Entrepreneur

What Are the Economics of an Actuator?

Follow us @CITOrg or @dihrie or this blog for current information on the new Smart City Actuator.

Running a successful Actuator, accelerator, incubator or similar early stage investment program requires finding the sweet spot where three sets of economics overlap: those of the early stage entrepreneurial ventures, the investors that support the ecosystem, and the actuator itself.

The economics for early stage entrepreneurial ventures is conceptually fairly gerbil-wheelstraightforward: when does the cash run out, and can I raise enough money before then to keep the company going? In the vernacular, this is the “runway”…how much runway do I have left. And the job of the early-stage CEO is almost always heavily tilted towards fundraising.

Two things make this more palatable. First, a successful accelerator will already include a number of investors in the ecosystem, and the program itself will help the entrepreneur better understand who to approach for funding, how and why. Second (the economic carrot in this plot) is the proverbial “exit.” At some point a successful early stage company starts selling enough product that somebody thinks the company has a great future, or the people are worth collaborating with, or the product is a good strategic fit.gerbil2 At that point they may buy the company, do an “acqui-hire,” or put in enough money that they bring in some new people to help run the company. Oh yes, and occasionally things can even appear so successful that they start selling stock to the public: the IPO.

Investor economics are also similarly straightforward: investors are alwaysreturns looking for good (or great) returns based on the amount of risk they take. Early stage investors make very risky investments, and so expect very good returns for their money. How risky? Well, the attached chart shows that roughly half of all venture investments lose money while only 5% generate about 1/3 of the total returns; not necessarily where people want to put the bulk of their retirement funds, for example.

On the West Coast this has in part led to the great Unicorn hunt, with big money trying to find or create the 1% of that 5% that turns into something like Facebook or the Snap IPO. But it does take big money; if 0.05% of your investments turn into unicorns, $1M investment per attempt takes $2B of investment capital. Things are a little more conservative on the East Coast, and the above chart also shows that half the returns come from investments that yield 2X to 5X the invested capital. And early seed round investments are more like $50K or $100K instead of $1M, meaning that this scales to be a feasible investment strategy for people with high risk tolerance but not quite as much investable capital as Silicon Valley.

For individual investors in this category finding a stream of suitable investments and assessing the risk of each one is a daunting challenge. However the Actuator plays an important role here as well, since a significant part of Actuator activity revolves around creating and evaluating a flow of interesting companies, and reducing the risk of those companies surviving and reaching market. This intermediary role for an accelerator in both reducing risk and matching investors and entrepreneurs is one of the characteristics that can make them so effective.

What about the Actuator economics? To understand that, these entities are best viewed as startup ventures themselves. The ones we have worked with around the country generally have operating costs in the range of $1M – $5M per year, accounting for salaries, facility and other associated operational costs. Where does that money come from? For many it comes from grants, or community or University funding, legislative appropriations or sponsorships, and these sources are critical for establishing and maintaining a program in the early stages.

But is there at least a conceptual model that would minimize or eliminate the need for these external funding sources over time? Yes, and it is very analogous to a startup gaining enough product traction to be self-sustaining on the basis of revenue generated from product sales. The “product” that accelerators “sell” is investment opportunity in early stage ventures. The quality of that product is directly tied to the quality of the incoming ventures as well as the ability of the accelerator to reduce the risk of those investments through mentoring and interaction with a robust ecosystem.accelerator-economics.png

One self-sustaining economic model uses equity investment returns of the accelerator to pay for operating costs, as shown in the figure. It takes 4-7 years or more to realize the value of these investments; the model assumes 5 years. It also assumes $2M/yr operating costs, a dozen investments of $50K per year ($600K total), and a distribution of outcomes consistent with those shown above. So after 5 years, 1/3 (four) of these companies are likely to have failed, we assume four generate 2X ($100K) returns, three generate 5X ($250K) returns, and one generates a 40X ($2M) return. Note that if your initial $50K investment was in exchange for 8% equity and no dilution occurs in between, the company value would need to be $25M for your piece to be worth $2M. As the economic model chart shows, under these somewhat optimistic assumptions (and assuming you can repeat this success year after year) the model can become self-sustaining.

While this is a challenging model, it is also helped by the fact that there are a number of secondary benefits that entice external groups to help defray some of the costs. For later stage investment groups this private source of vetted deal flow is attractive. For Universities the ties to entrepreneurship curricula make it a reasonable extension of those efforts. Opportunities for economic growth often entice legislatures, and strategic Corporate partners may see sponsorship an an inexpensive way to find strategically relevant innovative technologies.

Creating and sustaining a successful accelerator-type program requires the ability to thread the needle in a way that meets the economic imperatives of three major stakeholder groups: the entrepreneurs, the investors, and the accelerator itself. No wonder that many of these programs do not survive when the initial funding runs out. CIT has been fortunate to have both a successful investment experience with early stage ventures over many years, and much better than average outcomes in running accelerator programs directly. This proven success plus great partners, good timing, and a great environment for building business ecosystems is what will help ensure the success of our new Smart City Works Actuator.

Next (Thursday 3/9): Will the Smart Cities Actuator Make Me a Gazillionaire?

 

CTO SmackChat: Minimalism

First published 02/11/14 on MACH37.com

By now, most entrepreneurs have adopted the lean startup principles advocated by Eric Ries in his book The Lean Startup. A key concept is the Minimum Viable Product, the mechanism used to convey your core product ideas to potential early users, and test key market assumptions in an iterative process to ensure that what you finally deliver both solves a problem and can generate enough paying customers to build a business. Of course the hard nut with this concept is figuring out “minimal” and “viable” in a world where your startup may be created based on a good idea and not much else.

I have experienced first-hand a number of the traps that technologists tend to trip over with this concept. The classic one of course is building products that are never quite ready to ship because they need just one more feature. Early in my career I developed a number of highly optimized protocols for satellite-based networks; it turns out that only satellite builders determine the protocols that fly, and the best technology is often not the winner. Complexity is another dangerous siren song – after a few meetings where it takes half an hour for even the friendliest, most perceptive customer to go “aha!” you begin to wonder about the guy who made millions selling those plastic electric outlet covers to prevent toddlers from sticking their tongues in the outlet.

One of my startups embodied all of these traps in a single great idea. Well before iTunes perfected the concept, we built and tested a very efficient delivery system for selling individual movies, songs and other content onto end user devices. At the time, transmission costs were high and credit card transaction costs were also high. We conceived a closed loop where content was aggregated at a central point, shipped over satellite to every TV station in the country, and streamed over the unused bandwidth in HDTV to a small receiver gizmo connected to end user devices that would decode the signal and securely aggregate single transactions into a monthly billing. The actual system was tested in New York, Trenton, NJ, Baltimore and Washington DC, and overnight we could stream enough content to make the top 100 movies, 1000 songs, and other content instantly available to millions of users. Even the back end worked, but in the end I believe I was the only person ever to complete an actual purchase and pay for it on my credit card.

So how do you figure out the Minimum Viable Product? Especially when a company is just starting, the key notion is to get your idea in front of potential customers and see if it solves a problem they care about. At this stage it doesn’t take a lot of development, but just enough to be able to describe the problem and how you address it, the value proposition for the user, and enough of an indication of what a user would see and do to make it feel real. The acid test at this stage is finding a potential customer who indicates that if you can build it, they will try it and eventually buy it. That establishes the “viable”. Beyond that, the “minimal” is driven almost more by schedule than by features. How long will that first customer wait before they forget about you? How much do you have to demonstrate in terms of solving the core problem to entice your customer to take those next steps down the development path with you? In the end, both “minimal” and “viable” are defined by your early customers, not by you. Your job is to make a guess that is close enough to keep those early customers engaged until you are actually in a position to deliver something.

David Ihrie is CTO of MACH37 and has been the lead technical person for six startup companies. He has a BS in EE/CS and an MS in Management specializing in the Management of Technological Innovation, both from MIT.

CTO SmackChat: Technology is not Innovation

First posted 01/08/14 on MACH37.com

In his excellent book “The Idea Factory: Bell Labs and the Great Age of American Innovation”, Jon Gertner quotes Jack Morton, who worked at the Labs on the development of the transistor in the 1940s, saying “[Innovation] is not just the discovery of new phenomena, nor the development of a new product or manufacturing technique, nor the creation of a new market”, but all of these working together to deliver things that make a difference. Or, as one of our investors puts it succinctly: “a business without customers is just a hobby”.

As technologists, we of the nerdly persuasion tend to believe that the tech is the key ingredient in the success of any startup. At MACH37 we talk to a lot of incredibly smart technical people, some with potentially game-changing ideas…but, technology is not innovation. For a startup to deliver products that make a difference it takes a great technical idea, but also someone who knows how to build a business, someone who knows how to turn an idea into a product, and people who can find customers, understand their problems and sell them your idea. Innovation is a team sport.

So, how important is the tech? As we evaluate startups and talk to investors, a large majority consider it essential to have someone with deep technical domain expertise, as well as product development skills, as part of the initial entrepreneurial team. Many of those same people will tell you however that the initial technology contributes maybe only 10% or 20% to the success of the business, that the ability to pivot is critical, that technology almost never creates new market segments. My own rule of thumb is that your going-in idea is always wrong.

Making sense of the contradictions can be maddening…being passionate about your ideas but willing to turn on a dime; knowing what is necessary but not sufficient; being game-changing in a way that’s not too ground-breaking. This is the first of a series of posts to explore these contradictions from the technologist’s point of view. How many features make a product? When do you abandon Rev 1 and start over? When does one product become two? How do you know what customers really want? How far ahead of the market or the product can you be? And once you delegate the product design, and customer interaction and hands-on coding, how do you continue to add value to your organization?

David Ihrie is CTO of MACH37 and has been the lead technical person for six startup companies. He has a BS in EE/CS and an MS in Management specializing in the Management of Technological Innovation, both from MIT.