Its latest figures showing a loss of $1.6M indicate the problems associated with growth. Management is always challenged by the need to invest for growth ahead of the increased revenue.

The reasons for the failure and the implications that might be drawn from the failure are important lessons for marketers who give serious thought to Target Markets.

Before looking at the reasons for failure, it’s interesting to note that the campaign appeared to have a serious commitment to success:

• The duration of the campaign was two years
• A local health worker was assigned to the village to provide education and training
• The health worker made numerous visits to each family where she engaged in one-on-one discussions
• A doctor was made available to help educate the people of the village

In spite of this investment the conversion rate was extremely low – why?

Reasons For Low Conversion Rate

• Culture norms
• Childhood learning
• Who has influence
• Lack of audience understanding
• The strategy

Culture Norms

At the time of the campaign the widespread custom in the village was that sick people avoid extremes of “hot” and “cold” food and liquid. The act of boiling water was seen as taking the “cold” out of the water. Hence only sick people would drink boiled water, healthy people would not.

With hindsight, we can see that the existing perceptions of the audience might play an important part in thinking about how to conduct this campaign, but at the time no account was taken of audience attitudes.

Childhood Learning

People in the village learnt from childhood to dislike boiled water. Indeed from a taste point of view, most would only tolerate it if some flavoring were added. Boiling water was seen as a way to remove the “cold” quality.

Once again, with hindsight, we can observe that the campaign did not take into account this predisposition.

Influence

The health worker targeted individual families and would visit each family to explain the benefits of boiled water and other techniques for improving the quality of people’s lives. Many of the villagers saw the health worker as someone who was trying to add even more work to their already busy lives. Hence the message fell on “deaf ears” for many of the villagers.

Influence – the exception case

One of the housewives who did convert to boiling water did not have the traditional background of the other villagers. This woman had only lived in the village for about a year and was seen as an outsider. Here we see two interesting facets of “communication for change.”

The woman in question had come from the mountains and was concerned about the increased likelihood of illness on the plains where the village in question was located. Thus her predisposition was toward finding ways to avoid ill health.

In addition, she was seen as an outsider in the village and was not subject to the same peer pressure that perpetuated the cultural norms.

The receptivity of this woman’s attitude is another important lesson for people thinking about target markets.

Influence – Who should they speak to?

When you stand back from the whole situation you can see that going directly to villagers who had existing attitudes about boiled water was unlikely to succeed. So this raises the question of who should the health worker have approached? Clearly, she needed to find people who had influence over the rest of the village. This would most likely be the village leaders.

Lack Of Audience Understanding

The health worker was assisted by a doctor in trying to educate the people of the village. They explained about the microbes in the water and how the boiling process killed them. For the most part the villagers didn’t comprehend this for a very simple reason. We all know that people drown in water, so how could microbes survive? – The message didn’t make any sense to them.

The Strategy

With hindsight, we can see that a very different approach would be needed if the message was to “hit home.” Indeed a whole different strategy might have produced a very different result. The very obvious flaws in the strategy were:

• Lack of understanding of the audience
• Inappropriate message
• Message delivered to the wrong people

The example illustrates some of the key points to think about with regard to financing a start-up company, building value, and allocating stock ownership. Points of particular note are:

• When you make stock allocations, balance the dilution and the corresponding value you are buying. Make projections for several rounds of funding to estimate what will be needed in the future. Founders are often shortsighted in their initial stock grants to employees and give away too much, too early, without a real valuation of the company. Evaluate each dilution in terms of the future value it will bring.
• Do some soul-searching and ask yourself how much control you need. Can you continue managing and leading your company even if you do not have the majority of voting shares at the board level? Be careful with this issue. A “for profit” business, in most cases, never gives any one person complete control. Even where a business is owned by one person, they are still accountable to customers—there is no absolute control. Ask yourself, can you work with the investors and any new managers who might join the company?
• Complete all stock negotiations and ownership issues among founders at the outset of the company to avoid any disagreements later on.
• Make allowance for future stock options to provide incentives for new and existing employees.
• Focus on increasing the value of the company. Make this the super ordinate goal and have it permeate every employee’s vision of the future of the company. Note that of necessity, this discussion only considers the “wealth” side of the rewards for starting a company. Other factors (fulfillment, vision, passion, an interest in growing companies) may play an important role in decision-making, but their consideration would make this discussion unnecessarily complex.
  Business plans usually underestimate the amount of money required to complete product development and get to market. Think carefully about projections. Try to avoid increasing numbers by percentage, but rather think about the constituents of the expenditure or revenue and estimate how much is required.
• Be realistic in making market penetration/sales growth projections. Use “S” Curves to help think about market ramp up and exploding growth. This is particularly important when thinking about cash flow, which is the “lifeblood” of a start-up business.

Conclusion

One of the motivators for founders and employees of a high tech startup is to make significant amounts of money from the appreciation of company share price. To reach this goal, founders and management must focus on maximizing the value of the company at all stages of its growth.
Dilution appears at first sight to be a negative effect, but instead should be seen as an investment process in which every time the stock is diluted there is value added to the company. Stock options to new employees should be based on clear expectations that these new team members will increase the value of the company through their contribution. Taking additional investment or granting stock for strategic partnerships should be viewed through the “lens of added value.” To help with the decision making process, simply ask the question, “If it doesn’t add value, why are we doing it?”
This philosophy of adding value can percolate down through all parts of the company to all employees. As owners they can be directly involved in asking questions about how the investment of cash or stock will increase the company value. In their own role in the company they can be asking themselves, “How am I adding value to this company?” which is a far more powerful question than, “Did I do my job today?”
The bottom line is value, and if you are not delivering value, then why are you in business?

The company has now raised an additional $60 million for future growth and expansion. In addition, anyone who owns shares now has an opportunity of selling them in order to realize personal gain; however this is done with some caveats:
After an IPO, SEC regulations require that insiders cannot sell stock for six months.
When insiders sell stock, then others outside the company might ask why this person wants to sell if it represents a good investment. Thus, selling stock can send the wrong signals to the public market and depress the share price. Notice in the example that the shares for the public market did not come from existing shareholders, the intention being to send a strong signal to the market that “this is a valuable stock, and knowing what I know I expect it to rise to much higher value in the future.”

The mezzanine round is completed raising $9 million at $9 a share. Notice that if we price all outstanding shares at $9, then the value of the company is approximately $156 million. With sales at $50 million per annum, this gives a ratio of value to revenue of approximately 3:1.

Table 6 - Funding For Mezzanine Round

The applications for the product are far wider than first anticipated and the company grows more rapidly than expected, but this brings new concerns. The company must now defend its position and attempt to stop any competitors from developing a “beachhead” into the market. To fund future investment opportunities, the company decides to seek a further capital infusion through public investment. With this action the founders will complete one of the “outcomes” they envisioned when the company was started.

Second Round Funding

Product development continues, but as so often happens, challenges arise and the company misses deadlines. This delays the product roll-out, which in turn delays initial revenues. Now the company faces a cash flow problem as well as a lot of strategic problems, such as losing market share because they will be late to market. The investor insists that it’s important to get into the market as early as possible, and requests a revised business plan showing how time lines can be moved up with the additional funding. The new plan indicates a need for an additional $15 million investment. In spite of founder objections about further dilution, the board agrees to seek the additional funding; this is the second round.

Valuation and the Second Round

Table 5 - Second Round Investment

Once again the board has to estimate the value of the company so that it can set a share price for the second round of financing. Since the company has met key development milestones and has an experienced management team, the risk of the investment is being reduced. This leads the board to expect a significantly higher company valuation. Significant signs of success might be demonstrating that the technology can be productized, that beta site customers are being signed up, and that no unforeseen significant problems have been discovered. The board assesses that although there is slippage in the development schedule, everything is going according to plan, and they decide to offer shares at $6. Notice how the price to get into this deal has escalated from the original 2 cents with high risk, to a present $6 with much reduced risk.
The initial investor decides to put a small amount into this next round, but asks the team to seek another investor to help spread the risk. The experienced management team has little trouble securing this additional investment. Table 5 shows the resulting dilution when this second investment is completed.

Growing Value

Notice that the ownership share of the founders has now shrunk to 7% but the value of their equity has risen to $6M each.

The technically biased founders are keen to start product development, but their adviser counsels that the seed money will quickly be consumed and stresses the need to always try to anticipate future financial requirements. Two of the five founders take responsibility for seeking and raising additional funding while the others begin product development.

Through their networking and PR activities the two founders find a venture capitalist (VC) that will invest $10 million in the first round, but with conditions. He thinks the product idea is good and the founders technically strong, but the team lacks management skills. He offers the investment on the following conditions:

• Bringing in key managers, including a CEO, CFO and VP of Sales and Marketing
• Ownership of 51 percent of the company

Table 2

Note that after this first round investment, 51 percent of the company is valued at $10 million. Hence, the value of the company is now approximately $20 million (see Table 2).

Valuation and First Round Funding

The founders discuss with their advisor how much of the company they will have to sell for the $10 million. Unfortunately for our fictitious team, they lack management skills and a track record of starting and building companies. Investors focus on: i) The Team, ii) The Market, and iii) The Product Idea. Most investors consider the team to be by far the most important—common sense dictates if the team has good business sense, they will be in a good market with a good product. The value the founders bring is reduced because they do not a have strong management team, and this is reflected in the investor demand for 51 percent of the company.

So now the founders are faced with the opportunity to get the investment they need, but it will cost them control of the company. What should they do? For some people this can be a hard decision, one that should clarify their commitments. Their adviser points out that they still have a lot to learn about running a company and much of that can be acquired in the current enterprise. He suggests that if they can successfully grow this company and take it to an IPO, it will leave them with the experience and the resources to start other companies. In effect, they are getting paid to learn and still have an opportunity to significantly increase their personal wealth. The cost is giving up control. After long deliberations, they decide to accept the funding offer.

Dilution

Selling part of the company creates dilution of ownership. After the investment, each founder’s ownership share has been reduced from 20 percent to 10 percent, but the value of their holdings has not changed. Each now owns 10 percent of a $20 million company, whereas previously each owned 20 percent of a $10 million company. In the future, as the value of the company increases, so will each founder’s stock value.
Dilution may appear at first sight to be an undesirable sacrifice, but that perspective is very limiting and can sometimes restrict a company’s growth. There are two factors which need to be carefully balanced when selling part of a company: the amount of ownership sold, and the value which is bought by the sale. The goal is to make sure that when stock is sold, the dilution effect is offset by an increase in company value. For example stock may be sold in return for an infusion of capital, the addition of key employees, or the addition of some critical asset like a strategic partnership.

Table 3 - Effects Of Dilution

The addition of the new managers is a good example of dilution bringing increased value. Three key managers are to be added to the team: a CEO, CFO and VP of Sales and Marketing. Since each of the managers hired has previous start-up experience, they will expect to make a substantial amount of money over and above their normal compensation. The total equity required to capture these three critical managers is 15 percent. Table 3 illustrates the result of adding these managers to the ownership list.

What is not shown “on paper” is the value that this team has added. This might easily be seen by considering future investment requirements. When more money is needed, new investors will take a strong look at the management team. It must meet some minimum requirements; but above that, the more prestigious the team, the more likelihood of a higher future valuation.

Stock Incentives

Table 4 - Dilution Effects Of Employee Pool

Attracting and retaining new employees will require a stock option plan. As part owners of the company, people can feel that their efforts are making a difference, both to the company and to their own net worth. This provides great motivation for employees to make maximum possible contribution
Unlike founders’ stock, the options program provides an opportunity for employees to capitalize on the growth in value of the company without such a high risk and high degree of commitment. With a stock option plan, employees are granted the option to buy stock at a fixed price. When the shares are traded on a public market, if the share price rises above this purchase price, there is an opportunity to realize substantial gains. Such options usually “vest” over a period of time, allowing employees to buy their options at the set price once they are vested. By setting this vesting period in the future, the company can use “Golden Handcuffs” to retain the committed contribution of employees.
These “golden handcuffs” are important in the attraction and retention of key talent. It is important to note that such stock options are created by setting aside a pool of shares from which options can be allocated. The dilution effects of such a pool are shown in Table 4.

The Seed Round

Imagine that five people start a company that intends to provide a knowledge management tool to help criminal justice agencies solve crimes. The unique selling proposition will be the ability to convert data to knowledge, and then use AI techniques to develop scenarios for how a crime may have been committed. Financial projections indicate a need for a $10 million investment to complete product development, initial marketing and staffing.

The five founders enlist the help of an executive coach to help them think through the important issues in starting and managing their new company. The coach begins by counseling them on developing their vision, goals, and objectives and then reviews the stock structure and ownership.

With regard to each founder’s company ownership, their coach suggests that before any other stock is sold or promised, they must make an agreement on the number of shares each founder will own. He argues that delaying this until after the company has grown or other people are involved can create friction among founders.

Seed Round Funding

They incorporate as a “C” corporation and authorize 21 million shares. Each person agrees to make an initial investment of $20,000 with a share price of 2 cents, giving each founder 1,000,000 shares (see Table 1). This is the seed investment of $100,000.

The coach, with an eye on quickly building company credibility, suggests that they form a board of directors comprised of two of the founders and three industry/business experts to assist in guiding their decision-making.

Maximizing Founders Returns

Why would you want to sell part of your company? After all it’s more complicated to run a jointly owned company; you might lose control and possibly your position at the company. Why do it? The answer is simple – leverage! A company that is appropriately capitalized has a much better chance of success.

So for founders who decide that the investment route is the appropriate business strategy, what is the path to investment and how does it work?

The purpose of this white paper

This white paper is intended to help people unfamiliar with the investment process understand how it works and provide some suggestions on the decisions facing founders as they grow the company.
The key points presented in the paper include:

• Focus on Value Building
• How value is reflected in share price
• The dilemma of dilution as funding and staff are increased
• Critical stock calculations
• Why value building is the superordinate goal

The treatment is intentionally simplistic and readers should consult with their CPA, attorney, and stock plan consultant to develop their own cases.

The Format Of The Paper

To illustrate the points of interest, the following scenario describes a fictional start-up company and shows how the owners deal with some of the questions of stock and value as they progress from start-up phase to an IPO. The example does not represent a typical case, but is rather a compendium of some of the perplexing problems that founders might face.

Founders that elect to use the investment model to grow their company face a myriad of decisions, including:

• How much money will be required
• When investment is needed
• The best source of money
• How much of the company they must sell to raise the necessary investment
• Selling more than 50% of the company means giving up control; making a decision on whether that is palatable

Dell’s success was largely based on its radically different business model. Where other companies were using stores to sell their products, Dell launched with “telephone sales.” It’s ironic that after 30 years, Dell is attempting to build stores that emulate Apple – a departure from this once winning philosophy.

The lesson here is not so much about Apple’s success, but how the “value” component for customers can change. The challenge is to keep an eye on shifting values and perhaps, more importantly, look for new opportunities to deliver value.