Shark Tank: The Tank Can Only Do So Much

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Shark Tank is a very entertaining and popular show.  Each week, more than four million viewers tune in to see great ideas, strong pitches and newly minted potential millionaires.  Just as entertaining as the deals that go well are the ones that go poorly.  Here we explore the nature of deals on Shark Tank, the ups and downs of valuation, and the challenges in exposing venture capital type investment decisions to a broad audience.  After all, in the show’s need to reach a popular audience, it can’t show the more technical side of venture capital (VC) decision making.

 

First, let me share that I really enjoy Shark Tank.  I enjoy each of the venture capitalists on it.  Exposing a broad audience to the thought processes involved via a show about entrepreneurs, startups, and venture capitalists / investors is wonderful.  Yet, there are some challenges with exposing the process to a broad audience and that’s our focus here.

 

One of the givens, here, is that drama of the tank needed to be amped up to make it exciting for America.  Thus the dramatic music and monikers the VC team attach themselves including, for example, “Mr Wonderful”. I do not lament this at all.  It makes for excellent TV, drama, and adds to the appeal of the show.  Kevin O’Leary’s “Mr. Wonderful” handle is particularly funny and shows clear wit:  my bet is that, if Kevin is interviewed years from now about the show, he would be the first to explain this was sort of a tongue-and-cheek name with which he dubbed himself to add a little spice to the show.  It makes things a little over the top in a positive way.  Indeed, the juxtaposition of the title “Mr. Wonderful” against some deals which are really not so wonderful is always entertaining.  Of course, there are those moments where the deals Mr. O’Leary makes with business owners truly do make him their Mr. Wonderful–and, after all, the business owners wouldn’t be there if they didn’t need a Mr. Wonderful for something.

 

Besides the entertaining names and amp-ed up drama, there are some challenges in the show that we should explore as they relate to business model innovation, valuation and liquidation preferences.  Liquidation preferences you say? These are never even mentioned on the show.  This is one of the challenges in bringing Shark Tank to a broader audience. Each time Mr. O’Leary (ok, yes, I enjoy his disciplined investor role) asks:  “But how will I get my money back?”, he is boiling down a key part of portion of VC deals to a focus on how money is returned to investors.  In VC deals, this issue is much more complex than what can be covered in the brief, digestible portions required by the Shark Tank format.

 

Real-life VC deals typically include a term sheet, where the entrepreneur team is presented with the terms of the deal with which the venture capitalists will invest.  (Of course, many real life VC deals involve much more, such as a series of meetings rather than a less than five minute interaction on which the sharks base their investment decisions.) One of the most poorly understood elements of the term sheet is liquidation preferences.  It would be very difficult to put liquidation preferences on TV and make these sexy yet they are key in most deals.  Unfortunately, liquidation preferences are some of the most important terms on the venture capital sheet and can often lead to misalignment of the investor / entrepreneur team on down the line.  Let me explain.

 

A typical liquidation preference sheet will include terms such as a 3X, 1X, participation / no participation and no cap / cap feature.  Let’s take each one of these and explain what they can cause later in terms of investor-entrepreneur alignment.  First, when we invest in a new company we join the ‘stack.’  The stack is the order in which teams are paid back for their investment.  The most recent investors are at the top of the stack of cards and are paid back first.  Then, at the bottom of the stack, are the early stage  / series A / seed funding venture capitalists.  An exit event, most commonly selling the company to a buyer, is the time at which the buyout will occur and the investors have the ability to be repaid with their winnings.  The term sheet specifies on what terms and in what manner the investor will make back their money (and then some we hope–otherwise why assume the risk of the investment).  First, let’s focus on the ‘3X’ or ‘1X’ situations.  The investor will obtain either three times, thus the “3X” or one time (“1X”), or somewhere inbetween, amount for their initial investment.  So, if I give $5000 to a startup and there are no other investors later, and I have a 3X term I will expect to be returned three times my initial amount or $15000 during an exit event.  However, there may also be a cap.  A cap means I can receive no more than a certain amount. So, although this wouldn’t make sense for almost any deal, if I have a $10000 cap, and I have a 3X initial investment on $5000 I could only be repaid $10000 total at the end of the day.  Such deals are not done routinely.  We only use this to highlight the nature of a cap.  The cap says:  “Investors you can only obtain this much money in return total for your initial investment.”

 

More interesting is the concept of participation. That means that an investor will receive their 3X or 1X, sometimes called multiple, of investment return and then will go on to participate in the buyout of the shares (of which they own some) at the price stipulated by the buyer company.  So, in the example given above, the investor would receive $15000 plus the value of their stock as they participate in the stock buyout up to whatever cap exists if a cap is in the terms sheet.  No participation means they would receive nothing for that stock.  Keep in mind the investors are paid before the startup team in all scenarios. So, the startup team and the investor can easily become misaligned.

 

If you do the calculations for various sale prices for companies with various liquidation preferences in the term sheet, sometimes the amount the investor makes on the deal will not vary over a certain number of sale prices.  What I mean is that if a company sells between $1 to $5 million the venture capitalist may have the exact same return on the investment depending on their liquidation preferences per the term sheet.  Ut-oh.  Misalignment!  Where the startup team may want to hold out for a 5 million dollar exit (remember the startup team is paid last so they likely wish to hold out for more), the VC group may be content to sell at a much lower price.  After all, the VC makes the same amount at a 2-5 million dollar sale price depending on the liquidation preferences.

 

Do some math with the 3X, 1X, participation and cap versus no cap situation and you will see this to be true.  Again, this may cause misalignment when it comes time to sell a company.  We can’t highlight this enough:  the investors may wish to sell at a much lower price than the startup team because they will obtain the same amount in return regardless of the sale price. The investor team may want to hold out for more reimbursement for their company and yet the investors may wish to sell.  Clearly, pardon our repetition here, liquidation preferences are a source of misalignment.

 

So, on Shark Tank, liquidation preferences are never mentioned.  We can’t blame them!  How could that sort of explanation come across on TV, when many startup business owners are not acquainted with the liquidation preference issues?  In the tank, companies are often valued by saying 100% of the company’s ownership shares are equivalent to their gross sales receipts.  The shark will take that amount of ownership equity for an investment equal to the share price as determined by that calculation, and sometimes the shark also wants a certain amount of royalty for each object sold in perpetuity.  This is very challenging.   The shark becomes a part owner of the company and sometimes even takes majority interest in the company.  Again, usually the liquidation terms will be clear on the initial term sheet.  However, on Shark Tank, liquidation preferences are never mentioned.  Do the Sharks, some of whom are very experienced venture capitalists, expect to simply be reimbursed as if they were a routine owner when an exit strategy is executed? Or do they expect the company to continue ad infinitum and they can take profit as any owner would? It is very difficult to tell and again liquidation preferences would not play well on TV.  Again, in fact, liquidation preferences are often poorly understood by the entrepreneurs who accept investment deals. This is one of the more challenging aspects of venture capital and entrepreneur interaction.  It’s no surprise that some Shark Tank deals despite a handshake on TV, break down in the due diligence process or later once the show is over and the lights are off.  There is a lot more to a deal than how things look on the tank on TV, and that’s ok.

 

Let’s return to valuation:  one of the other challenging aspects of Shark Tank is the valuation.  Valuations are done very strictly and are often based on gross revenue.  Sharks often incredulously ask owners of the company how they can value a company so highly when it has done so little in sales.  For now please recognize that this is a very conservative, pro-Shark method of valuation.  It does not make the Sharks wrong or “evil”.  In fact, they are simply trying to ensure that they are being conservative investors in this respect.  They only have a brief window on which to evaluate a company for significant investments.  If it were you, wouldn’t you adopt a valuation method that is conservative in your favor?

 

However, I would like you to recognize and perhaps search online for methods of valuation for different companies. I think you will find that very enlightening and different than the seemingly straightforward method of valuation that the Sharks use on TV.  Again, I really enjoy Shark Tank and I think it is excellent because it exposes America to certain ideas about investing, building a business, and innovation.  It shows personal stories of Sharks and future millionaires who have worked hard and brought a company very far.  It really highlights the American dream.  Certain limitations are imposed by the fact that it must make for good, watchable, TV.  And I respect that.  It’s more valuable to have an entertaining show that demonstrates the basics of investing and business building rather than have a perfect show that focuses on liquidation preferences, term sheets and valuation models.

 

A lot of what the Sharks talk about is interesting to me for other reasons.  Remember, it is very challenging for a Shark to hear a cold pitch and determine whether to invest or not.  In this respect I don’t blame them, and as a matter of fact compliment them, on using conservative valuation methodology.  This is because they have not built personal relationships with these entrepreneurs.  Recall they have to decide in a relatively short amount of time, if the TV show runs as advertised, whether they will or will not invest in a given situation.  This makes valuation very difficult and makes the deal fraught with much more risk than you would typically have up front in a deal.  As was recently explained in Venture Capital 101 on Coursera by the Ulu Ventures team:  the bulk of cold calls deals, or deals that are not introduced to venture capitalists by friends or others in the VC community, typically go bad and are low-quality investments.  This is why the venture capital community typically gives a “no” 99% of the time to deals which do not come to them from friends or contacts.  Although we don’t know all the background on Shark Tank and we don’t know how entrepreneurs are vetted before they are on TV, if Sharks truly have such a brief time to vet the deal and decide whether to invest we can understand and appreciate why they are so conservative in the valuations.  My bet is that entrepreneurs and teams are often selected based on their story, the quality of the potential deal, their looks, and other things that may make them more TV friendly with only the investment opportunity as one parameter.

 

In the end, Shark Tank is an excellent TV show that exposes America to the investment community, some of the ways in which investment deals are done, and highlights many of the tenants of the American dream.  This useful, excellent show has certain constraints owing to the fact that it functions popular TV show.  Again, the dramatic music, the over the top pitches, and sometimes even the Sharks’ responses (I don’t recall as many surprised whooooaaa’s from the Sharks in the first season), are meant to heighten drama and interest in this excellent show.  Rather than feeling this detracts from the show, I feel it entices a broad audience to understand and be exposed to the rudiments of investing.  The limitations of Shark Tank include the valuation methodology and the absence of discussion of liquidation preferences to name a few, yet we can all enjoy this excellent TV show and that brings real value to us as an audience.

 

Don’t Just Decide With Your Gut: A Decision Tree Is A Great Tool

 

I have a personal interest in decision making that started from an MBA course on decision analysis.  It made me fascinated with the idea of advanced techniques like decision trees with conditional probability versus making decisions with our intuition alone.  One of the more interesting things that I have run across that I want to share with you includes the idea that the human mind is a programmed coincidence machine.  That is, because of how we have evolved, we are set up to notice unusual cases.  For example, when lightening strikes a log we imagine fire.  However, commonly, there is not fire when lightening strikes.  In short, rather than notice the everyday, mundane, central tendency of a set of occurrences, we recognize the exception to the rule. This is very normal and it is just how, some say, we are built. There are entire books written about intuition versus more explicit decision making.  Decision making tools can help us move beyond how we evolved and how we simply react.  Here we explore one tool of explicit decision making and its far-reaching effects.

 

Rigorous decision making has several advantages, including the fact that it is more easily taught, can make our assumptions in decision making very clear, and can force us to be reproducible in our decision making.  It also allows us to demonstrate how we arrived at a decision very clearly.  One of the most useful tools I have found to achieve these ends is the decision tree.

 

The decision tree utilizes conditional probability to demonstrate the expected payoff for each possible occurrence in a scenario.  Above, I have included a sample from one of our team’s projects.  The question is should we invest or not invest in a given startup.  You can see, as we work from left to right, we have several different scenarios outlined. Each scenario has an expected payout and a probability of that expected payout occurring.  We are able to multiply the expected payout from each branch, times the probability of it occurring plus at each node the similar risk adjusted probability from the other branch.  This is called rolling back the decision tree. Eventually, we will obtain an expected payoff from each branch.  Here we weigh the expected payoff from investing in a company versus the expected payoff for a more passive income type investment such as investing in mutual funds or a buy and hold strategy in equity based securities.  The specifics of what the decision is are not as important as the fact that we can frame it this way and do the best we can to find high quality probabilities for each event occurring.  The returns from the stock market are fairly well known, and, by the way, don’t bank on the returns we saw in 2013 continuing.  In any event, we can plug in high-quality probabilities to the equity back securities branch (invest in the stock market branch) fairly directly.

 

Calculating the expected payout from the investment in the new company strategy is more challenging.  We are using a home run, base hit, strike out type mentality and nickname each of our branches in that way.  Over time, we have come to describe a home run return as one with a 9 x MOI (Multiple Of Investment) return.  We are very conservative in assigning our probabilities such that we can make the highest quality decisions.  To be conservative, we place this as a low-probability event on the decision tree.

 

Another useful property to emerge from this is that we are able to examine our assumptions and the probabilities we use in terms of how they affect the model. This is called a sensitivity analysis.  We can vary the probabilities and determine if changing the probabilities changes our ultimate answer.  Interestingly, sometimes in very complex decision trees, changing our underlying probabilities does not effect the outcome owing to the magnitude of the expected payout, or other probabilities, etc.  This is always enlightening and shows us that no matter whether we agree on a certain probability our end decision does not change.  This has always been personally fascinating to me and has lead our angel team to what we feel, overall, to be higher quality investment decisions.  I invite you to read more about conditional probability along with decision trees, and the progenitor of many of these techniques:  John Nash (who received the Noble in part for his work on probabilities in Economics).  Consider watching the hollywood movie version of Nash’s life, A Beautiful Mind, if you have some time.

 

I think you will find the decision tree very useful as has our team.  A recent venture capital course, Venture Capital 101, given on Coursera.org highlighted how Ulu ventures and other venture capitalists use similar techniques in their vetting of high quality deals and of decision making in an invest or don’t invest type scenario.  Clearly this type of work would not play well on TV and is not readily performed for investment related TV shows like Shark Tank.  It would be very challenging to explain this in a way that is palatable to a broad audience.  However, conditional probability diagrams and decision trees such as this are very useful to obtain high quality decisions in investment arenas, healthcare, and many other endeavors.  Decision making tools can help us move beyond our old mammalian brain and make higher quality decisions.

 

Speaking of Shark Tank, our next blog entry will include some thoughts on Shark Tank and its positives for innovators as well as entrepreneurs.

Building An Entire Ecology Around Your Business Canvas

 

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http://strategy-models.blogspot.com/2011/06/use-of-porters-1985-value-chain.html

 

One of my favorite things to discuss with new startup teams is strategy.  Michael Porter, from Harvard Business School, has nicely described several concepts that are integral to our understanding of strategy for an existing business, a new business, or business looking to change.  Professor Porter has given us a framework called Porter’s Value Stream.  If you haven’t heard of Porter’s Value Stream I invite you to take a moment to go to Wikipedia and look at this powerful concept. Porter’s Value Stream has several important consequences that can and have been leveraged to great effect.  There are also unique facets to this concept that can give insight to the nature of our new business, existing firm, or other system and how it competes.

 

For example, sources of competitive advantage may include the manner in which discreet activities in the value stream interface.  Inbound logistics is one of the first primary activities of Porter’s Value Stream.  Inbound logistics refers to the manner in which we bring in a substrate to which we add value.  The way in which we add value include our firm’s operations.  Sources of competitive advantage may include the way in which inbound logistics hands the baton off to operations.  A smooth transition in that area can be a source of competitive advantage.  Similarly the way in which our operations fit into our outbound logistics may be a source of significant competitive advantage.  Clearly Amazon and other retailers in their space draw a portion of their competitive advantage from their excellent outbound logistics and the interface between their outbound logistics and operations. Again Porter’s Value Stream is very key.

 

This post builds on this concept of Porter’s Value Stream.  In anther post we will discuss more of its specifics and consequences. However, here, I want you to recognize some interesting concepts around Porter’s Value Stream and how firms compete in industry. Take, for example, Disney World.  You may have been to Disney World lately with your family.  If you haven’t, I invite you to take a moment to just read up on exactly what Disney is doing nowadays.

 

Disney and other companies like Apple have created an entire ecology into which the consumer fits.  That is, many of us have experienced the feeling of being seemingly locked in to Apple or Google’s products because, for example, all of our music is on our iPhone and our iPhone interacts with our iCloud.  Our iCloud gives us email etc.  This “lady-who-swallowed-a-fly” scenario is no accident.

 

Apple has created an entire ecology into which we fit and it is one that seeks to contain our spending habits.  We don’t spend outside of the ecology because we obtain maximum value inside Apple’s ecology. There is no need to take the time to export our songs etc.  Apple and other companies may even make barriers to exporting our music and other digital information so that we must stay inside their ecology.

 

Clearly this is a situation in which the firm delivers maximum value not just with the classical concept of Porter’s Value Stream but, in fact, because there is an entire ecology into which they fall.  This concept of ecological thinking or consumer ecological thinking allows us to open broad possibilities for business model innovation.  Let’s return to Disney’s on-location operations at Disney World.

 

Disney World is literally an entire world of consumerism.  That is, they have the multiple theme parks, they have a resort at which you can stay, they have an entire down town shopping district and they deliver all of this in a manner which is value added.  You need not rent a car to get from the airport to Disney…you can take the Disney Magical Express. The Disney Magical Express imports you into the ecology where you stay at the Disney hotel on property and take the monorail or Disney transportation to the various locations.  You are encouraged to spend all of your money on Disney property in a clear Disney ecology. This is not to say this is a trap or is somehow bad or wrong, this is to say that Disney and other companies have set up a strong system that delivers maximum value within their ecology.  Again, for Disney you need not rent a car or be bothered with any issues like that.  Your luggage is whisked quickly and effectively from your arrival at the hotel to your room and Disney has many other value added systems they can run because of economies related to their ecology.  It is truly an interesting concept.

 

3D printer manufactures like Makerbot realize their 3D printers are part of an ecology.  So, when appropriate, they extend to supplying 3D scanners that interface easily with those 3D printers.  Viola, building ecology.  What are some ecologies that exist in surgery?  Are there any places where the business canvas you’ve recently designed for a new service line may fit?

 

In fact, there are ecologies that can (and do) exist in surgery and healthcare although it may feel unusual to think of things this way.  When a patient enters the hospital there is an opportunity to create an ecology for the patients and their families. Although the primary activity of the hospital is delivering excellent patient care, there is an opportunity while the family is in the hospital with the patient to direct their spending toward add-ons related to their loved one’s stay.  There is nothing evil, wrong, or malicious in this; it can be the provision of an excellent service and a real patient satisfier.  Where charging $12 for a cup of coffee would likely be inappropriate, allowing a Starbucks or similar chain to rent space in your lobby (or setting up a coffee cart yourself) may be a nice value-add to the ecology of your hospital.

 

Creating these ecologies can often occur in service lines as well.  That is, vascular surgery may provide a free screening for peripheral vascular disease and thus import patients into their ecology.  A patient now has contacted the vascular service, is known to them, and may come to feel comfortable with the advanced practitioner or surgeon performing the screening.  It may become easier now that they know their way to the hospital or similar location to return to it for further care.  These types of events are ways in which the ecology of service can be created.  A trauma service may use the open abdomen technique when necessary and go on to perform add-ons for patients who require them.  That is, they may then perform component separations etc where necessary.  To be clear, I am not supporting doing procedures for patients who do not require them.  I am saying that thinking of services lines as creations of ecology in which we can deliver maximum value is a very different way of thinking of business models but in fact these typically exist in healthcare.

 

When I work as a surgeon I am careful to only perform interventions for patients who need them rather than in the interests of revenue or ecology and I think it’s important to have made up our minds ahead of time about where we stand on issues like these.  On another personal note, I avoid applying population level data to individual patients without extreme caution.  I do not look at insurance or consider reimbursement in forming treatment plans for individual patients.  (I’ll step down from the soap-box yet you may hear that again at some point on this blog.)

 

Again, just as Disney is seeking to do the best possible job and deliver the most value for the dollar, healthcare business model innovation can deliver the most value for patients or their families who need a given service, device or even a meal.  So, next time you think of how you will innovate your business model, consider cases like these.

 

Innovating an entire ecology around the business model (including add-ons and additions) can often be useful especially after we have finished our business canvas and have a system that is running nicely.  For more information on Porter’s Value Stream and business model ecologies, perform a quick google search and take a moment to review Porter’s Value Stream as it contributes to the margin we can obtain on different business models.

Did You Know? Interesting Facts About Angel Investing and VC

One of the questions I often get from would be founders is ‘Where do I get the money to do my startup?’  This is an interesting question that has been covered in a lot of introductory business books and beyond.  Here I will highlight some of the interesting facts about how to find and raise money to found your project.

 

First, be aware that most conversations regarding funding result in a “not right now” or outright “no” answer. You need to get used to approaching people with your idea and having them not invest for one reason or another. These are often not commentaries on your idea, you as a person, or your talent.  There are many things that go into the decision about whether or not to invest in a startup.

 

We should also highlight that the initial money to fund a business model comes from a few sources including the classic three F’s: Friends, Family and Fools.  This is a tongue in cheek way of saying that the initial funding for any business model is often extraordinarily high risk and that only someone who really cares about you or who is very foolish should invest in your new, unproven idea.  Shows like ‘Shark Tank’ etc. highlight that business models that have income or demonstrable sales can be valued a lot more readily in different ways than brand new ideas with new, novice, or even an experienced team.

 

After the initial business model is created and funded by the three Fs or even the founding team itself, there are additional sources of funding that can come in different rounds. One of the ways you can obtain seed funding for your business is with what’s called angel investors.  Angel investors are individuals or teams that provide seed funding according to certain criteria.  Often teams have what is called an investment thesis.  An investment thesis describes that team’s approach to investing, the niche in which they choose to invest and other important factors they consider when it comes to investing.

 

In addition to the idea of an investment thesis, you may be interested to learn some factors that venture capitalist are well aware of.  It is important to understand some of the interesting consequences of an investment thesis, whether that be for a venture capital (VC fund) or an angel investment team.  There are other important facts as well.  First, interestingly, 99% plus of cold calls, meaning deals that come to a venture capitalist or angel investor which are not referred to them by someone they know, fail.  This is an incredible attrition rate and one well known to VC and angel investors.  In short, if high quality deals are not introduced by people the VC team knows, there is already a known substantial failure rate.

 

Next, interestingly, you may be surprised to hear that the vast majority of VC is in one of two geographic areas. This is the Silicone Valley area and the Boston / Greater Metropolitan area of Boston.  In other words a great deal of the United States VC funding occurs in one of these two areas and of these two the Silicone Valley / Stanford area has significantly outnumbered the Boston area in terms of total amount invested and other measures like the number of startup boards on which a given venture capitalist sits.  (Many VC team members sit on multiple boards.)  These are indicators of VC activity and really highlight the geographically narrow venue for VC in the United States.  Other centers are starting; however, these two comprise far and away the majority of VC in the United States.

 

So, when you go to take on investors for your newly minted business, it is again important to realize that often their decision to invest or not invest is not a direct commentary on the quality of you, your idea, your team or your experience.  Importantly, in fact the VC / Angel Investors decision is often contingent on their investment thesis. You may not be in the area of interest or expertise for the Angel / VC investor.  They may refer you to someone who is.  Again, remember, there is a great deal of failure before success when you are seeking seed or series A funding.

 

Last, there are some interesting consequences to VC and Angel funding, which we could easily fill a book with.  One of the more interesting ones, and least understood ones, is called liquidation preference.  This is the manner in which venture capitalist or angel investor extracts their money in a so-called exit event from the company.

 

An exit event can be, for example, when the company is purchased by another company.  Purchases such as those constitute the majority of exit events. Then, what is known as the ‘stack’ gets executed.  The stack, if you can imagine as a stack of a deck of playing cards, means the last round of investors are paid first from the top of the stack etc, down to the your initial or seed investors at the inner most layer.  The manner in which payouts occur is called liquidation preference and there are many interesting factors in liquidation preference.  Before you start a company and take on investors I encourage you to read and learn more about liquidation preference.  For now, let me share that liquidation preferences often cause a misalignment between the interests of the investor and the initial startup designer and owner.

 

Investors become part owners of the startup in almost every deal.  However when an exit event occurs there can be significant misalignment between the investor-owner and the initial startup team’s interest. These may be owing to liquidation preference.    Interestingly, the liquidation preference sometimes means that the investor owner would be willing to sell the company for a much lower amount than the initial startup team. Again, liquidation preference is often misunderstood and has significant consequences for eventual payout from the startup in the event of an exit strategy execution.  For more information regarding liquidation preferences, exit strategies, and how these may impact your startup idea along with investor opportunities I would perform a quick google search and learn all you can.  Specifically focus on terms like “1x”, “participation”, and “cap”.

 

In startups I have helped perform we use multiple techniques to keep everyone aligned.  These include some classic techniques like dynamic ownership equity and liquidation preferences that attempt to keep everyone’s interest in the company aligned, so the company can move forward as a team.  These are just some of the challenges and nuances of startups and some of the ideas that make starting a business so interesting and so much fun.

 

In the next blog entries we will describe other interesting facts about business model innovation and how to mitigate certain risks while accentuating the benefits of a startup.  I would also add that one of the single most useful tools in business model innovation has been the concept of dynamic ownership equity.  I first encountered this concept of dynamic ownership equity in a text by Noam Wasserman, from Harvard press called The Founder’s Dilemmas. For more information regarding tools to improve alignment in your fledgling business model I invite you to take a look at that useful text.

Useful Mind Tools: The Concept of Type 1 and Type 2 Error

 

Medicine is filled with the usage of the term “alpha”, especially in statistics and journal articles.  Medical literature and literature across multiple disciplines often uses alpha to reference the quantifiable rate of a type 1 error.  A type 1 error is considered, in a word, tampering.  That is, saying that there is something wrong or different, and actively addressing the perceived issue when in fact there is no such issue, is a type 1 error.  Again, if we were to describe a type 1 or alpha error in one word that word would be “tampering”; there is simply nothing wrong with the situation and adjusting it would be improper–but we commit a type 1 error when we doso anyway.

 

There may be some confusion over the term alpha because there other usages of the term you may see online.  Alpha is also used to describe the rate of return on a mutual fund in excess of the quantifiable risk inherent in that mutual fund’s distribution of underlying assets.  Meaning the alpha can indicate the bang for your buck you get above and beyond the risk inherent in a certain investment.  There’s an interesting investment blog called “Seeking Alpha”.

In this entry we discuss alpha from the more common standpoint of tampering and its utility in making decisions.  This is readily applied to how we develop new business models and how we re-work old ones.  The importance of considering type 1 and type 2 error in medicine and in decision making can’t be overstated.

 

A type 1 error, again placing a chest tube when in fact no chest tube is necessary, frequently has less harm inherent in it than a type 2 error which is under-controlling or under-recognizing a situation and not treating the very real issue.  Telling a patient that they are fine only to have an issue later is clearly under-controlling or a type 2 error.  Also, type 2 errors are often heavily focused on by the legal system. The legal system tends to really frown on type 2 errors.  For that reason fluid, acute care and trauma situations are often very demanding in terms of decision-making. We often do not have enough data, time, or other information to know every direction a scenario can take.  Despite the conditioning of M&M and the retrospectoscope (which often give the illusion of perfectly available information, etc.) we should take a moment to recognize the realities of decision-making as it progresses forward through time with the uncertainties the come from real-world sources.  Of course, there is our years of education that encompasses multiple different scenarios and which can help minimize the unknowns.  Nowadays it is more and more challenging to educate residents and fellows in the same manner in which many of us were educated. That means, it is hard to make sure they see every direction a scenario can go.  That is, in part, because they have less hours spent in hospitals to take in all possible scenarios as residency classically teaches those points by a brute force methodology.

 

Often, in trauma and acute care surgery, type 1 errors are less devastating than type 2 errors in my opinion.  You and I likely agree that this is sort of a philosophic point.  Maybe you feel, for example, that “first do no harm” means our prime directive indicates we should not have intervened with a central line if a patient is later found to not require a central line.  In my opinion, that type of thinking fails to recognize decision-making moves forward in time with relevant uncertainties.  The retrospectoscope should be discarded.  However, others may feel that the risks inherent in failing to intervene constitute doing harm.  It’s always interested me how people feel differently about the modern sense of “first do no harm”.  Given the choice, and broadly speaking, I’d rather commit a type 1 error in my specialty than a type 2 error.  (Of course, I’d rather avoid errors all together.)

 

I am interested in finding new and different ways to educate residents and fellows given the constraints on their time now, and thinking of type 1 and type 2 errors helps do that.  Rather than lamenting the current state of affairs with medical education, I do feel this is an evolve or die scenario wherein we need to focus on new and better ways to ensure excellent patient care in the future via innovative techniques to educate our residents. I think one of these is explicitly teaching about type 1 and type 2 errors.  Thinking of issues framed in terms of type 1 and type 2 errors is just one part of a larger framework that encompasses decision-making in uncertainty.

 

Decision-making in uncertain situations can often carry a very negative connotation to physicians and surgeons.  In short, we may have been educated with the philosophy of being ‘right, wrong, but never in doubt’. However, that focus on certainty etc. may lead us to immediately react, in my opinion, negatively to the term uncertainty.

 

So let’s clarify:  in this context “uncertainty” does not mean personal uncertainty on the part of the physician or surgeon.  “Uncertainty” here means that we all recognize a scenario has multiple different ways it can progress. For example placing a chest tube when we think there is a pneumothorax can have several consequences. We can have been incorrect despite testing (pCXR) and with our exam that there was in fact pneumothorax.  This is unusual but is possible.  We may have a patient in PEA, or have a trauma patient “code” in front of us.  We may feel placing chest tubes in those scenarios has little downside risk.  However, we can have other issues with chest tube placement, including hemorrhage, diaphragm injury, abdominal organ injury and some of the other catastrophic and rare downsides to chest tube placement that we have all seen in our practice.  So, what are we to do? Analysis paralysis is one issue that probably each of us has seen arise.  That is a situation where all the multiple ways in which a scenario can unfold leads to us not making a decision.  In my opinion, not making a decision is as important of a problem as making an improper or poor quality decision.

 

In short, thinking of issues in terms of type 1 and type 2 error rate can help us frame and deal with the fluid situations that arise in acute care surgery, investing, and business model innovation.  Further, we can use tools to quantify scenarios and make the best quality decisions we can despite probabilistic influences.  This type of advanced decision-making is not typically taught in medical schools of reinforced in residency.  However, seeing it, and using it, can be performed on a daily basis given the multiple decision tools that exist.  Further, we can always utilize the framework ahead of time to formulate high quality decisions based on different scenarios when they arise.

 

The concepts of type 1 and type 2 errors are useful mental tools to frame just what to do in trauma, acute care, investment, and other important high-stake decisions in our lives.  I invite you to read more about type 1 and type 2 errors at your leisure and have found this personally to be a very useful tool for my clinical, investment and general decision-making toolbox.

Even More On The Business Canvas

Let’s take a minute to expand on the business model canvas from yesterday’s entry.  There are some useful consequences of the business model canvas which are worthwhile to explore.  This is especially true regarding the bottom of the business model where we review costs and revenue streams.  Usually, when I have prepared one of these with start up teams, we will determine the costs and revenue on a monthly basis.  This is a useful technique to help determine initial seed funding required to give the business an adequate runway.  Here I will list some truisms I have learned from experience and that are typically taught in business schools.  I wont cite or point you to specific resources on the web but I have found these rules of thumb to be useful:

 

First, new startups need approximately at least a five month runway to determine whether they are viable or not.  The concept of runway is an important one.  Here, runway means the amount of time until the business is able to cover its own costs of existence.  When a business can cover its own costs the airplane has sort of taken off. It is useful to get a sense of how much cash is required for this runway.  For that reason, cash burn rate is a key concept in startups and new processes.  The cash burn rate as you may have guessed intuitively is the amount of speed with with your business utilizes its cash resource.  Cash flow is a key concept in any business and this is even more true for startups.  So, the business model enables us to solve for approximately how much we think a business will need on a monthly basis.  With more startup experience certain costs become more known quantities.  How much does a bookkeeper cost? Do we even need a bookkeeper? How much are bank fees? How much are lawyer fees? Do we even need a lawyer? Over time and with different startup experience we learn how much and what type of resources are necessary to make the startup go effectively.

 

So, if we calculate this on a monthly basis we get a sense of our cash burn rate.  One typical technique is to make all of these costs a worst case cost scenario.  That is, how much can the costs be if the worst case arises.  This is also part of how we evaluate whether a business model is worth our time and effort.  If the cost loaded business model can’t fly we consider carefully before progressing.  However, even with worst case cost loading many businesses can and do survive.  Keep in mind the overall attrition rate for businesses is more than 60% in the start up field.  Some of the tools we discussed so far are pointed towards lessening that risk of failure. With each start up we learn not only more quantifiable tools to decrease our risk but we also learn more of the philosophic approaches to startups, such as the importance of flexible tools like the business model canvas instead of more rigid and lengthy investments of time like traditional business plans.  So some unique consequences of the business model canvas include the ones we have talked about.  Specifically the cost and revenue projections at the bottom of the business model canvas are especially useful.  We usually use post it notes on a business model canvas to represent the different costs we expect.  Again, we often calculate these on a monthly basis.  There are some fixed costs which must be incurred upfront and we add these into part of the initial capital investment to get the business off the ground.

 

So there are those interesting consequences of the business model canvas that allows us to quickly calculate an approximate cash burn rate and runway for the business given a certain amount of capital investment.  Interestingly we have found usually 5-7 months to be the amount of initial runway necessary to get the business up and running to where we have a sense for whether it is worthwhile to continue as a going concern or not.

 

In subsequent blogs we will talk about other unique tools in addition to the business model canvas that are really worthwhile for startups, whether that be a central line service in your hospital, new medical practice, or other unique opportunities that arise.

The Business Model Canvas

 

 

Business Plans Are Sometimes Replaced By Business Model Canvas

Stanford, and other business schools, has a strong focus on entrepreneurship.  I’m impressed by how things like business plans have been replaced with more modern tools like the business model canvas.  If you’ve never seen a business model canvas, let me invite you to go to wikipedia or a similar location and investigate.  A low-res sample of the setup is included above.

 

Canvas Is Less Cumbersome Than Business Plan & Easier To Prepare

The business model canvas is one of the current tools used to design and startup new business models.  It’s much less cumbersome to prepare and, perhaps more importantly, is a graphic representation of a business model that is easy to review owing to the fact it’s exactly one page long.

 

Canvas Serves As Visual Record Of Business As It Evolves

This tool often serves as a visual record of the business as it evolves.  For example, when a startup team meets and chooses to adapt its business model, a new or modified business model canvas serves as a visual record for where that model is at that time.  These are easy to review later as a history of the startup.

 

Even Most Well-Constructed Business Plan Rarely Survives First Contact With Real World

Why focus on a flexible plan to this degree?  Well, as any startup team member will tell you:  even the most elegant business plan rarely survives first contact with the real world.  For those of us who have done this before, and likely you if you’ve had startup experience, we recall a famous quote by none other than Mike Tyson (which is one of my personal favorites):  “Everyone has a plan until they get punched in the face.”

 

Flexible Decision Making Strategies Are Useful For Fluid Situations

 

So it is with startups.  For that reason, modern emphasis is placed on more evolved decision making techniques such as decision trees, Boyd’s OODA loop, and similar modern methodologies for decision making in fluid situations where uncertainty abounds.  Here, of course, this is uncertainty in the sense that there are multiple paths a situation could take, and these branch points introduce probabilities we can try to quantify in order to make the best possible choice given the expected type of outcome.

 

These newer, effective tools can be utilized by us whether we are business people or surgeons.  They can line up the probabilities so that we have the greatest chance of success.  In later posts, we’ll discuss some of the tools for addressing a fundamental issue we face every day:  decision making in uncertain situations.

Santa Should Have Done A Lean Startup

kringlejpg

 

 

For Mr. Kringle, starting up a global manufacturing and distribution network in 2013 would be challenging.  Looking back on his success, a nice instance of where success is not defined by income by the way, it is easy to imagine that Santa’s service emerged fully formed and streamlined.  (If by streamlined we mean hand-delivering all toys from house to house the world over while relying on flying reindeer who are, no doubt, apt to get sick and / or just not fly.) Lean startups leverage a sophisticated understanding of how to start a company in order to get things done.  Nowadays, no doubt, Santa would startup Lean.

 

Although Santa’s team has deep roots in history, the lean startup does not.  The lean startup is a relatively recent phenomenon that conjures thoughts on a certain attitude, philosophy and tool set for how to start a business both effectively and quickly. Three of the most important tools of the lean start up include the business model canvas, the minimum viable product and an iterative approach to the business model along with number 4, customer development.  These modern tools would have helped Santa quickly determine whether people liked his service & products.  He would have learned quickly what to focus on even if his market changed.

 

Santa may have used the business model canvas and the concept of the minimum viable product.  We spoke before about the business model canvas and we have also described the concept of the minimum viable product (which is a product offer that has the least amount of features a customer will purchase). Perhaps, for example, children would have accepted receiving gifts over two, three, or seven days instead of all in one night.  This may or may not have made life easier for Santa.  Again, do children need Santa to deliver everything himself?  Who knows now, yet at the beginning Santa could have learned what people would accept and what he could create most easily.

 

Let’s focus on the idea of the minimum viable product (MVP) more closely.  The MVP is a useful concept because it allows you to iterate the product quickly, it is usually more straightforward to build or create as it has less features, and it helps you test the market in a rapid fashion.  Santa could have learned a great deal from his Lean experiment.

 

Before Santa built toys to spec and delivered them all in one night via reindeer (and often chimney), what child could have even imagined such a thing?  There is a classic line from Henry Ford that is if he had “asked their customers what they wanted they would have said a faster horse.”  This indicates that, sometimes, the market doesn’t know exactly what it wants until it sees it.  Santa could have developed the demand for his service and perhaps spread across the world more quickly.

 

It is just that customers in the market have points of pain, issues, or other things they need satisfied.  They will tell you soon enough if your product  helps ease their pain.  One of the functions of our team of angel investors is to give some guidance on some other unique tools that can really lean the process for you to get your business. We have a series of several steps that are changed depending on your unique business idea and model.  We have both established and new businesses benefit from these steps, and we have mapped out certain tools that can also eliminate completely sources of overhead that can be barrier to your startup.  Who knows if our experience could have helped Santa–after all he did very well on his own if we measure by market share alone.

 

In the end, Santa may have been able to utilize modern tools of the startup to great effect.  Using a business canvas and MVP, he may have been able to learn that there is no need to push his reindeer so throughout one night once per year.  Perhaps he would have used another service or independent contractors to help make deliveries.  However, as historians will tell us, it is often unfair to use modern knowledge to criticize the ancients–after all they did very well with what they had.  So it is with Santa:  even though he may have a different model if he had used the Lean startup tools, he’s done very well for us all.

Happy Holidays.

 

To read more about Lean startup tools:  on the main home page, click the plus sign and select from the archives.  If you have a moment and interest, go back and review the first blog entry in the series that highlights the business model canvas as an effective way to create and iterate your business model.