Episode Transcript
Speaker 1 00:00:10 Hello everyone. Today I want to talk about fundraising because there's a flurry of announcements from HR tech vendors and other companies on raising money and they're all proud of it. And the question I want to ask is, is raising money always a good thing? And I'd like to suggest that yes, it is in some respects, but it's not necessarily always a good thing. The typical announcement you'll see is so-and-so company just raised a hundred million dollars. Our valuation is 500 million, 700 million, whatever it is. We're so excited about our new venture capital partners because they took so-and-so public, their strategic partners to our business, and therefore we're a great company. In fact, if you wanna spend some money, you can even get the NASDAQ to put your picture in Times Square. You do have to pay for that as a celebration on the money you raised.
Speaker 1 00:01:02 Now, raising money is important and it goes back to the fundamental issue of how businesses operate. Businesses are made up of two things, labor and capital. Labor is the ingenuity, the creativity, the pioneering innovation, the sales marketing, customer service consulting that you do to serve clients. Capital is the money you use to build infrastructure and to acquire assets. Most of the capital that companies spend money on is for hiring people, but oftentimes it's to build infrastructure to buy and build manufacturing plants and other capital investments. Of the two, I would argue that the labor is much more important than the capital. It's obviously very nice to celebrate the fact that you raised a bunch of money, but it's a lot nicer to celebrate the fact that you have a whole bunch of great customers who are buying more and more things from you that are very, very happy and that your company is operating in a profitable mode and you're sustainable and doing great things for the economy and society.
Speaker 1 00:02:08 Having a bunch of money in the bank doesn't have anything to do with that. So an announcement about the fact that you raised a bunch of money is really not an announcement about your business, it's announcement about your financing, just like going public is the same thing. Now in the world of capital versus labor, there's different ways to acquire capital. If you've went to business school, you've learned about the cost of capital. The best way to raise capital is through your customers, through your profits. You know, I've now run two bootstrapped companies successfully, and in both cases we were profitable from the beginning almost all the time. Sometimes we lost a little bit of money and we ended up having plenty of money to invest and didn't have to incur the much higher cost of external capital. Now, we weren't trying to build a billion dollar company, so it was a different situation.
Speaker 1 00:02:54 I think if you talked to Tim O'Reilly over at O'Reilly Media, who I've spent a lot of time with, he would tell you the same thing. They built quite a successful company without raising any capital at all. But that said, there are times when your company is not profitable for some time to come. You believe the market is big, you believe you're going to have an incredibly successful thing, and so you're gonna go out and raise capital. What is the cost of that? Well, there's a lot of costs. The first is the cost of the bankers who get you the money. Uh, they do take a percentage up to seven or 8% in some cases depending on how you raise money. The second is the cost of ownership. You do have to give up a significant amount of ownership in your company that impacts your ability to monetize your work as an entrepreneur and it impacts your employees and potentially impacts your success in the future.
Speaker 1 00:03:48 The third is you give up a lot of rights. Most investors want a seat on the board. They want preferred stock. I was involved in the board of a company where one of the investors had what were called blocking rights, which meant that the c e O could not sell the company without making this particular person happy. And this particular person had a lot of, uh, unrealistic expectations. And so there was no way to do a few of the deals they wanted to do. And there's sorts of other things that investors ask for that are also costs. And then there's the cost of really having a board that may or may not work. Having a board is a very important part of a company. In most cases. The board is a huge asset. You hope that the people on the board are smart, experienced, savvy, they have all sorts of great connections.
Speaker 1 00:04:36 They can help you with hiring, they can help you with strategy. They can help you with m and a. That's usually true in most cases, but not in all cases. So if you're raising money and you don't know the people that are gonna be on your board very well, you're gonna get to know them. And so there's a cost to that too, <laugh>, uh, and you have to remember that the investors that come into a startup or a fast growing company really only care about one thing and that is making a return. They may or may not care about you as an individual. You're replaceable. The company could be sold, they could decide to split off the company into something else, and there's all sorts of things they might do if they feel they're not getting a return. So I think one of the costs of raising money is this enormous burden of responsibility to the investors.
Speaker 1 00:05:25 Now in the world of business, that's all a good thing. That's really the way businesses operate. The operators or managers work for the investors and the investors and shareholders are intended to be governance partners with the management and leadership. But the more money you take, the more that balance moves in the direction of the investors. A good example of this is what happened at WeWork. The CEO of WeWork did a magnificent job of convincing a lot of investors, very smart ones that WeWork was a technology company, but it actually was a real estate company. So people invested in WeWork with the expectation that it was going to be this magnificent new social networking kind of lifestyle thing when the actual financials were more like a company that owns a bunch of real estate, which isn't a bad company, but it's not valued at nearly the same valuation.
Speaker 1 00:06:17 And so the ceo, who was a very charismatic guy, essentially got buried under that weight of those investors and then he eventually got kicked out. Of course, he took a pretty good piece of money with him, but those are costs. Those are real costs to you as you raise money. So I want you to be aware of that. Now, the second thing I would say broadly about raising money is to remember that of the two factors in a business, labor versus capital labor is by far the more important. Now, it doesn't feel that way from the stock market numbers and the press releases and the emails you get about fundraising, but in my opinion, it doesn't really matter how much money you have if the company's not operating and run well, cash in the bank doesn't really generate any return. It's a question of how it's allocated and used.
Speaker 1 00:07:07 And so when you raise money, you're suddenly going to be forced to spend it. You're going to be forced to hire people, you're going to be forced to build more products, you're going to be forced to spend more money on sales, more money on marketing. Some of these expenditure areas are not only expensive, but they're risky. I've talked to a lot of companies that hired senior sales forces and looked around a year or two later and said, gee, we're not hitting our numbers. What are we doing with all these people? So your ability to manage the company, grow it, you're gonna need an HR department, you're gonna need an IT department. You're gonna need great recruiters, you're gonna need great sales operations people. That is a big part of raising money too. And your investors will expect you to be ready to ramp that stuff up.
Speaker 1 00:07:54 Now, for those of you that have done this before, that won't be a surprise. But if you're a smaller startup raising money, those are other considerations to remember and investors will be happy to replace you with somebody who can do those things if you feel or they feel that you're not capable of doing them. Now, the alternative to raising money is not bad. I know not a lot of software companies think this way, but there are some great companies. You know, Atlassian grew for a long time without raising a lot of money. Base camp, the companies that I've worked on, uh, grown don't require a lot of capital to grow. Now they grow a little slower, but that's not bad. And I sometimes think slow growth is healthier than fast growth. It's sort of like a tree or a forest or a garden. If you over fertilize it and everything grows like crazy, you do end up with a lot of weeds and then you have to kind of get rid of them.
Speaker 1 00:08:47 So the alternative to massive amounts of fundraising is smaller amounts of fundraising and focus more on expenses and profitability. And my experience in all the companies I've worked with is that those are very important disciplines regardless of how big you are. Now, companies like Amazon and Google and Facebook that are essentially moonshot companies, even LinkedIn really was that way. They were more than happy to take massive amounts of capital and build something that was expected to be enormously successful and they were enormously successful. But for every Google, Facebook, Amazon, apple, of course Apple took a long, long time. Apple's an example of how long it can take. There are hundreds of pats.com Nokia. There's hundreds of companies that didn't hit that magic curve, the ever-increasing upward sloping curve that we all try to get. The odds are you won't do that. In fact, the odds are against you becoming one of those hypergrowth companies.
Speaker 1 00:09:53 You will be at some point, but eventually you'll reach a point where it's harder and harder to hyper grow because you're just bigger. So I think the way to think about fundraising is raise enough money to do what you know you need to do, but wait before you raise too much. Now, there seems to be a new school of thought amongst many of the venture funds that we're gonna give you a huge amount of money. So you can do a lot of big things. And the expectation there is that we think your company has so much potential that we're gonna give you a massive injection of cash and we want you to grow as fast as you possibly can to dominate the market that you're in. I just got off the phone last week with a, an entrepreneur I've known for many years who has a very successful company in the HR domain and they just raised a massive amount of capital and he's sort of blown away because he's never had this much money in the bank.
Speaker 1 00:10:51 And he said the reason he raised so much money is the investors came to the conclusion that his company is worth almost 3 billion. So they want to throw a whole bunch of money in there. Of course that means he gave up a lot of equity, but the upside to that is he sees it and they do, and I think they're reasonably accurate that this is gonna be a pretty big hyper-growth company for some time to come. But that's a very unique situation. If you take too much money and you're not ready to spend it, that will turn out to have been a very expensive decision later because those investors will have an enormous amount of influence over you a year or two or five years later. The final thing I want to talk a little bit about is business models. Why is there a lot of investment money going into startups and tech companies right now?
Speaker 1 00:11:35 Well, there's really two reasons. One is interest rates are very, very low. So if you have a billion dollars sitting around and you need to invest it, you're not gonna buy bonds. I mean, there's just no return. You're not gonna buy high dividend stocks cuz there's not much return on that either. So eventually you're gonna start investing in riskier investments and you know that the stock market is enormously valued right now. So if you can find a pre i p O company that you have confidence in, you're gonna throw a hundred million, 50 million, 20 million whatever is into that company because there's a pretty good chance that something good will happen. And investors know that the a hundred companies they invest in, one or two of are gonna be huge home runs, maybe 10 or 15 are gonna be triples or doubles and then a bunch of 'em are gonna kind of pay back two or three times their investment or maybe not at all.
Speaker 1 00:12:21 So there's a lot of money available because of the low interest rate environment. Interest rates will go up, we're going through an inflationary period, so that will change the stock market. The stock market is teetering at an all time high. I'm not saying it's gonna go down, but it's not likely to continue like this forever. So those exit strategies will turn into m and a in the next few years. And that's one of the reasons there's so much money floating around. And that money might get tight if the interest rates go up and this market slows down. The second reason there's so much money available for you to get invested is the platform business models. Every software company I know wants to be a platform company, which means recurring revenue and recurring revenue seems like this magic thing. Of course, the value of recurring revenue is that the net present value of a five year revenue stream is three and a half, four times what it was once a year.
Speaker 1 00:13:17 However, this is not a new idea. The phone company had a recurring revenue model in the sixties, <laugh>, it was your phone bill and they got disrupted by mobile and a whole bunch of other cable and all sorts of other things. So recurring revenue models don't last forever, you have to invest in them. But the reason people wanna raise money for platform businesses is because they have to build a platform and building the platform takes money and time and you end up spending money on aws, Hulu Cloud or Microsoft Azure. By the way, those three cloud vendors last quarter did close to 25, I think it's close to 27 billion in revenue in one quarter. They're growing at about 45% a year. And a lot of that money is coming from the investments that you're getting to buy those services to build your solutions. And those are expensive platforms.
Speaker 1 00:14:02 So a lot of this money you're taking in will go into building the platform, licensing the servers and applications from the cloud providers, signing agreements with the the cloud providers, and then building the infrastructure on top of that and the people. I think that platform business model is certainly popular and powerful and useful and it will go on for some time to come. But a couple things to think about. First of all, once you have a product that is in a recurring revenue, you still have to differentiate it, you still have to sell it, you still have to keep it competitive. Somebody will copy you, there will be alternatives and there will be a disruption. There will be a version of what you do that will be better than what you're doing. And so just because recurring revenue models are popular doesn't mean they're easy.
Speaker 1 00:14:52 And I would add to that, that one of the biggest issues a lot of relatively small HR tech software companies have is they don't want to invest in consulting. And there's a belief out there by the financial community that consulting revenue is just not that valuable. And investors will typically say consulting revenue is only worth one or two tons revenue. You know, I think that's a little bit misleading because you know, if you look at the revenue from Deloitte or Accenture or pwc, they're generating 65, 70% margins and it is recurring. There is a recurring nature to services revenue that's pretty good. And even if you're a technology vendor selling a tool or a system, unless it's a relatively low end, easy to use thing, having some services is important and you certainly need technical support and implementation services regardless. So I think the heavy focus on recurring revenue might confuse you that these other things are not important.
Speaker 1 00:15:50 And let, let me just give you an example of that. Cornerstone on demand, which is a company I've worked with since they were founded, was an exceptionally well run company for many, many years. Really did a magnificent job of building a great product and selling and marketing and building a sales force and a service organization all over the world, scaling up the platform underneath it. And then when the company went public and Adam Miller was still there, there was a period of time where the valuation wasn't growing and the financial community basically said to the cornerstone folks, you're doing too much consulting. We want you to grow recurring revenue faster. So Adam actually did a lot of work to sell off and discontinue a lot of the consulting that Cornerstone was doing. I remember that very vividly. And their valuation went up a bit, not a huge amount, but it did go up and they started to look more like a Salesforce type company.
Speaker 1 00:16:41 Well now that they're even bigger and they've acquired Saba and Lumes and they're actually a complex company under the covers, they're starting to scratch their head and say, gee, we need some services to help our customers learn how to use all this. So my message here is that just because you believe the recurring revenue multiple is so high and your investors are dreaming about these massive multiples on the recurring revenue that you're building, I would not hesitate to build a good service organization. It will really help you a lot. It will pay for itself, it will be profitable and it'll make your customers extremely happy and much more loyal to you in most cases, unless you have a more of a low end product that's very self-service. So what am I really getting at here? I know this is a lot of information. I think the bottom line is for those of you that are buyers or consumers of HR technology, when you see a vendor announce a massive funding and a great valuation, it obviously gives you a sense of confidence that this is a company now that has money in the bank.
Speaker 1 00:17:44 They have great board and they have solid investors behind them and therefore they have sustainability. But you have to also reflect on the fact that with that capital comes a and a set of challenges that the management team is dealing with. If you're an an entrepreneur or a an executive, I would just remind you of the same thing. Raising money is a financial event. It's not a business event. It is an important and time consuming process and most CEOs spend a significant amount of time promoting their companies to investors. But eventually you have to generate a profit, as they say in business school, if you've, you know, read the books on capital markets, companies that don't make a profit are worth zero. I know that's hard to believe, but ultimately if they don't ever make a profit, they're never gonna be worth anything. So you have to apply the funding in a way that continues to grow.
Speaker 1 00:18:37 So I'm a big fan. Listen, I'm a big fan of entrepreneurism. I'm a big fan of the business community and all of the creators in the market. The investment community is a massively important part of this industry because the investment community makes decisions about where to allocate capital. I do think we tend to over glorify investors. I think it's the entrepreneurs and business leaders who are really the heroes. The investors sometimes get more credit than they deserve. And just remember the balance between labor and capital. Your company is your people and regardless of how much money you have in the bank, spend it wisely. Build the infrastructure so that every person you hire is an additive value to your culture and your business. Build the operations skills so that you can operate at a higher level. Don't forget where you started. There is a tendency in a lot of entrepreneurs who raised a bunch of money to drift into new areas that they think are attractive.
Speaker 1 00:19:36 Most companies I find are really good at something that they usually found out early in their lives. And Facebook is basically still a social networking company. Google is still a search engine. Apple is still a consumer technology company. Microsoft is still basically productivity tools company. I know a lot of the other things have been added to that, but don't lose your focus on where you started as you get drunk with the investment and the money and all the cash and all the people that you're hiring. I hope this was a good perspective and I look forward to hearing from you. If you have any comments.
