the exact 40%/60% mix of stocks and bonds assumed by Wade) then there’s almost 0% chance that you’ll run out of money by the time you reach 95 (and a small chance thereafter).

But, there’s a 30% chance that you’ll run out of money by age 95 if you increase that ‘safe’ withdrawal rate to just 5%.

You’re supposed to use these ‘retirement economics’ to make decisions like:

“Well it’s very likely that either my wife or I will live to 95 and we don’t want our money to run out, so we’ll invest all of our savings in a 40% stocks / 60% bonds portfolio, and we’ll only withdraw 3% of it each year just to be sure that our money won’t run out.”

That seems like sound economical judgement for the average person …

… BUT, you are not average!

For better or worse, you are … well … you.

Besides the obvious [AJC: who says you want to wait until you’re 65 to retire?!], when YOU are 95 (albeit in the 10th percentile), how happy will you be if your money has either either already run out or there’s a reasonable chance that you will soon be out of money, hence out of care?

I would argue that only a 100% chance of your money outliving you is acceptable.

Even then, only with a LARGE buffer, so you never need to worry about even the possibility of your money running out!

In my opinion:

Only a 0.00000000000000000% withdrawal rate is acceptable.

Now, 0% does not mean withdrawal nothing, but it does mean having a sustainable, self-regenerating supply of income; this is not as hard to achieve as you might think.

For example, you can create an ongoing stream of income from:

1. Inflation protected annuities (albeit expensive)

2. TIPS (albeit a low return)

3. 100% owned real-estate (albeit, needs management)

4. Dividend stocks (my least preferred as they are sometimes a sub-par investment that tends to rise-fall with the markets).

Remember, when you retire, you want not only ZERO chance that your money runs out, but you don’t even want to get anywhere near to zero by a wide margin.

Don’t you?